Developing quality benchmarks

By James Cochrane, Director TCA for FX Product Manager, ITG

Unless a TCA system has plentiful data and flexible benchmarks, it will only answer the most basic questions and fail to provide valuable insights that will lead to lower transaction costs and improved fund performance. As in the equity market, the foreign exchange market demands pre-trade analytical tools and peer group analysis that will measure slippage in traditional trading styles as well as quantitative trading and algorithmic trading.

New FX TCA tools reveal currency costs in a market that was previously ignored or believed to be too ungainly to accurately measure. Before the advent of electronic trading platforms, liquidity pools were accessed through banks that offset client transactions in an interbank market largely hidden from view. Aggressive investors managed their foreign exchange relationships tightly, keeping costs low, but accurate measurements of costs was only undertaken by a few firms using internal systems. Without access to all available data in an over-the-counter market, transaction cost analysis could only provide educated estimates. Over the past four years that has changed, but too many of the tools still lack the data and experience to precisely measure transactions on a millisecond level over the course of a trading session, quarter or year. Recent FX TCA analysis has relied on too little data and used only daily benchmarks such as high, low, daily average and an estimated weighted daily average.

Transaction cost analysis in the foreign exchange market must mature from the present perfunctory state. Demands for simple compliance and best execution measurements will not satisfy the needs of institutional investors to manage portfolio risk and improve fund performance. In order to better measure these costs and design a product that will evolve with industry demands, transaction cost analysis tools must have a solid foundation of copious market data, flexible benchmarks and calculation engines that will correctly apply the former with the latter. This will also lead to more accurate peer group rankings and advanced pre-trade analytics.

One key area of development is access to new sources of liquidity that have been formed outside of the interbank market, although the bank’s prices are still considered the official market. Through price aggregation and prime brokerage, funds can access prices that are inside the traditional “pip” and in sizes less than one tenth the traditional block amount. Quantitative and high frequency traders can access liquidity that will not be offset by traditional brokerage firms. Access to these prices is important in order to measure trading costs against all available liquidity. Millions of indicative quotes, tradable quotes and actual executions from many of these new liquidity pools, as well as the traditional sources, must be collected and analysed in order for dissemination of cost analysis to be accurate. To keep pace with the competition, institutional trading teams require sophisticated analysis of their foreign exchange transactions and standing order fills. Portfolio managers need sharp analysis in order to be more cognisant of foreign exchange transaction costs that negatively impact their returns.

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