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Reuters Edge

FX market braces for rise of algorithms

CHICAGO (Reuters) - Global investors using complex, computer-driven models will increasingly pump up the foreign exchange market’s volume, creating both opportunities and headaches for market makers.

People work beneath a foreign exchange quotation display monitor at a brokerage in Tokyo January 29, 2007. Global investors using complex, computer-driven models will increasingly pump up the foreign exchange market's volume, creating both opportunities and headaches for market makers. REUTERS/Toshiyuki Aizawa

In algorithmic trading, hyper-fast computer programs based on mathematical models essentially make split-second financial decisions to find optimal prices.

With hedge funds and other high-frequency investors gravitating to so-called algos, the programs are already helping to keep trading volume robust even as volatility in the currency markets generally declines, according to panelists at an industry conference sponsored by FX Week magazine this week.

“The barriers to entering this market have decreased, yet how does one on the buy side or the sell side manage liquidity when it is spread across so many different venues,” said Darren Jer, regional FX sales manager with ICAP. “The key is algo trading,” he said in a panel discussion.

In the past, algorithms were primarily used in equity markets. Tech-savvy investors are now using algos in the currency market to improve execution timing exponentially, broaden portfolios and spread risk out further.

Within hundredths of a second after an important piece of economic data is released, trades originating from an algo are entered. That obviously poses challenges to the more traditional, manual dealers, industry participants said. More recent algos have also been known to scan news releases for word combinations and predict subsequent equity and FX market movements.

FX Concepts, a hedge fund with roughly $12 billion in assets, has employed algos to help price relatively illiquid currencies.

“We’ve been surprised by the quality and quantity of liquidity we’ve been able to put together on our platform,” said Kelly Adams, chief technology officer at the fund.

In terms of daily traded volumes, the foreign exchange market is by and far the king of asset classes. Average volumes are expected to climb to nearly $3 trillion a day in the next year or two from $1.9 trillion at present.

A large chunk of the volume is being driven by a flood of funds using algos, which in turn greatly increases the buy and sell orders that market-making banks receive.

PERSONAL TOUCH

Jennifer Mihocko-Tierney, director of U.S. e-commerce with Barclays Capital, said clients are demanding better technology from investment banks in terms of trade execution and clearing.

“If you’re missing one of those pieces on the sell side, you’re losing revenue,” she said at the conference. Mihocko-Tierney said banks will probably become more solution-oriented, concentrating more on meeting the unique technology needs of investors rather than taking a one-size-fits-all approach to research.

Of course inhumanely fast trades automatically entered by mechanical brains still require person-to-person interaction between the sell side and the buy side.

“Direct relationships will always come in to play. The key driver behind that is clients’ appetite for running execution risk,” said Jeremy Smart, executive director and global head of e-sales with Morgan Stanley.

Not everyone is convinced that algos are transforming the sell side of the market. Gavin Wells, managing director of FX spot and interest rate trading at Citigroup, said electronic platforms that largely eliminate the need for brokers provide all the functionality buy-side investors need, and that he has found no clamoring need for more algo products.

“I get the sense that developing algorithmic trading solutions is the latest buzz word, because I haven’t yet met a client who really wants it,” he said.

Still, exchanges may have extra motivation to adapt and improve their execution systems, at the very least, after February 27, when a surge in risk reduction caused the biggest tumble in U.S. stocks since the attacks of September 11, 2001. Some believe more could lie ahead.

Stock exchanges around the world were flooded with sell orders, while other markets had a pullback in risky trades.

“That was only a tiny snapshot of what we might be in for in the next 12 to 24 months. I think we’re going to have a more significant stress test of the current technology,” said Derek Sammann, managing director and head of FX products with the Chicago Mercantile Exchange.

Reporting by Kevin Plumberg; editing by Frank McGurty;RM: kevin.plumberg.reuters.com@reuters.net; kevin.plumberg@reuters.com; 646-223-6304

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