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Algos in FX: slow start, massive potential

Although algorithmic trading has been slower to gain traction in foreign exchange (FX) than in equities and other classes, it will continue to capture volume in FX.

A new report from Greenwich Associates analyses the evolution of algorithmic trading in foreign exchange.  It reviews the current rates of algo usage and trading volume, examines the reasons algo trading adoption in FX has lagged and projects where FX algo trading will go from here.

“Given the potential stakes, it is only a matter of time before issues of data scarcity and other hurdles are addressed and algorithms take on a central role in FX trading,” said Ken Monahan, senior Aanalyst for Greenwich Associates Market Structure and Technology, and author of ‘Digitization Delayed: Why Algos Aren’t More Popular in FX’. 

Massive potential

In the US and Europe, only 37% of FX market participants use algorithmic trading, and those that do use algo trades for only 22% of their overall volume. By comparison, algorithmic trading has become nearly ubiquitous among institutional traders in equities, where almost half of all trading volume (46%) is now executed through either direct market access (DMA,) smart order routing or algorithmic trades.

There are several reasons for the relatively low level of uptake in FX. The lack of trade disclosure requirements in FX means market participants do not have access to the universal data on pricing and execution that inform algorithms in equities. Also, many FX trades originate as second-order hedges, as opposed to alpha generators, and this limits the utility of algo trades to some market participants. Looking a bit deeper, less than half of FX market participants use benchmarks to measure trade performance, and even fewer use the sophisticated transaction-cost analysis (TCA) systems that have served as an accelerant for algos in other asset classes.

However, there is every reason to expect that algo trading will evolve into a mainstay in global foreign exchange. One central reason is the size of the potential market. FX traders view algorithms as a perfect fit for the biggest trades - the area of the market that represents the last redoubt of voice execution.

“The fact that traders see algos as effective tools for both large trades that need to be worked over time and big trades that need to be executed quickly show how impactful algorithmic trading will ultimately have in this market,” concluded Monahan.

 

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