Exchanging Ideas

Asset management houses are changing the way they organise their business as the asset class is transformed by new technologies and regulations. That means an emphasis on best execution, as well as the technologies to go with it as FX evolves into more of an actively traded asset class for our portfolio management.

“We face regulatory adverse impacts on liquidity and fragmentation, on the other hand it’s been major central bank policy diversion that contributed to higher volatility since last year,” Schoeppe told the Buy-side Perspectives.

“Therefore modernising best execution concepts has been a focus theme in the asset management industry: how can we get the best result from liquidity providers for our investors?”

Deutsche Asset Management has reformed its FX trading in recent years. At one time, the firm didn’t have a dedicated FX desk. Then the asset management house began to automate FX positions arising from securities trades. Such Treasury FX trades were collected and executed at 10.00 and at 16.00 daily.

As the market becomes increasingly electronic and sophisticated, Deutsche Asset Management has increased the proportion of its FX flows that are traded in an automated manner from zero to between 30-40% - a percentage that is expected to rise as the firm continues to automate in the coming months and years.

“This era of market structure changes continuously leads to electronic routes taking major shares of FX trading, meaning systematic data access and handling has become increasingly important for asset managers in the light of MiFID II regulations,” said Schoeppe. “Technology continues to be the most important factor in this electronic migration: leveraging an EMS/OMS suite for the asset class FX to become most efficiently traded is key.”

Historically, FX has been traded bilaterally on an OTC basis. A host of new platforms have emerged in recent years where FX can be traded in a more electronic exchange-style execution environment. Examples include FXall and LMAX. At the same time, other tools such as BlackRock’s Aladdin order management system have emerged, which combine risk analytics with portfolio management, trading and settlement tools on a single hosted platform.

“One key aspect involves active counterparty management and enhanced communication: our traders need to continuously assess and monitor what areas of the business liquidity providers are committed to, which impacts how and where our business is executed,” said Schoeppe.

For Deutsche Asset Management, tools such as Aladdin are useful because they remove the problem of reliance on numerous different IT interfaces. They are also better suited to non-equity asset classes than some of the older technology platforms, which in some cases were originally designed for equities only and then simply ported across to FX and other asset classes, with the result that their abilities were not always ideally designed for OTC products.

While undeniably important, technology is not everything in FX, however. A more holistic perspective is one of the key areas that Schoeppe likes to emphasise when it comes to achieving best execution in FX. For example, he says that tools such as Transaction Cost Analysis (TCA), while useful, are not the be all and end all solution to all the asset manager’s needs.

“TCA supports achieving the best overall result of trading - which does not only consists of the best price though,” he said. “For example it’s no use having one counterparty at the top of the pricing list if the same one fails in every second trade matching, or for example provides no market colour/research to us.

Liquidity analysis is key for point-in-time or automated execution which continue to play a major part of the daily basket of modern buyside FX traders adapting to change and enhancing their trading style – they must understand how our liquidity providers handle our orders and confirm their intention for best execution.”

For this reason, every year votes are collected from Deutsche Asset Management on which broker provided the best service, and this feedback is shared with the sell-side. In this area of liquidity fragmentation, there is also the continuous need to remain engaged with the sell-side, and to ensure liquidity and pricing are sourced from multiple different sources to maintain execution quality.

“Our biggest duty in the FX industry is to strive for more transparency and the infrastructure needed to keep up with the growing volumes of data,” said Schoeppe. “We have to elaborate best execution across the whole firm, and therefore not just performing internal TCA but also evaluating what specialized providers can offer including multiple benchmarking. The challenge remains that FX is an over-the-counter product and no official mid-market reference point currently exists. But we are getting there with the right mix of indicative and tradeable reference prices which both have their value in existence.”

Aside from technology, one of the most visible drivers of change in the FX market is the overriding hand of regulation, directed by the European Commission and specifically its forthcoming MiFID II legislation, which was originally due to take effect in January 2017 but has now been pushed back by one year due to lack of time to finalise the regulatory technical standards. These are now expected to make an belated appearance .

While the original MiFID was conceived with a limited goal to promote transparency and competition in the European markets, its successor is a far more ambitious. MiFID II encompasses all equities, fixed income and FX products. Crucially, FX derivatives are being forced onto centrally traded and cleared platforms. That means that a significant portion of the market is moving towards electronic execution. But more broadly, asset managers must also consider their best execution obligations under MiFID II – a task that requires both verifiable data and the means to understand and analyse the market.

The increased focus on regulatory scrutiny also links back to the demand for more transparency. For example, the global central banks are launching a code for FX traders around the world, encompassing a code of conduct and ethics. Schoeppe recalls that on joining the industry, he had to pass trading and compliance tests in some industry areas – but that such tests seem to have fallen by the wayside in the years afterwards. Now, these tests are being brought back across the industry and made mandatory again – a move he sees as correct and positive for the industry.

“Internally we continue to see an increase of frequency and face-time spent in our governance processes and forums where our trading results are reviewed and discussed with compliance, risk, settlement, operating, and technology specialists as well as of course with our PMs,” he said. “The asset side will continue pushing for more transparency into the markets.”