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How Choosing the Right Marketplace Can Help Hedge Funds Optimise Their Foreign Exchange Performance

More money is flowing into the foreign exchange markets than ever before. The latest triennial survey by the Bank for International Settlements (BIS) released during 2005 revealed that daily foreign exchange turnover had soared to US$1.9 trillion in 2004, up from US$1.6 trillion in 2001. This growth is being propelled by trading from non-bank financial institutions – pension funds, asset managers and, perhaps most strikingly, hedge funds.

The Lure of the Foreign Exchange Markets

One reason that hedge funds have flocked to the currency markets is their volatility. Faced with lacklustre equity markets, investors were drawn to foreign exchange, where economic and geopolitical uncertainties had created instability and hence greater potential for alpha.

Hedge funds are also attracted to the currency markets because they offer enormous potential for leverage. For major currency pairs, banks can let customers trade on two to five per cent of margin, meaning that a hedge fund with a mere US$10 million could be trading a US$200 million position in and out of the market in a single day. This allows smaller players to punch above their weight in a way that is much harder in the fixed income or equities markets.

As hedge funds, like other market participants, become more international in outlook, they are trading more foreign exchange for both transactional and hedging purposes. Finally, there are simply more hedge funds and other alternative investment vehicles around than there were in 2001, being given more money by institutional investors and wealthy individuals to invest both in currencies and in other asset classes.

Electronic Trading Has Opened the Market to New Participants

The rise of online foreign exchange portals has also played a key role in driving up foreign exchange volumes. Telephone trading, while it works well for global macro discretionary traders, is not conducive to the high-frequency, model-driven strategies employed by the majority of funds. Electronic trading finally gave hedge funds a method of execution that was fast and efficient enough to support even the most dynamic trading strategies.

Rather than having to ring several banks to ask for a quote, funds can now see prices from all their liquidity providers on a single screen. By increasing the speed of execution, online portals have made it possible for hedge funds to push larger trades through the markets, at higher frequency. Through improved price transparency, they have made it far easier to achieve best execution and get the optimal price on every transaction. These advantages have led to existing foreign exchange traders increasing their trading volumes, and new ones entering the market.

Sophisticated, Dynamic and Demanding Customers

Hedge funds are among the most technically sophisticated organisations operating in the financial markets, and are widely credited with driving recent technological advances in foreign exchange. They have been quick to adopt electronic trading, which complements their typically high-volume, dynamic trading strategies. They are also pioneering model-driven trading, in which trading decisions are made by complex computer programmes that track markets and execute when certain conditions are met – the parameters tracked by various models can range from currency prices to trading volumes or price movements in related markets. By managing individual trading decisions, these models free up traders to focus on monitoring overall market position and developing new strategies to generate alpha.

Any fund that has made a significant investment in trading technology needs to be sure that its trading partners – whether these are individual counterparties or multibank portals like FXall – are operating at a similar level of technological sophistication. If the bank you are dealing with is still delivering prices over the telephone, or over a slow or unreliable Internet platform, it's impossible to get the most out of your trading technology – it is a little like owning a video phone when the rest of the people you know have yet to graduate to picture messaging.

Choosing the Right Marketplace

So what do hedge funds need to look for in a marketplace? High-speed connectivity and straight-through processing are essential if trading models are to work effectively. Funds also need a constant flow of up-to-the-minute market data to feed into these models, whether this comes from their trading platform or an independent market data provider. Deep liquidity is a must for active dealers who demand the ability to fill large trades, at tight prices, in seconds. A confidential trading environment is another requirement for funds, which need to deal in the confidence that the market will not be alerted to their decisions. Finally, hedge funds are increasingly looking for platforms that go beyond execution to automate the full transaction lifecycle, including prime brokerage messaging and the instantaneous download of trade details into portfolio management systems.

Checklist – Five Steps to More Efficient Foreign Exchange Trading

  • Instant access to deep liquidity
    Speed of execution is crucial for hedge funds, especially for those that have invested in algorithmic trading models. If there is any slippage between the time the trigger to buy or sell is generated, and the time the trade is executed, the fund loses out – and loses one of the main advantages of algorithmic trading models, the ability to trade instantaneously when market hits a certain point.

    By linking to a continuous streaming prices service, rather than a request for quote service, hedge funds are virtually guaranteed a permanent source of liquidity. This ups the chances of achieving the rate initially targeted. To make sure orders get filled quickly, funds should also make sure that the platform they choose offers deep liquidity in major and exotic currencies from a broad range of liquidity providers.

  • High-speed connectivity
    To execute every transaction as closely to the signal as possible, hedge funds need high-speed connections that make it possible to request and execute a trade within fractions of a second. Since every fund will have their preferred connectivity method – for example, Java, Microsoft COM or FIX – they should look for a platform that supports this, rather than one that requires them, to install new technology.

  • Fast, accurate market data
    Trading models make lightning-fast decisions based on changes in market conditions. For this reason, market data needs to be a key consideration in any choice of trading platform. Funds may want to select a provider that combines execution services with a comprehensive, unbiased source of real-time market data that they can use as the input for their trading models, as well as for marking their books to market.

  • A completely confidential trading environment
    Understandably, hedge funds place a high value on confidentiality, and the ability to take large positions without alerting the market. Confidentiality is therefore central to any fund's choice of trading platform. It is essential to select a model where transaction details remain completely confidential between the customer and the liquidity provider, and are never published to the market.

  • Seamless straight-through processing – including prime brokerage messaging
    Automating the full deal lifecycle makes trading quicker and more efficient, as well as reducing costs and minimising operational risk. It is therefore important to select a trading platform that automates the full deal lifecycle, rather than one that just offers execution.

    For hedge funds, prime brokerage messaging has historically been one of the most cumbersome elements of the foreign exchange trading process. It is typically a laborious, manual procedure carried out by middle and back office staff. The high dependence on human intervention increases costs and risks, and means that errors can take hours or even days to resolve.

    The best foreign exchange trading platforms have addressed this problem by created automated prime brokerage messaging solutions. These solutions enable the automated exchange of give-up messages in real-time, so that all counterparties receive a timely notification of the status on any deal.