Analysing The Cost Of FX Trades

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With Daniel Chambers, Head of Trading, Sequoia Capital Fund Management
Sequoia Capital Fund Management (SCFM) is an alternative investment management company specialising in investing via quantitative strategies and returned 13% in 2015 net of fees. Since going live in June 2011, SCFM has managed to provide an average monthly net return of 0.71%.
The decision to execute entirely through electronic trading was a natural one to make as it is in keeping with SCFM’s ethos of implementing technology to increase productivity. SCFM has always traded electronically, with varying degrees of sophistication. Two of the main drivers for this decision were the reduced risk of errors during execution and increased efficiency. SCFM executes all orders in the market electronically throughout the European liquid trading hours. Although FX is a 24-hour market, liquidity is not equally distributed throughout. A look at the daily profile of spreads in the vast majority of pairs highlights how much more one can expect to pay to execute overnight relative to in the middle of the European trading day. This is certainly a consideration that needs to be made with volume constraints measured against a trading day that is not 24 hours long.
Execution Process
Trades are executed by sending orders via FIX to an aggregator and receiving the information for each clip also via FIX. The trades are sent to the prime broker and matched immediately. As well as matching with the PB, the trades are also matched against the initial ticket to ensure execution took place as expected. All of the processes are automated. Once the trades have been matched, it is possible to view information related to the trading session such as execution costs and share of flow per liquidity provider. This systematic, straight through process is essential when executing multiple times per day in a large number of crosses. The FIX protocol makes the whole process easier and enables us to execute in this fashion and to retrieve all relevant information for analysis conveniently. The orders are placed in the market with the intention of creating as little market impact as possible. A conscious decision was made to execute only with banks, and specifically the large institutions, as opposed to ECNs and other third-party vendors. This provides a level of anonymity when executing. There are undoubtedly other participants with whom we could trade on an ECN, but a direct relationship with the LPs supports communication and assists in reducing market impact. In our opinion, executing with enough liquidity providers directly enables the client to receive the best of both worlds; greater anonymity and diverse flow with extremely tight spreads and great depth.
Improving the steps needed for execution is an ongoing process to ensure all measures are being taken to ensure the most secure and efficient methods are being implemented. The back office/operations systems were prototyped by people with relevant business knowledge. This facilitated us being able to create something effective in a short period of time.
Cost Analysis
A significant amount of work has been carried out to quantify, analyse and understand the various components of our execution costs and how they might be reduced. Costs are measured against various benchmarks, including arrival and risk transfer price. Over the last few years there appears to have been less liquidity available in the G10 space. Particularly difficult have been the Scandinavian pairs, which have been noted to be behaving like emerging market currencies. Building our capability to drill down into each cross and its various cost components has revealed the most useful information. Deep examination highlights information not available through superficial analysis. Although a lot of what has been revealed is in line with what one might expect, such as EURUSD and USDJPY being cheap to trade, there are other very interesting observations to be made such as discovering if trading EURNOK, EURSEK is more cost efficient than going for the NOKSEK directly. Much of the knowledge gleaned leads to enhancements in execution algorithms. We approach it as a four-part process including:

  • Collect – What data can be collected and stored?
  • Calculate – What information can be derived from the data?
  • Input – How can that then be used in any part of your execution strategy?
  • Monitor – How to monitor and quantify the changes made?

This segregation of the different components involved, each with their own elements, allows clear and precise planning for how to implement change.
Trade Cost Analysis is a concept that has been around for a while and we have seen a shift from post-trade cost analysis to pre-trade cost calculation or estimation. The ability to determine the optimal time to take executing an order is a progression from simply measuring incurred costs. Typically used for these estimates are factors such as current volume relative to averages and volatility. The nature of financial markets would suggest that on any individual execution, you’re not guaranteed to be right in your estimation, but over time and with enough observations the estimates should be correct within a margin for error. Being able to store and compare estimated versus incurred is vital to improving confidence in estimates.
Market Analysis
With China’s circuit breakers active twice in the first four days of trading this year and crude close to $30 per barrel, the theme this year appears to be uncertainty. In a period where the Federal Reserve have recently raised rates for the first time in seven years, more and more emphasis is put on what comes out of the central bank’s meetings in terms of pace of subsequent actions going forward. Other central banks have proved in the last year that they are willing to shock the market with unexpected decisions if seen as being in their best interest and we’d expect this to be the case going forward. The increased volatility impacts all participants executing in the markets and their execution methodology needs to be able to adapt to the environment.

Despite this increased volatility, typical spreads have remained consistent with those seen last year with a profile throughout the London day that is to be expected. Below is a plot displaying the aggregate spread in one particular cross for the last three months of 2015 and the start of 2016.

Liquidity Provider Analysis
When analysing costs, it is important to go beyond simple market analysis. One step further when looking at execution costs is to analyse differences in costs (impact) and market structure when executing with each LP. This is important in guaranteeing best execution. Being an OTC transaction, it can be difficult to demonstrate best execution in a similar fashion to other securities. However, the work being done with our LP analysis is another step we’re taking on our side in attempting to ensure that best execution is achieved. This year is likely to include further attempts to regulate market activity, with a spotlight on FX. Various scandals, accusations of rigged markets and numerous lawsuits have pushed clients to allocate resources to monitor the realisation of best execution. As the markets become more highly regulated, monitoring and evidencing best execution becomes more vital.
The analysis also helps to ensure that each LP is accountable to the client for the methods they use to gain share of your flow and also how they are then working to reduce the risk they have potentially just taken. Potentially, as uncorrelated flow is as likely to be risk reducing for the LPs as it is increasing. Ideally you are executing against the skew of your liquidity providers. This is where an LP has interest in a specific side of the trade as opposed to simply quoting a bid/offer to you with no interest. The reason this is ideal to trade against is because it reduces the likelihood that the LP will need to go to the market as you’ve actually aided them in reducing their risk.
In order to conduct analysis, we store all quotes received throughout the day, which amounts to approximately 40 million. We store several of the fields available including bid, ask and volume. We devote substantial resources to ensure the accuracy and validity of the data. The timestamps and prices provided to us via FIX for each fill we execute are systematically compared to the quotes we were receiving and storing at that point in time from the relevant counterparty on the relevant side of the quote. This ensures that the price quoted to us was a true reflection of what could have been achieved at that moment in time. All fill and rejection rates are measured. Further confidence is gained in the quotes received from the LPs when experiencing a fill rate of 99%.
Having such a vast amount of data at ones fingertips provides you with almost limitless potential for study and analysis. Prior to building and implementing this database, important choices needed to be made with regard to how to store data, what to store and how to retrieve it. Once this has been done, it is important to understand what is in front of you, how to produce results from it and how to interpret the results accurately. At SCFM, some of our projects are to quantify liquidity provider-specific market impact. The results of our research thus far have been extremely revealing. It is very interesting to see the magnitude of the disparities between LPs.
Additionally, good communication with all of our liquidity providers has been vital in improving execution. LPs are able to price more confidently when there is a clear understanding of the effort you are making to trade responsibly and reduce market impact. Also, the feedback the LPs provide is extremely useful and has helped shape nuances in execution patterns.
The future
At SCFM, we’ll continue to endeavour to keep costs at a minimum through ongoing analysis and constantly improving execution algorithms.
The trend in the market appears to show that more organisations, particularly large institutional funds, are attempting to assess and reduce transaction costs. There are a number of vital questions that must be asked by any participant executing orders in the FX markets and we would suggest they include, but are not limited to:

  • Are our cost assumptions accurate and are our incurred costs as low as possible?
  • Are our incurred trading costs being driven solely by market conditions/structure (liquidity etc.) or by our method of execution?
  • Are our liquidity providers managing the flow benign to us and each other?
  • What is the total impact of execution costs on overall performance (returns)?

Many of the methods and practices applied when researching this particular area of the business are apparent throughout the organisation. We apply a research-based approach to all the work we undertake. Each member of the team brings different qualities to the table and it is because of this that collaborative and peer reviewed work produces the greatest results. So much of our work is simplified by having an industry standard protocol such as FIX as it facilitates managing enormous amounts of data and a smooth flow of information between market participants.
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