Posted by Dan Hubscher
Equities markets, which have seen HFT and algo trading go through the roof, have recently started clamping down on excessive and cancelled orders. As my colleague recently explored, Deutsche Börse, Borsa Italiana, NASDAQ and Direct Edge have all announced intentions to discourage the number of cancelled orders they receive. They will encourage the "good" liquidity, those players with high fill ratios, and punish the "bad".
The IntercontinentalExchange has already seen good results from a policy it implemented last year aiming to discourage "inefficient and excessive messaging without compromising market liquidity." Regulators, too, are taking note; the SEC is considering charging HFT firms for cancelled trades.
A combination of economic incentives and controls makes it happen. In addition to adjustments to their rebate schemes, exchanges must monitor their market makers in real-time to make sure that they are living up to their quoting obligations. This monitoring can also include spotting the "Stupid Algos" blamed for generating a burden the exchanges cannot bear.
It was only a matter of time before other asset classes started to see similar problems with excessive orders, and a similar response via a new generation of intelligent “sensing” algos – but with a twist.
FX is increasingly traded by computers. Consultancy Aite Group said in a report last year that FX algorithms will account for more than 25% of FX trade volume by the end of 2014. And as algorithms take control, the opportunity for a flood of quotes and cancellations increases. Order-to-trade ratios, the number of orders that come in compared with the number filled, create a load on exchanges and electronic markets and they can provide a smokescreen to hide potentially abusive behavior (so-called “quote stuffing”).
We see innovative FX brokers taking measures to rein in unproductive order flow. Similar to equities marketplaces, FX dealers and brokers are increasingly utilizing tactics that discourage excessive orders, but in a very different way. Because FX is mainly traded via single dealer platforms, multi-dealer platforms such as FXall, and interdealer marketplaces, it is fragmented in a different way from equities.
So it is the FX brokers that are acting like exchanges and taking the initiative to control toxic order flow with their pricing strategies. Brokers need to see every opportunity and threat hidden in their customers’ flow patterns, and automate their own real-time responses, to stay profitable as markets change. Brokers servicing HFT clients react to predatory algorithms and fluctuating fill ratios by manipulating the spreads they offer. Traditional customer profiling based on purely historical data is good for strategic decision-making. But for more tactical decisions with immediate impact,real-time analysis is additionally required.
A responsive broker can, for example:
- Mitigate "toxic flow" by detecting predatory patterns in real-time, and automatically widening spreads to those clients
- Increase business by detecting reduction in flow from “good” clients, and automatically reducing spreads to those clients
- Preserve the relationship by detecting pending credit breaches, and immediately calling the client
Our customers use the Apama platform to perform their own customer flow analysis. Both global and regional FX brokers now optimize how they serve their customers based on detailed real-time diagnosis of their flow. Key parameters include P&L on individual trades, an aggregated view of individual trades over time, and the performance of tiered client groups. Using real-time customer flow analysis brokers (and banks and trading platforms) can figure out which customers are providing the types of order flow that they need.
Customer flow sits alongside other real-time market trend analytics such as volatility, average daily volume, and depth of book. For example, flow from a specific customer is high but liquidity is thin - then time of day impacts spreads in addition to customer behavior. Our customers have also been generating pricing dynamically – adjusting spreads and skews - based on market conditions and customer trading patterns – including HFT patterns.
Dynamic pricing builds on an aggregated order book as source pricing. A basic pricing service dynamically applies a set spread to the base price generated from the aggregated book. A more advanced service changes the spread based on any data or rule, for example:
- Current volatility
- Depth of book (volume on bid/ask side)
- Real-time risk parameters such as profit/loss levels
- Current vs. target position (changes the spread or skew automatically, and updates the auto-hedger service)
- Customer tier
- Historical & real-time customer trading behaviour
Brokers can take input including aggregated FX prices, customer trading patterns, market volatility and hedging activity - all in real time - into the platform. The analysis generates dynamic pricing (spreads/skews) and it can work to incentivize market participants to provide quality - not quantity - orders.
Toxic order flow, like excessive orders-to-trade, can tax trading systems and create an environment where fraud and market abuse can flourish. Using real-time customer flow analysis to get a handle on your customers' order flow will help to prevent this. Customer flow analysis can be used not only for dynamic pricing, but also for customizing product offerings and enabling banks and brokers to create execution algorithms for their clients to use. By being proactive, FX brokers and banks can avoid the issues that plague equities. And make money along the way.