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.