Short-term volatility might crimp returns for many asset owners
Updated with correction
The increased use of algorithms in foreign-exchange trading is expected to be a long-term boon for pension fund executives seeking better execution and lower transaction costs, but in the short term the algorithms could cause market volatility that might affect investors' costs and returns.
The latest case in point — the Oct. 7 decline in the British pound against the U.S. dollar that sent it to its lowest level in 31 years after an early morning trade caused algorithms, possibly set off by news or social media reports on Brexit, to sell off the pound in a matter of moments.
“Yes, institutional investors should care about algorithms,” Denis Ignatovich, co-CEO, Aesthetic Integration Ltd., London, a financial technology startup that offers formal verification of trading algorithms. “There are billions of dollars at stake with them. All these things you're seeing — the flash crash we just saw with the pound — are the same issues other critical industries have had for some time.”
Added Anthony Perrotta Jr., partner, global head of research and consulting, TABB Group, New York, “Algorithms were definitely at play” in the Oct. 7 decline, “but can you ultimately blame them for this? I guess functionally, algorithms worked. They aren't a fail-safe; the algorithms judged that, based on trading strategies, it was a good time to start buying. But on the flip side, would we have had the same volatility if human beings were behind both moves in either direction?”
Mr. Perrotta said the pound's plunge in the early hours of Oct. 7 in London was “a confluence of issues at play, a perfect storm.” The trade order was issued after London trading hours, a time when there were conciliations on the previous day's trading orders, “so the markets are thin at that time,” he said.
Tod Van Name, global head of electronic trading for foreign exchange and commodities at Bloomberg LP, New York, added that the trade also was affected by reduced inventory from banks as a result of regulatory capital requirements — all of which triggered massive sell orders by algorithms. “Lo and behold, you put all these together and you'll have a case where there'll be a meltdown,” Mr. Van Name said. “Electronic trading can be advantageous, but other times it can run away from you.”
At one point on Oct. 7 the pound dropped 10% to $1.15, its lowest level since March 1985, before rebounding four minutes later and ending the session in London down 1.4% to $1.24.
Despite the quick turnaround that day, such volatility caused even in part from algorithm use — on what is the world's largest unregulated over-the-counter market — can impact asset owners' decision-making on investments in general.
“I think the market is split on the use of algorithmic trading in anything over the counter,” TABB's Mr. Perrotta said. “The real concern for asset owners is the violent nature of price swings if you take human judgment out of the equation. You could be forced to make a quick entry or exit decision based on the wrong reasons given a particular period of time. ... Algorithms provide the tools that can give the user control over their particular trading strategy. If you know when to get in and out of a position, they can execute more efficiently than humans. But the question is: If you don't have that capability and other algorithms are moving the market, they can force you to do things you might not want to do.”
Still, algorithm use won't be going away in the FX market. Use of algorithms in Bloomberg's FXGO platform is growing to an expected 25% of spot trading volume by the end of this year from just 5% in 2014, Mr. Van Name said. “Much of the increase is because there are much smaller (FX) trades being made now, and being made more frequently, with algorithms providing a way to fragment these trades,” Mr. Van Name said.
So, sources said, asset owners will need to monitor volatility of the FX market while the use of algorithms continues to increase and the algorithms themselves become better.
“Algorithm use has definitely increased in foreign exchange as clients are taking more control of trades and taking that responsibility away from custodians. That's a positive trend as the FX market matures and investor sophistication increases,” said Bill Goodbody Jr., senior vice president, head of FX, at New York-based Bats Hotspot LLC, the FX trading venue of Bats Global Markets Inc. “FX is a fundamental kind of market that's extremely fragmented, where every client has a different experience in terms of pricing and trade equivalence. Anyone who does FX trading has to be smart about it. It's not just best price, but when's a good time to trade? It's five days, 24 hours a day in FX transacting, with definite ebbs and flows. What you see is different based on when you transact. Spreads can be very different throughout the day.”
One way algorithms can help asset owners is in analysis of the FX market, by such measurements as the impact of the spread and the timing of trades, Mr. Van Name said.
“It's important for pension fund managers to use these tools to reduce costs and maximize returns,” Mr. Van Name said. “Having that analysis is really important. If you find out the best way to sell sterling, find the best time and venues in which to make that sale, you can know what the transaction costs are before the trade is made. In FX, it's hard to do transaction cost analysis because the FX market is over the counter, whether using a variety of venues or direct trading. If there were a consolidated tape, it'd be easier to prove how well a trade was executed. What distinguishes good algorithms — their secret sauce — is their ability to provide unique quantitative analysis. It gives the buy side more control, much greater than in the past. Overall, pension funds and asset managers can now take a hard look at what they're doing. There's absolutely no question that more pension funds are controlling their foreign exchange and seeing it as a fiduciary responsibility.”
At the $30.8 billion Indiana Public Retirement System, Indianapolis, algorithm use in FX is seen as “a long-term net positive,” said Scott Davis, chief investment officer. “However, we actively observe investment processes and results to ensure that our portfolio is appropriately risk managed.”
Mr. Davis said the use of algorithms “has increased transparency in a market historically dominated by dealers. As a result, this should decrease transaction costs within INPRS' portfolio. There might be instances that algorithms exacerbate market volatility, but this might be more of an issue for short-term investors, rather than long-term investors like INPRS.“
TABB Group's Mr. Perrotta said he advises pension fund officials and other asset owners to “stay on top of TCA (transaction cost analysis), best execution, upgrade their technological infrastructure, use brokers with solid technological infrastructure. Those are all good things to be focused on. The world is changing, and not only market makers have to change with the times. Asset owners need to as well.”
This article originally appeared in the October 31, 2016 print issue as, "FX algorithms could be great for long term but ...".