FXTechnology

Why FX Algos May Belong in a Risk Manager’s Trading Toolbox

By October 11, 2023No Comments

Some NeuGroup members are using algos to reduce trading costs and take advantage of aggregated liquidity in the FX spot market.

FX algos offer corporate risk managers a well-established technology tool that can, ideally, lower trading costs while increasing speed and efficiency without moving the market when the need to trade falls outside the window of optimal liquidity in the forex market. Algos allow managers to define specific trading rules based on timing, price or quantity to determine trade execution parameters, such as waiting for the market to reach a level where they want to buy or sell instead of taking the current price—including the spread—that a bank is offering at spot.

  • But corporates need to weigh the benefits of algos against the execution risk of using an automated instrument that trades currency over time, meaning the market may move against it. That’s one of the considerations about the tool that arose at the fall meeting of NeuGroup for Foreign Exchange where peer group leader Julie Zawacki-Lucci moderated a discussion between the FX risk manager of a mega-cap corporate and Justin Mitrani, head of electronic fixed income and currency sales in the Americas at Societe Generale, which sponsored the meeting.
  • Execution risk, opportunity cost and the work it takes to both understand algos and execute trades with them may help explain why fewer than one-third of NeuGroup members in attendance said they use algos. Also, some risk managers may need to convince finance leaders to approve the use of algos or change their treasury policy.

Types of algos. So-called passive algos are the most common type used by corporates looking for an alternative to locking in a price in what practitioners call a risk transfer trade with a bank that offers a bid-ask spread. The bank takes the risk and the corporate must “cross the spread” to secure a fixed price. By contrast, a company using a passive algo can set a limit price and may “capture the spread” if another FX market participant takes the other side of the trade. The potential cost savings over a large number of trades during the course of a year can total millions of dollars compared to using risk transfer trades, members said.

  • The execution risk that the market moves against the corporate while it waits, though, creates the possibility of opportunity cost, Mr. Mitrani said about using an algo instead of locking in a price. “Clients have to weigh, ‘what is my opportunity cost for not transacting immediately?’”
  • He described other algos, including those that are time- or volume-based that try to replicate the currency’s time weighted average price (TWAP) or volume weighted average price (VWAP) during the life of the trade.
  • Opportunistic algos, another kind, attempt to take available liquidity; the client ends up crossing the spread, but because the algo has aggregated liquidity from multiple sources, they may obtain a better overall price because of the spread compression achieved, Mr. Mitrani explained. Few corporates use these, he said.

Using the tool. The member who uses algos has employed them more often as technology improves, and noted that he is able to enter algo trades electronically in his trading platform, FXall. He does not use them daily and considers algos “part of the toolbox” that account for about 10% of his total trading volume.

  • The member’s company only hedges balance sheet exposures and uses algos, for example, when it needs to do a spot trade to make a large FX payment to fulfill a contract. The member also turns to algos to hedge changes in forecasts that are greater than $50 million.
  • He noted that most banks only offer algos for spot trades, which must be rolled forward to work as a balance sheet hedge. Mr. Mitrani said if a client is using an algo offered by Societe Generale, the bank will price the forward.

When to use the tool. Mr. Mitrani said he sees more use of algos on larger trades or for emerging market currencies. “If market conditions are challenging, an algo can help you tap into additional liquidity sources,” he said. In addition, “when markets are volatile, and generally spreads widen, you get the benefit of spread compression through aggregation and access to an increasingly fragmented FX market. And because markets are moving, there is potential to capture spread.”

  • Both the member and Mr. Mitrani said algos provide flexibility for risk managers who have a view on the market. “If you think the market is coming toward you in your trade, you have the ability to slow your trade down and let the market come to you so you can capture more spread,” Mr. Mitrani said.
  • The member said algos are also useful for executing trades in overseas markets overnight. Timing also comes into play when a large spot trade comes in during illiquid hours and the banks’ bid-ask spreads are extremely wide. In this case, he can avoid the cost of risk transfer to the bank and use a passive algo that allows him to “capture the mid”—the middle of the spread between a currency’s bid and ask rates.
  • These algos may take a couple of minutes or longer to execute the trade and are among the most successful when the market is hardly moving, he said. One reason is the aggregation of liquidity over time.
  • Another NeuGroup member, at an earlier session, said it’s especially important that an algo is stealthy in an illiquid market. “You cannot have a stealthy algo that does not know market liquidity,” he said. He gave the example of putting on a Chinese currency trade on a Friday afternoon that moved the market “like an elephant walking in.” To guard against elephants, he measures the average market mid five minutes before algo execution and five minutes after it.

Goals and benchmarks. Both the risk manager member and Mr. Mitrani agree that corporates considering or using algos need to know why. “The client should have a clearly defined benchmark going into the trade. What are they trying to accomplish?” Mr. Mitrani said.

  • Being clear on the goal and the benchmark will help determine what to do if the market moves against you. “How do you handle it if you’re starting to lose on the trade? When do you say I want to finish this trade and move on more quickly,” he added.
  • Mr. Mitrani echoed the member in underscoring the value of algos as an execution tool offering another option to trade foreign currency. Through this lens, he said, “it becomes more a matter of clients creating what their execution workflow is, when they want to do a certain trade a certain way, what are those parameters and finding the choice that works best for them.”
Justin Jones

Author Justin Jones

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