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Trading Technology

08:00 AM
Michael Sparkes
Michael Sparkes
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Driving Competitive Advantage Through FX TCA

Accurate TCA for FX trading has proved more challenging than in equities, delaying its progress. But the benefits to trading strategies can't be ignored, and investors are already positioning FX TCA as a critical business function.

"The most valuable commodity I know of is information," to quote Gordon Gekko from the 1987 movie classic Wall Street. This line has never been more significant than in today's data-fuelled financial markets, where detailed analysis of information can provide that all important competitive edge -- both now and in the future. To achieve this, firms are looking toward transaction cost analysis (TCA), which enables them to reduce costs and hone trading strategies.

This isn't new. TCA has been established in equities for many years, and though compliance was initially the main driver, it has increasingly proven to add alpha to the execution process. As a result, it's not surprising that the TCA focus is spreading beyond equities, with foreign exchange (FX) trading coming into the spotlight.

It is not simply a case of applying the equities model to FX, however. The idiosyncrasies and inherently complex structure of currency markets have presented challenges to TCA's progress in FX. Added to this is the fact that FX has often been outsourced to third parties or may be a secondary or subsidiary trade linked to another asset. So not only has accurate TCA for FX trading proved more demanding than in equities, but the impetus also has not been there in the same way.

However, times are changing, and recent events emphasize the need for smarter use of TCA in FX. ITG said in a recent report on tradable data between London and New York before and after the 4:00 p.m. fix, "the costs from the order arrival time until trade execution are on average 17 basis points 20% of the time." This is crucial, because 17 basis points of implementation shortfall for up to 20% of all days can cost asset managers millions of dollars of value lost from their funds. That's not an insignificant amount for any investor.

With greater scrutiny on the role and efficiency of the 4:00 p.m. London fix, the time has come for members of the asset management community to take full advantage of the data available to inform their execution strategies. Forward-thinking investors are already beginning to position FX TCA as a critical business function, enabling better trading outcomes and enhancing performance. Last month's data can be a significant input to this month's decisions on when and how to trade, maximizing the benefit from FX trading. This takes on even more significance when you consider the percentage of the collective pension funds that directly or indirectly participate in the currency markets. Even incremental improvements must be pursued.

To make these improvements, asset managers need to squeeze the very most out of all the information at their disposal. For this to happen, TCA providers need to anticipate what an asset manager might require from their data analysis in the future. A combination of growing regulatory pressure and a need for higher returns is triggering clients to demand even better execution. This will see them asking more testing questions above and beyond the standard analysis.

New technologies are also driving new trading strategies in FX, resulting in a need for further analysis on topics such as algorithm selection and the use of trading venues. Such granular analysis sits alongside the broader questions of investment process, such as the most effective time of day to trade a given currency pair, the optimal frequency of book squaring, or the decision on when to use an electronic crossing network, rather than calling a bank on the phone.

The key to unlocking future success is for the TCA provider to work closely with the asset manager ahead of execution. This enables both the provider and the asset manager to get a better understanding of the investor's objectives and set these against the prevailing market conditions before deciding on its trading strategy. It really is a classic case of using data to support the decision-making process. As we move forward, asset managers who achieve competitive advantage will be the ones that adopt this approach in order to advance their trading strategies in FX, using that "most valuable commodity" -- information -- to answer the increasingly testing questions for tomorrow, not just the ones for today.

Michael Sparkes is a Director in ITG's London office, responsible for business development of Analytical Products in Europe. He has more than 25 years' experience in the investment industry, specializing in international portfolio management, product development and ... View Full Bio
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