28th January 2021 | Quod insights
The growing focus of traders to achieve effective workflows, save cost and time, and improve execution outcomes for more efficient alpha capture is leading to greater adoption of Smart Order Routing (SOR) tools. How can the SOR address the changing needs and challenges faced by the FX market?
This blog was written by Medan Gabbay, Chief Revenue Officer at Quod Financial.
The full version of the blog is available on E-Forex.
- The increase in electronic access to liquidity in FX, and cost pressures, are driving the buy- and sell-side to focus more on advanced technology solutions, driving industry adoption of evolving SOR tools.
- Among the powerful range of new behaviours that will bring value to the FX trading desk, the FX SOR is moving from high-performance real-time decision making to multi-workflow automated trading.
- This new and evolved SOR in the FX market is helping traders work out the best way to achieve their desired outcomes, becoming a true tool for smart order workflows.
The foreign exchange (FX) market has significantly increased reliance on electronic channels in recent years. Refinitiv, states that more than 80 percent of spot market volume is now transacted electronically. This increase in electronic access to liquidity means that advanced technology solutions for choosing how to interact with liquidity are essential to every trading desk.
As the FX market continues to evolve and become increasingly electronified, trends are showing that the actual volumes traded in the interbank market as a whole are decreasing (as per CLS). Many of the large volumes driven by systematic and speculative funds have retrenched and the highly fragmented markets of 2012-2015 have given way to a consolidation of liquidity and a significant rise in Full Amount trading.
Although we see a significant increase in the electronification of processes across all asset classes, the market consensus is that protecting your LP relationships is a priority over anonymous ECN / sweepable liquidity.
It is in this world of highly electronified and positive-behaviour-driven trading that the new Smart Order Router (SOR) must shine.
Shaping the Trade: The old SOR vs the evolving new
In FX, one of the most influential factors in execution outcome is “shaping” the trade. Even in a mono-market execution, deciding how to split the clips to reduce impact or slippage, or even whether the full-amount will achieve a better outcome is all data based decision making that can be performed by the SOR.
Old SOR technology could often not be trusted to respect even Full Amount restrictions, so execution decisions were often completely siloed to avoid Sweeping Full Amount, for example.
The Evolving FX SOR
The new data-driven intelligent SOR can predict market movement, reject rates, last look behaviours, and respect LP relationships by adhering to constraints that protect your LPs from behaviors potentially viewed as toxic, as well as mix different liquidity pools respecting rules for how to interact with them.
The evolution of the FX Smart Order Router has been the move from high-performance real-time decision making to multi- workflow automated trading. However, the selection of these workflows are still highly limited to determinations made by the traders themselves.
Configuring a SOR to decide between which ESP venues to execute what clip size on has evolved to a total decision between multiple streams of liquidity with different behaviours and rules.
FX Smart Order Router: Helping bring value to the trading desk
1. Double Hit Protection
Ensuring that following any execution, traders are prevented from executing again for an agreed time window. This can vary based on the chosen LP, execution method, CCY, and market conditions. For instance, an emerging market (EM) CCY during low volatility could have a 45 second hit protection window allowing the LP to hedge their risk before the client can trade again.
2. Micro-Volatility Prediction
Using AI/ML agents to predict volatility in a market over the next 100ms. This allows passive pegging to achieve 5-10 pip improvements (on average) in execution improvement by being consistently better placed in the market to capture the largest offset.
3. Stream Selection
Using historical data analysis to evaluate the likelihood of slippage or iceberg liquidity via different execution methods. A probability can then be used to determine if Full Amount, Aggressive Sweepable, or Passive liquidity will give a better overall execution in current market conditions, rather than just making a simple price based decision on where to execute.
Streams may be prioritised by the SOR by evaluating:
- Accept / Reject Symmetry:
Will trade be accepted or rejected in different market conditions symmetrically and can this behaviour be predicted to avoid rejection?
- Cost of Rejects:
Can the likelihood of having an order rejected be predicted, and can the ongoing cost of that rejection be measured? This allows traders to avoid the LP in specific conditions or remove them altogether where the cost of one rejected trade could outweigh the benefits of using them.
- Hold Times:
Analysing the last look and hold times between placing trades and fills/rejects which could impact the overall execution quality of the trade, while also evaluating if including an LP in an aggregation of liquidity impacts the overall spread/execution analytics and decay faced while executing.
4. ESP vs RFQ
An increase in the availability of Executable Streaming Prices (ESP) streams have also opened new territory to take advantage of SOR technology. ESP streams are no longer the exclusive domain of spot FX but are now regularly offered for Forwards, Swaps, NDFs, and even broker dated FW / Swaps.
A trader can now send an IMM date to the SOR that is collecting data on thousands of real-time prices each second to execute with the best LP, rather than the traditional RFQ alternative limiting selection to a small panel of LPs while leaking intent to the market.
5. Multi-Market and ECN
Next Generation of SOR - Data Intelligence
The future evolution of the FX Smart Order Router is to provide real-time feedback to the trader on workflows they may not have even considered through simulated decisions on millions of combinations of liquidity and execution methods - A true tool for smart order workflows and not just smart order routing. It is a paradigm shift that turns the concept of SOR on its head.
FX etrading has already automated a great number of routine jobs. The yesteryear trading floors with hundreds of traders on the phone are today replaced by a few silent traders manning exceptions in the systems that process in milli-to-microseconds tens of thousands of quotes and orders each second.
In reality, machine learning (ML) will bring intelligent decision making to systems which for a very long time aimed to only become faster, but not always smarter. ML will allow near time predictions and analysis which will drive systems and decisions. It means that the silent trader will now have a better understanding of what the system and overall market is doing.
Smart Order Router (SOR) - Manage and seek liquidity with 470+ configurable parameters
Smart Order Routing vs Algorithmic Trading
A common question asked is whether a SOR is an algo (algorithm). Technically, the SOR rests upon the same technology used to develop and engage in algorithmic trading.
In a MiFID context, it can be argued that distinct from an algorithm, the SOR does not ever fail to execute on available liquidity. It never removes itself from the market or chooses to pass an opportunity to execute in the prospect of better future returns.
The SOR is about the best possible immediate action and therefore does not require the same level of scrutiny as a more time based automated policy. The answer is open to interpretation and we see clients deciding in both directions based on their internal evaluations.
