Analysing The Cost Of FX Trades

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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