In association with

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Foreword

With new regulations coming into effect in the United States from the Dodd-Frank Act, change is underway for the FX market as participants support new requirements for reporting, clearing and swap execution facility trading. Following the lead set in the US, we expect further clarity on regulations to emerge from Europe and Asia this year. In these times of change, exciting growth opportunities and new products are available that institutional clients can take advantage of to increase the efficiency of their foreign exchange trading.

We begin this year’s best practice guide with an update on the regulatory changes taking place in the US, including detailed recommendations on actions market participants need to take and an implementation timeline. We then explore how markets are changing in rapidly developing economies around the globe through increased investor interest and technology access. With the rise of the Chinese renminbi as an international currency and the electronification of local and non-deliverable forwards markets, there are significant growth opportunities in newly industrialized nations. Next we examine the benefits of new trading technologies that are being embraced by market participants. These include electronic multi-bank options platforms, execution algorithms and transaction cost analysis tools. An article on leveraging liquidity channels to achieve best execution details the advantages of different trading venues, from disclosed relationship trading to anonymous active trading channels. We conclude with an analysis of the technology challenges liquidity providers are tackling to balance client needs while effectively managing risk.

As the FX market continues its transformation, FXall continues its own evolution as part of Thomson Reuters to meet the comprehensive foreign exchange execution, workflow and insight needs of its institutional clients. We remain active advocates for the global industry, encouraging prudent implementation of new regulations. We will continue to work closely with all market participants to deliver a best of breed customer trading solution with the most influential community and deepest liquidity guiding our clients through the evolution of the FX market.

Phil Weisberg, CFA

Global Head of FX, Thomson Reuters

Opportunities in a rapidly changing market Best practices evolve with the new FX landscapeContents

Foreword 1

Regulatory update - Increasing transparency in OTC derivatives trading 2

Timeline - CFTC implementation of the Dodd-Frank Act 8

Currency markets evolve in rapidly developing economies 9

New FX tools enhance execution performance 14

Leveraging liquidity channels to optimize execution 18

Technology challenges facing liquidity providers 22

Contacts 25

For best practice codes of conductwww.bankofengland.co.uk/markets/forex/fxjsc/index.htmwww.aciforex.com

Although each of Euromoney Trading Ltd and FX Alliance, LLC has made every effort to ensure the accuracy of this publication, neither it nor any contributor can accept any legal reponsiblity whatsover for consequences that may arise from errors or omissions or any opinions or advice given. The publication is not a substitute for professional advice on a specific transaction.‘Best practice in foreign exchange markets’ © 2013 FX Alliance, LLC

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At its Pittsburgh summit in 2009, the G20 made a commitment to financial market reform, stating that all standardized over the counter (OTC) derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs). In addition, the G20 said OTC derivatives should be reported to trade repositories and non-centrally cleared contracts should be subject to higher capital requirements.

The US Treasury decided in November 2012 to exempt FX swaps and forwards from certain regulation under the Dodd-Frank Act, freeing them from mandatory clearing and exchange trading requirements. FX options, non-deliverable FX forwards and cross-currency interest rates swaps, however, will be subject to mandatory clearing and have to be traded on a swap execution facility (SEF).

Regulatory update – Increasing transparency in OTC derivatives tradingWhile deadlines for finalizing and implementing new derivatives trading regulations continue to shift, end-users must prepare for change

In order to trade what the US authorities define as a swap under the Dodd-Frank Act, end-users and their banks will have to comply with external business conduct (EBC) standards which aim to increase both pre- and post-trade transparency. Under these standards banks will have to agree and sign protocols with end-users designed to better inform them about the full implications of their trading activity.

“EBC standards were established with the goal of making the bank responsible for educating its customers so that they understand the risks of what they are trading,” says Jodi Burns, head of regulation, post-trade networks and market intelligence for Marketplaces at Thomson Reuters. “It also increases transparency through more explicit documentation. The effort required to comply with the rules is large, given the amount of documentation that needs to be re-signed between a bank and its client: so-called re-papering.”

The deadline for implementation of the new proposals is now 1 May 2013, after it was pushed back from October 2012, and many believe it will be extended again. Despite the rules being finalized in April 2012, banks report that as few as 5% of their clients have so far re-papered. Burns says that end-users need to realize the urgency of the situation and ensure that they comply with the regulations, or risk being unable to hedge their currency exposure on the swaps market after the cut-off date.

“My advice for clients is to move forward with it. While it may seem like an annoyance with no apparent benefit, they should complete the work because the banks may not be allowed to trade with them any longer. It won’t be because they don’t value their relationships, it will be because the banks’ hands will be tied,” says Burns.

Howard Tai, senior analyst at research and advisory firm Aite Group, says, “Neither the regulators nor the market participants are prepared for the implementation of Dodd-Frank’s EBC standards, that’s why the deadline has

Jodi Burns, head of regulation, post-trade networks and market intelligence, Marketplaces, Thomson Reuters

Howard Tai, senior analyst, Aite Group

What are the different requirements for FX instruments under Dodd-Frank?

Instrument Reported to Swaps Data Repository

(SDR)

Cleared Traded on Swaps Execution Facility (SEF)

FX Options

NDFs

FX Swaps

FX Forwards

FX Spot

Note: Blocks are required to trade under SEF rules and be reported to a SEF, but are not subject to specific execution requirements, such as RFQ to a minimum number of providers

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been postponed twice previously. There are over 20 sets of requirements under this set of EBC standards and many of them are not easily quantifiable. I would encourage the regulators to go gently on enforcement once the 1 May deadline has passed, rather than drawing a hard line in the sand. It’s best that they spot-check for individual entities’ progress towards compliance over time.”

Uncertainty remains for SEF rules and European regulationsAside from complying with EBC standards under Dodd-Frank, the challenge for end-users of the FX market is that while the big picture goals of regulation are in place, regulators are still hammering out the details. In the US, the Commodity Futures Trading Commission (CFTC) has missed numerous deadlines for the publication of the final rules on SEFs, even though draft rules were first published in early 2011, causing frustration for those looking to launch SEFs and confusion among end-users.

This confusion is exacerbated by differences between the US and European regulations. The analogous European regulation to Dodd-Frank – the European Market Infrastructure Regulation (EMIR) – does not contain a statute allowing the regulator, the European Securities and Markets Authority (ESMA), to rule on an exemption for FX swaps and forwards from central clearing. ESMA is likely to follow the US lead, but clarity is still needed around the Basel III proposals from the Basel Committee on Banking Supervision (BCBS) which could impose mandatory variable

margin and initial margin requirements on un-cleared FX products like swaps and forwards.

“The biggest challenge for the market is preparing for regulation when a lot of the regulation has not yet been defined,” says Robin Poynder, head of market insight at Thomson Reuters. Poynder believes that end-users need to be more engaged in the process of regulation than they have been to date. He says they have relied too heavily on banks to guide them through the process of regulation and clearing requirements.

End-users not only need to prepare for the coming regulation, according to Poynder, but also to recognize that there is still time to lobby regulators and influence how the rules will be applied. “Regulation directly affects the buy-side in terms of how they trade, their trading models, their cost of capital as well as their cost of execution,” he says. “The primary aim of legislation is to protect end-users’ access to the market. Unequivocally, there are elements of regulation as it stands that will hurt the end-user in terms of their ability and cost of execution.”

Poynder cites the fact that the amount of margin that is put up for non-cleared trades, both in terms of initial margin and variation margin, has been proposed to sit between 2% and 15%. Even if a bank’s return on equity for entering into the trade were a generous 3%, then having a collateral cost of 5%, for example, would mean it was not worth doing the transaction. If those collateral calibrations are set higher than the return for a bank, the bank has two choices: not to price the trade or to pass the cost on to its customer.

Trade reporting rules, especially in markets that are illiquid, could lower the incentive for banks to price a trade. As other participants in the market will know the details of a deal 30 minutes after it is transacted, market makers will either have to hedge their position quickly or take the risk on to their books long term. In either scenario, that is likely to mean wider spreads for end-users. It is possible under these circumstances that if a bank’s cost of business goes up, these costs will be passed on to customers as the bank tries to maintain its profitability.

Aite Group’s Tai says, “Looking down the road, buy-side trading costs for executing OTC derivatives will inevitably go up, particularly due to posting higher margin and compliance-related costs. This is not necessarily a bad thing – it will force buy-side portfolio managers and traders to thoroughly examine and prioritize their

Robin Poynder, head of market insight, Marketplaces, Thomson Reuters

Reporting    

•  Trades on a SEF (Swap Execution Facility) -> SEF will report •  Non-SEF trades that are cleared -> Clearing firm will report •  Non-SEF trades that are not cleared -> -SD (Swap Dealer) reports all trades where it is counterparty -If there is no SD counterparty, MSP (Major Swap Participant) reports the trade -If there is no SD or MSP counterparty, ECP (Eligible Contract Participant) reports the trade •  Regardless of who reports your trades, you must register as an ECP with the DTCC (Depository Trust & Clearing Corporation) and obtain a LEI (Legal Entity Identifier)

Clearing    

•  NDF (Non-Deliverable Forward) trades (and in the future, options) in mandatory cleared currency pairs must be cleared, unless you utilize the End-User Exception •  If your trades need to be cleared you must establish a relationship with a clearing firm or prime broker •  Non-financial ECPs must decide whether to pursue the End-User Exception, which provides relief from mandatory trading and clearing requirements

SEF Trading    

•  ECPs that do not qualify as End-Users must join a SEF to trade their NDFs (and in the future, options) in mandatory cleared currency pairs •  ECPs that will use the End-User Exception for some trades will need to join a SEF and notify the SEF of clearing broker relationships •  If you use a SEF’s RFQ (Request for Quote) mechanism to trade non-block NDFs, you must RFQ to a minimum number of providers

As  an  ins'tu'on  trading  FX,  what  do  I  need  to  do?  

As an institution trading FX, what what do I need to do?

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investment strategy prior to using these instruments, thereby eliminating some of the excessive speculative elements from the OTC marketplace.”

Market concerned over the futurization of swapsAnother concern over the new regulations as they stand is the so-called futurization of swaps, which could mean that, counter to the original intention of the legislation, end-users are less likely to fully hedge their exposure. The prospect arises from the potential regulatory arbitrage between the CFTC’s existing rules for the futures markets and the partially complete swap rules under Dodd-Frank. As the SEF rules have not yet been finalized, futures exchanges have been given a head start to eat into the swaps business.

Under current proposals, swap trades will be set on a minimum initial margin based on five days trading, against one day for futures. This effectively doubles the amount of margin required for swaps over that for futures. This change has prompted futures exchanges to launch swap futures, products which start trading on a futures exchange but clear to a swap in the end. Block trading rules also favour futures. These allow investors to bypass the normal price transparency rules with exchanges able to set their own size limit. In order to encourage business in the energy sector, for example, futures exchanges have set block sizes low, sometimes in single digit contracts.

Wayne Pestone, chief regulatory officer at FXall, says under SEF rules for swaps, block sizes are likely to be larger, creating further incentives to use the futures markets. The problem is that futures, although potentially cheaper than swaps, may not perfectly hedge an end-user’s exposure because they are more standardized. In FX, for example, swaps can be customized to any date. A corporation that has a contract due in 17 days can hedge its currency risk to the 17th day. In futures, unless there is enough interest, contracts for those odd dates are not going to be listed, so a corporation will only have the choice of hedging with, say, 15- or 30-day futures contracts.

“Not only will futures end-users be unable to perfectly hedge and forced to assume more risk than they previously did when trading in the swaps market, that risk will be absorbed by the segment of the market that is least likely to absorb it,” says Pestone. “Corporations who trade treasury as a by-product of what they actually do are not supposed to be the ones that are absorbing risk in the market. That is a bank function.”

Pestone believes that the authorities should even out the potential for regulatory arbitrage and have the same rules regarding margin requirements and block trades for futures and swaps. Furthermore, he says there should be a moratorium on new swap futures products until the details of the SEF rules have been put in place. “There might not be any swaps left to trade by the time SEFs are up and running,” warns Pestone.

Burns believes there should be more recognition at the CFTC that as a result of the Dodd-Frank Act, it is now regulating two markets – futures and swaps – that are profoundly different. “These markets should not be forced to converge into one model. Regulators need to be mindful about the consequences of imposing a rule in one market without thinking about the ramifications for the other market. If they are not careful, in their effort to clean up the swaps market – which will likely benefit from some improvement – it could be killed. That would be a bad thing; nobody should feel proud about that.”

Wayne Pestone, chief regulatory officer, FXall

Swap Dealer (SD) Companies in the business of buying and selling swaps. Intended to include banks/dealers, but could apply to very active traders. Includes anyone doing more than $8b non-hedged swap transactions annually

Major Swap Participant (MSP)

Companies with sufficiently large positions (excluding hedging or mitigating commercial risk) to pose systemic risk to the market

Eligible Contract Participant (ECP)

Financial or non-financial companies that don’t qualify as SDs or MSPs. Non-financial companies and small banks (less than $10b in assets) can qualify for an exemption from clearing and trading mandates

US Persons Any company or subsidiary whose trading impacts the US economy, and is therefore subject to Dodd-Frank

End-User Exception (EUE) Non‐financial entities may elect to use the “end-user exception” to the mandatory clearing requirement for mitigating commercial risk

Commodity Futures Trading Commission (CFTC)

The US regulator charged with implementing and enforcing Dodd-Frank (enacted by US Congress)

Swaps Data Repository (SDR)

Data warehouse to which all Dodd-Frank trades must be reported (and provided to CFTC to regulate OTC markets)

Designated Clearing Organization (DCO)

Clearing houses

External Business Conduct (EBC) Standards

Dodd-Frank rules that apply to SDs and MSPs when trading with counterparties, including special entities

 Dodd-­‐Frank  Glossary  

Dodd-Frank Glossary

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Timeline - CFTC implementation of the Dodd-Frank Act

Currency markets evolve in rapidly developing economiesInvestors seek growth opportunities in newly industrialized countries where markets are changing rapidly with the gradual removal of capital controls and increased market electronification

Matt O’Hara, senior VP, global head of business development, Marketplaces, Thomson Reuters

Since the collapse of Lehman Brothers and the ensuing economic downturn in the developed world, investors have turned to Asia and Latin America to lead the recovery. Economic advancement, both in terms of rising trade flows and an increase in financial market sophistication, goes hand in hand with a growing need to hedge currency risk.

“When we look to the future, there is a lot of opportunity out there,” says Matt O’Hara, global head of business development, Marketplaces at Thomson Reuters. “Investors in the developed markets are looking south and they are looking east.” O’Hara believes there are fantastic growth opportunities for currency trading in Latin America – not just in Brazil, but also Chile, Colombia, Peru and Mexico – as well as Russia, Turkey and Africa.

O’Hara also sees growth potential in Asia, particularly China, but also India, South Korea, Malaysia, Thailand, the Philippines, and Indonesia. “These are all areas we are focused on, where we anticipate growth in the future,” he says. He believes that there will be a revolution in the way currencies are traded in the developing world, with volumes growing as investors move from voice to electronic trading.

The increase in electronic trading in these countries is a result of investment in trading infrastructure by local banks. These banks were relatively untouched by the financial crisis which engulfed their peers in developed markets.

In Brazil, banks have thrived as the economy is relatively closed. And thanks to strong credit ratings, Brazilian banks are investing in their businesses in an attempt to move from being a customer of the large tier-one banks in the US and Europe towards being a competitor. Within Brazil, banks are investing heavily in technology in order to access markets directly and to improve distribution to their clients. They hope to steal a march on US and European banks which are not yet established in this market.

Timeline  –  CTFC  implementa-on  of  the  Dodd-­‐Frank  Act  

Jun Aug Sep Oct Nov May Dec

2013

Publish final SEF & Made Available for Trade rules

SEF approval

Clearing determinations finalized for FX

Earliest date for SEF

applications

*ALL DATES ARE BEST ESTIMATES AS OF THIS GUIDE’S PUBLICATION AND MAY BE SUBJECT TO CHANGE

Clearing determinations proposed for FX

Jul

FX SEFs responsible for NDF trading,

reporting to DCOs and

SDRs

Timeline - CFTC implementation of the Dodd-Frank Act

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Hedging currency riskThe move towards e-commerce is likely to be repeated across the developing world, allowing it to benefit from the associated improvements in currency trading execution and workflow practices that have long been enjoyed in developed nations. As most of these emerging economies employ capital controls, offshore hedging must occur in the OTC non-deliverable forwards (NDF) markets. NDF trading, which is also conducted over voice or banks’ single dealer platforms, is set for some major changes due to regulation emanating from the Dodd-Frank Act in the US.

These new regulations will mean NDF trades will be subject to central clearing and reporting and certain trades will have to be conducted on a swap execution facility (SEF), a significant change from what until now has been a relatively opaque market. As a result, NDF trading will become increasingly electronic and transparent, a move that could benefit end-users.

Jonathan Woodward, head of new sales, Asia at FXall, believes that regulation will make trading NDFs a lot more transparent, with the electronification of the market enabling

clients to hit open order books, making price formation a lot easier. He says at first there may be a shrinkage in the market as electronification causes deal sizes to fall, but as high-frequency investors become more active, volumes and transparency will increase and the quality of execution for clients will improve.

But Mark Johnson, global head of cash trading at HSBC, doubts whether the increased transparency will benefit customers, especially those looking to trade illiquid currencies. He argues that the reporting requirements will mean market makers have little incentive to hold risk in these markets if all market participants know the details of their positions. As a result, spreads will widen for the end-user, and these increased costs will eventually feed through to the person on the street, exactly who the authorities are trying to protect with the regulation.

“For bespoke tenors in illiquid currencies, if the market is too transparent, then the

risk mechanism will start to falter. Ultimately, clients want an efficient risk transfer, and this regulation will potentially be counterproductive,” says Johnson.

China and currency internationalizationChina is among the countries expected to be major contributors to global growth over the coming years. In the currency markets, the push to internationalize the renminbi has accelerated faster than many had predicted, as the Beijing authorities have sought to reduce the country’s reliance on the dollar.

Recent steps to liberalize China’s current account have prompted some observers, such as HSBC, to predict that the renminbi will become fully convertible within five years.

Evidence of China’s desire to internationalize its currency can be seen in its efforts to boost the use of renminbi in trade settlement. China has signed bilateral currency swaps with a range of countries worth RMB 1.3 trillion – effectively allowing the country to avoid the use of the dollar.

Furthermore, a pilot trade settlement scheme introduced by the Chinese government in 2009 has expanded rapidly. In 2011, trades settled in renminbi quadrupled to reach RMB 2.1 trillion, around 9% of China’s total trade, then rose to 13% by the third quarter of 2012. Deutsche Bank predicts it will hit 15%, or RMB 4 trillion, in 2013.

Alongside efforts to increase the use of the renminbi in trade settlement, the development of the market in offshore renminbi, or CNH, has also been a driver of Beijing’s efforts to internationalize its currency.

Renminbi deposits in Hong Kong have seen rapid growth. They rose from RMB 63 billion at the start of 2010 to RMB 550 billion in the middle of 2011 according to the Hong Kong Monetary Authority (HKMA). That pace of growth has slowed, with deposits climbing to RMB 603 billion by the end of 2012. The HKMA says the pool is liquid, sustained by market forces and supporting a wide variety of financial intermediation activities.

Offshore renminbi boomingThe offshore renminbi business is booming, with the outstanding amount of dim sum bonds rising 62% to RMB 237.2 billion in 2012, while renminbi bank lending rose

Flag Country ISO Code

Projected 5Y Annual GDP Growth Rate*

Argentina ARS 3.3%

Brazil BRL 6.8%

Chile CLP 8.8%

Colombia COP 6.4%

India INR 21.2%

Indonesia IDR 12.6%

Israel ILS 6.2%

Malaysia MYR 10.3%

People's Republic of China CNY 12.0%

Peru PEN 8.6%

Philippines PHP 8.8%

Russia RUB 10.5%

South Korea KRW 8.3%

Vietnam VND 10.4%

Common non-deliverable currencies

Jonathan Woodward, head of new sales, Asia, FXall

Mark Johnson, global head of cash trading, HSBC*Based on IMF GDP growth estimates from 2012 to 2017. The average

five-year annual projected growth rate for G7 member nation is 3.2%.

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157% to RMB 79 billion. Renminbi financial products have also become more diverse, with renminbi futures and A-share traded funds launched in the market.

The increasing sophistication of the renminbi market has sparked rapid growth in the CNH FX market as investors look to hedge their currency exposure. HKMA estimates daily turnover in CNH has reached $5 billion. While that is a small fraction of a global FX market that turns over $4 trillion a day according to the Bank for International Settlements, the CNH market is growing fast.

Thomson Reuters says daily volumes in CNH trades across its platforms hit $1 billion for the first time in January 2013, up from just $100 million in 2011.

FXall’s Woodward expects aggressive growth in the CNH market over the next five years, with its share of global trading volumes rising from just under 1% today to over 5%. With more banks quoting CNH, there is increased demand. “As we see more securities and other types of investment being listed in renminbi, then we are going to see greater flow as more asset managers investing in those products look to hedge their currency exposure through CNH,” he says.

Full convertibility would clearly be a game-changer for trading the renminbi, an event that is looking increasingly likely in the coming years. “I would not be surprised if the renminbi were nearing full convertibility by 2017/2018,” says Woodward. “After that the sky is the limit and it will become the second or third most traded currency.”

Currency convertibility likely for many emerging markets Full convertibility would effectively kill the offshore NDF market in renminbi, but until then, it remains a significant source of liquidity for investors looking to hedge their exposure or speculate on the direction of the currency.

Still, as trading volumes in the CNH market have been growing, volumes in the renminbi NDF market have been declining.

Johnson from HSBC believes that once China opens up its borders, it will only be a matter of time before other Asian countries, such as Malaysia, Taiwan and South Korea, follow suit in order to compete. He believes India and Brazil, where daily NDF volumes are estimated to stand between $5 billion and $10 billion, may also consider allowing full currency convertibility as they weigh up the merits of having an offshore market in their currencies over which they have no control.

“Some might see it as a threat to the NDF market, but it is obviously not a threat to the FX market because it makes trading simpler if everything is deliverable,” says Johnson.

For now, however, Johnson says the NDF market is here to stay for offshore investors wishing to speculate or hedge in currencies that are illiquid or subject to capital account restrictions.

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The FX market has changed dramatically over the past decade as institutional clients have adopted electronic trading technologies. Today, the market continues to evolve with an increased focus on regulation, transparency and best execution. In order to meet new requirements and stay ahead of market trends, FX participants are embracing new electronic solutions that best support their needs.

New multi-bank options platforms The latest technological advances in the FX market are making a diverse set of tools available for a new wave of customers. That is particularly true in the options market, historically the preserve of large, sophisticated investors and traders, where the development of electronic trading is helping to level the playing field.

FX options have traditionally been traded over the phone or through bank single-dealer platforms. To receive multiple prices for an option order, customers would have to reach out to liquidity providers separately, which can be a time-consuming process. The advent of multi-bank electronic platforms for option trading has introduced new efficiencies and innovation to this previously manual market. Now, with banks streaming prices over multi-dealer platforms, price discovery has in some cases become instantaneous, allowing customers to choose quickly with whom to trade. Electronic trading is also less cumbersome, and can help improve trade workflow, by reducing input and payments errors.

Eric Jawitz, head of options at FXall, believes the electronification of the options market will push customers, such as corporates, to move away from using forwards to cover their exposure in favour of options. This shift will increase the efficiency of institutions’ currency hedging strategies. “For corporations that are set up to trade options, the back office has been an impediment for them,” he says. Electronic platforms can now make it easier for clients to execute, match and confirm option trades, streamlining these previously challenging tasks. “By simplifying the trading and back office process for them, we are seeing more corporates start to think about using options where they weren’t before,” he says.

New regulations, such as the Dodd-Frank Act in the United States and the Markets

New FX tools enhance execution performanceTechnological advances are improving price discovery and trading efficiency, attracting more risk-averse end-users into the FX market

in Financial Instruments Regulation (MiFIR) in Europe, will require options to be cleared in the future. Mandatory clearing is likely to reduce settlement risk for options, encouraging and increasing their use.

While most electronic options platforms are currently offering vanilla options, in the future more complex products, such as barrier options, are likely to be traded. Currently multi-bank platforms support trading of: puts, calls, zero-cost option strategies popular with corporates, such as collars or risk reversals, straddles, strangles, spreads, seagulls, and any multi-leg option that a customer wants to put together.

Clients can also trade strips of options and synthetic forwards. “When you start getting into strips, these take a long time for a person to price, but a system can price instantaneously,” says Jawitz. As users are able to realise the benefits of trading options electronically, trading this way is likely to become more common and fully integrated into customers’ workflow.

Transaction cost analysis Technology is also helping to improve trading efficiency elsewhere in the market. The increased use of transaction cost analysis (TCA) shows that investors are increasingly focused on extracting the best possible value from their trading activity. A recent survey by Greenwich Associates found that the number of FX trades using TCA increased to 33% in 2012 from 28% in 2011. Furthermore, of those institutions with assets of more than $20 billion, 41% use TCA.

The driving force behind adoption of TCA for FX has been an increased focus on cost saving across the financial community. Recent media attention and legal scrutiny involving US pensions funds dissatisfied with FX pricing has also increased the move to new models for analysis. The challenge with FX trading has been that there was no benchmark for price and volume at any particular point in time as there is for exchange-traded instruments such as equities. However, the advent of electronic trading platforms in FX has recently made that data available, improving transparency.

Phil Weisberg, global head of FX at Thomson Reuters, says institutions are being increasingly held to account over how they transact their FX business. “Customers generally have fiduciary responsibilities: if they are asset managers, to the people whose assets they manage; or if they are corporations, to shareholders. In the

Eric Jawitz, head of options, FXall

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FX market, access to transaction data traded on electronic platforms can be an advantage. Data can be compiled to protect anonymity while also being a reference source for the market,” he says.

Customers doing enough business through multiple execution mechanisms over a platform can review analytics around volume and price, as a function of trade size, at any particular time. This can provide insight into the best price for the interbank market and the best price available to customers, which is the most relevant factor.

Algorithms are increasingly popularThe focus on TCA and obtaining best price is driving the increasing use of algorithms as an execution technique in FX. Long established as standard practice in the equity markets, algorithmic execution strategies allow computer-driven models to conduct trades on behalf of customers. Currently, it is estimated that between 5% and 10% of institutional investors are using algorithms to execute FX transactions. Some believe that when peer group TCA reveals the benefits of using execution algorithms, that adoption rate will accelerate markedly.

James Kwiatkowski, head of transaction sales at Thomson Reuters, says execution algorithms were introduced into FX largely because they proved their effectiveness in the equities markets. Re-engineering algorithms from the equity market for FX meant that they were not initially fit for purpose. Now algorithms are specifically designed for FX and innovation is driving demand for the products.

“Asset managers who use equity algorithms are now saying that algorithms which meet their needs and solve certain problems in FX can be extremely useful, particularly when they are integrated into their workflow so they can benefit from straight-through processing and an error-minimizing audit trail,” Kwiatkowski says.

Of course, like any execution style, clients need to monitor how well algorithms perform against other methods of trading, and in different market conditions. Algorithms that perform well in trading the euro against the dollar may not get such good results when executing in the Mexican peso market. It is crucial to understand and choose the right execution tool for a specific trading objective.

Clients need to monitor how well algorithms perform against other methods of trading, and in different market conditions

“ “

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From using advanced order types on an anonymous electronic communications network (ECN) to collaborating with bank counterparties on a portfolio of trades, there have never been as many ways to access liquidity in the foreign exchange market as there are today. Investors are becoming more sophisticated in the ways that they trade and new participants are using trading venues designed for a particular segment of the market. With regulatory requirements and cost efficiency on everyone’s minds, it is crucial for institutions to be aware of available liquidity channels and to analyse their appropriateness for an execution strategy.

Execution methods FX is an over-the-counter market, traditionally based on bilateral credit relationships. At the most basic level, customers request a quote from a bank with which they have credit. Historically, trading occurred over the telephone, but since the advent of trading platforms it can be done electronically. On multi-bank platforms, institutions can request a quote from multiple liquidity providers simultaneously, benefiting from price aggregation and typically reducing the cost of a transaction.

“Our statistics show that a customer that goes to three or more liquidity providers for a price is able to cut spread costs in half compared to reaching out to a single provider. This is simply because different providers will have a natural desire to be on the buy or sell side of a trade at any given time,” says James Kwiatkowski, global head of transaction sales at Thomson Reuters. “That narrows the effective spread of trading.”

Another style of execution is collaborative trading. A client - which may have a large trade to execute, illiquid currencies or a portfolio of trades to transact - sends a trade to a particular salesperson at a bank, effectively using that person as a consultant to get the best possible price. The client forgoes the benefits of price aggregation for those of collaboration.

At the other end of the spectrum are more ‘trader-oriented’ execution tools. Rather than clients sending out price requests, banks stream prices all day to certain customers on platforms such as FXall. “It’s still relationship trading,” says

Leveraging liquidity channels to optimize execution

Means for accessing liquidity in a fragmented market

Kwiatkowski. “You know your counterparty and they know you. But the rate stream is always ‘on’ rather than a price being generated at request.”

Request for quote (RFQ) execution is generally favoured by corporates whose requirements may include asking for a price from a set number of liquidity providers. Corporates using RFQ execution can also benefit from straight-through processing of trades. Typically, such customers do not have an execution desk and do not employ a professional risk manager. Corporate treasurers might be less concerned about getting the absolute best price for a particular trade. What is more important is that there is an audit trail and that they choose the best possible price when they decide to transact a deal. Asset managers also have workflow requirements that favour the RFQ model and straight-through processing, although most execution desks will be more sensitive to price.

Mul$-­‐Bank  Model  

Liquidity    Provider  

Liquidity    Provider  

Liquidity    Provider  

Broker    Dealers  

Hedge  Funds    CTAs  

Corporate   Asset  Managers  

Banks  

ECN  Model  

     

ECN  PlaAorm  

Corporate  

Bank   Broker-­‐  Dealer  

Broker-­‐  Dealer   Bank  

Hedge  Fund   HFT  

Rela$onship  Trading   Ac$ve  Trading  

Hedge  Fund  

Trading  Models  

Trading  Venue  

Trading  Venue  

Trading models

20 21

Just measuring all this and picking off the low-hanging fruit really has a profound impact on what it costs you to get things done. It pays to be thoughtful about your trading activity

“ “Another mechanism is the ECN, where counterparties are generally anonymous to each other. A buy-side customer typically accesses the system using the credit of a prime broker. ECNs are used by customers that value anonymity, such as hedge funds and banks, whose trading style might be more active and are more concerned about latency.

Of course there is no hard and fast rule about which execution method a particular market segment will employ. Over time there has been some blurring between client segments, with some asset managers establishing prime brokerage relationships, and even some corporates participating on ECNs or requesting continuously streaming quotes to trade more actively and reduce spread costs.

How to think about your execution strategyIn the current environment, it pays for investors to take a more quantitative approach to evaluating how they execute their FX business. Those who think more about execution tend to trade more effectively. Laurie Berke, principal at TABB Group, comments, “The FX market has become far more complex over the last five years, and that complexity gives rise to a need for quantitative analysis in trading. With liquidity increasingly electronic and dispersed, institutions need tools and analytics to enhance their use of different order types and execution venues. The ability to analyze spread costs, market impact costs and even reversion on pricing will help traders reduce their costs to trade.”

Very simple things can make a big difference as far as efficiency is concerned. Some corporates aggregate their FX orders and execute them all at once. If those

orders do not net very much, and they wait to transact until they have accumulated large positions, not only will they endure greater P&L volatility, but they will pay more to get the trade through the market. If these corporates transacted as the trades came in, they would take less market risk and pay less of a transfer price to do so.

Similarly, a corporate can re-engineer its processes so that it trades when the market is most liquid. It can trade more efficiently and enjoy tighter trading spreads by, for example, simply trading major currencies when the market is more active during London trading hours, or trading Asian or Latin American currencies when those markets are more active.

Evaluating internal operational procedures with the benefit of data can make a difference in overall performance and costs, which can have an even bigger impact in today’s market conditions. Phil Weisberg, global head of FX at Thomson Reuters, notes that “just measuring all this and picking off the low-hanging fruit really has a profound impact on what it costs you to get things done. It pays to be thoughtful about your trading activity.”

In the wider picture, customers that tend to transact larger volumes also have to ask whether it is optimal to pay a bid/offer spread to carry out their FX business. They should consider other execution methods, whether that means using algorithms or direct interaction in a central limit order book, to put on or take off currency risk.

“That is an equation that customers have to look at,” says Weisberg. “How much spread am I paying to the market and how much would it cost me to reduce that amount of spread?”

Customers also need to consider whether it is worth having an execution desk or if the cost would be greater than the spread they are paying to the market. As execution management technology gets better, the trade-off between customers executing and assuming more risk themselves against assuming zero execution risk and letting that be borne by a bank or a liquidity provider is shifting and has to be constantly monitored. For many smaller and medium-sized companies, of course, it will still be efficient to pay to remove the currency risk; for larger institutions that may not be the case.

Larger institutions should evaluate updating some of their execution processes to reflect the savings they can generate if they assume incrementally more execution risk themselves. This trend occurred in the equities markets and is likely to become increasingly important within foreign exchange as the asset class gains increased attention and focus.

James Kwiatkowski, head of transaction sales, Thomson Reuters

Laurie Berke, principal, TABB Group

22 23

FX remains a top priority for banks as they battle to win share in the $4 trillion-a-day market, where volumes have grown 25% in the past three years. With flow from both investors and global institutions managing currency risk, the FX market is a gateway for banks to build strong relationships with clients by providing essential liquidity. In addition to support for new regulatory requirements, banks are focused on risk management and connectivity to help them win in this market.

Banks invest in FX technology As new regulations such as the Dodd-Frank Act come into play, clients are looking to their banks to meet swap dealer reporting obligations and fulfil external business conduct standards. Amid the preoccupation with support for these new regulations, the main purpose of banks tends to be ignored. Liquidity providers are paid to absorb market risk. The main challenge facing banks is the drive to increase profits in an environment where capital concerns are more acute than ever.

Joséphine de Chazournes, senior analyst at Celent, comments, “The relentless increase in technology spend, which we estimate to be around $1.5 billion in 2013, is a big challenge facing sell-side firms. Banks need to invest in technology, not only to attract more volume, but to be able to capture good and non-toxic liquidity. The commoditization of electronic trading technology has increased competition at the front of the pack, and top-tier banks have invested in technologies that aggregate

liquidity, distribute prices and route orders to the best venue.”

“Specifically for banks, there is a need to manage multiple distribution channels,” says Seamus O’Sullivan, global head of business execution, Marketplaces, at Thomson Reuters. “They have clients coming at them in a whole range of different ways from voice to phone, through to their single-bank platforms, and through multi-

Banks look to balance the trading needs of their clients against internal needs to manage risk

Technology challenges facing liquidity providers

bank platforms. Meanwhile, the emergence of new liquidity pools forces banks to persistently evaluate how to connect to the right sources of liquidity in an increasingly fragmented FX market.”

Building relationships is, of course, costly. Banks are constantly looking for new customers and new markets, but have to be mindful of the costs and their impact on margins. Connecting to new counterparties in new regions requires investment, as does managing those credit relationships. And with high-frequency trading demanding ever increasing speed of execution, banks have to adapt to increasing tick rates and growing volumes in terms of the number of transactions they have to deal with, while ticket size is falling. Keen to maintain their customers, banks are adjusting to the new landscape in the way they connect with their clients.

In addition to investing in technology solutions to manage risk better and transact more volume, banks are busy rolling out new products, such as execution algorithms. These leverage bank liquidity channels and advanced execution logic to execute client orders efficiently. One of the key drivers in client adoption is demonstrable savings.

Howard Tai, senior analyst at Aite Group, comments, “As you can see with the launch of bank-provided algorithms, there is a greater need for increased transparency in the marketplace, not only post-trade, but also pre-trade. Banks are struggling to come up with appropriate execution performance measurement tools that can help their clients quantify the benefits of using their electronic tools. Achieving success in this area should give banks a more sticky relationship with clients.”

Outsourcing opportunities Historically, banks made significant margin through their trading activity. Wide spreads meant healthy returns, and they could control their revenue flows. Now that has changed, and banks are focused on how they manage their operational costs.

With the top FX banks invested heavily in sophisticated e-commerce systems, mid-tier banks are increasingly concerned about being disintermediated from their clients. These banks have fewer resources to compete and are looking to vendors for solutions. Banks want to retain access to the market while maintaining an

Seamus O’Sullivan, global head of business execution, Marketplaces, Thomson Reuters

Joséphine de Chazournes, senior analyst, Celent

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As the market’s leading electronic platform for foreign exchange trading and now part of Thomson Reuters, FXall offers the broadest suite of insight, access to community, flexible execution tools, end-to-end workflow management and straight-through processing to supply clients with a single platform to meet all their execution needs. As a trusted partner to the institutional foreign exchange community, FXall provides a fair and conflict-free trading environment for over 1,300 active traders, asset managers, corporate treasurers, banks, broker-dealers and prime brokers around the globe with the most liquid, efficient and transparent foreign exchange venue.

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FXall’s services are not intended for, and are not available to, private customers, and are not intended for distribution into any jurisdiction where such distribution is restricted by law or regulation. FXall’s services do not constitute investment advice or an advertisement, offer, or solicitation of an offer, for the purchase or sale of any investment, securities or other property, or a representation that any investment, security or other property is suitable for any person. In Austria, Belgium, Czech Republic, Denmark, Estonia, Finland, France, Greece, Ireland, Italy, Latvia, Netherlands, Portugal, Romania, Spain and Sweden, FXall acts through FX Alliance Limited (regulated by the Financial Conduct Authority), 30 South Colonnade, Canary Wharf, London E14 5EP. In Australia and Singapore, FXall acts through FX Alliance International, LLC (ARBN 097 253 640), (a Delaware (USA) company, members’ liability limited), 909 Third Avenue, 10th Floor, New York, New York 10022. In India, for Authorised Dealer members of the Foreign Exchange Dealers Association of India, FXall acts through FXall International (Mumbai) Private Limited, Level 1 Trade Centre, Bandra Kurla Complex, Bandra (E) Mumbai 40005. In other jurisdictions, FXall acts through FX Alliance, LLC (a Delaware (USA) limited liability company), 909 Third Avenue, 10th Floor, New York, New York 10022. FXall, FXall Trading, Accelor, OrderBook, Portfolio OMS, Settlement Center, Indicative Quotes, Accelorate, QuickConnect, BankStream, QuickOMS, QuickTrade and all associated logos, are the trademarks of FX Alliance LLC. FXall is a Thomson Reuters Company.

element of flexibility to differentiate their FX offering; increasingly, they are willing to outsource trading infrastructure to help achieve that goal.

“It is evident that the strategy for the top five mega FX banks is different from the next tier,” says O’Sullivan. “Mid-tier banks are increasingly looking not to be technology organizations, but instead to focus on their customers.”

One outsourcing strategy is liquidity distribution solutions, which can range from single-bank portals to access to multi-bank platforms. This overcomes the problem of infrastructure management and the constant need to change adaptors and connections to various different liquidity pools. Having a vendor partner manage that function can help a bank achieve significant cost savings. Using a hosted distribution solution also has benefits for smaller banks, which may be connected to a number of different liquidity providers. Not only can they get the latency benefits of co-location, but if they want to bring on a new application programming interface to connect to a new liquidity pool, then the adaptors are already in place.

Another outsourcing opportunity is order book technology, which deals with the ledger of customer orders that rest with banks, including limit and stop orders. John Ashworth, global head of enterprise solutions at FXall, says, “There is no strategic benefit to banks in building an order management system. It is a utility that should be rented from a provider. Clients can easily send orders via multi-dealer platforms to a specific bank. Banks do not need to do anything. It is good old-fashioned software engineering, solving a workflow problem and delivering value to banks by taking a headache off their desks.”

The use of vendor solutions, however, is not exclusive to small and medium-sized banks. De Chazournes at Celent comments, “Today, even tier-one banks, who historically built most of their technology, are looking to buy internalization or crossing software from vendors to integrate into their current architecture to adapt quicker to the new market structure. The tier-two and tier-three banks that are lagging in terms of technology in FX also have an opportunity, starting from scratch, to buy the latest state-of-the-art solutions to play catch-up.”

Ultimately, of course, it is the client that will benefit from the increased efficiency of liquidity distribution. A wide range of customers have not entered the world of e-commerce and still transact their FX business in the traditional way.

O’Sullivan says the market is still evolving, with clients moving their trading activity from telephone to banks’ single-dealer environments and then on to multi-dealer platforms. “Obviously, the multi-dealer environment has got benefits in terms of access to liquidity, but it also overcomes regulatory requirements of best execution,” he says. “I think you will see a natural evolution towards that environment.”

www.fxall.cominfo@fxall.com

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WORKFLOW & ORDER MANAGEM

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