Articles
September 1, 2024
Originally published in FX Algo News, August 2024
Increasing buy-side sophistication in electronic trading practices continues to fuel the demand for greater transparency from FX Algos. Much of what was once accepted as a “black box” is now expected to be disclosed. Alongside this evolution of client knowledge, FX Algos are becoming increasingly complex – the need for clear communication and understanding between providers and their clients has never been stronger.
While initiatives like the FX Global Code emphasize the importance of transparency, they also recognize the need to balance this with the protection of proprietary information. This raises a critical question: How much transparency is appropriate?
The transparency conundrum
FX Algo providers leverage proprietary technology and quantitative methods (including artificial intelligence and machine learning) to perform smart order routing and other components of the FX Algo service. This intellectual property and software are often developed in conjunction with the provider’s separate role as a principal market-maker.
These proprietary methods allow firms to maintain a competitive edge across both their Algo service provider and principal market-maker businesses, but they can place limitations on the degree of transparency it is possible to give clients.
Conversely, it is the client who bears the execution risk when using an Algo. They need to trust that the Algo’s behaviour and decisions are in their best interest.
This trust is built not on legal requirements for full transparency, but on the understanding that clients need sufficient information to make informed decisions about when to use an Algo, which provider and product to use, and then analyse how the Algo performed.
Striking the right balance
While complete disclosure of proprietary methods may not be feasible or desirable, Algo providers are often best served by being as forthcoming as possible with their clients within the constraints of protecting their intellectual property.
It’s important to note that it’s not necessary for clients to access or understand all elements of FX Algo decisions. For example, the decision to trade on a particular venue, price, or order type may be a result of the provider’s proprietary signal generation, or alpha. These trading signals give providers an edge when trying to achieve best performance. This falls under the intellectual property of the provider and is part of what differentiates their offering in a competitive market; the provider’s expertise in these areas is one of the motivations for selecting and using the Algo.
On the other hand, the provider needs to share enough information to allow the client to make informed decisions, giving them the confidence that they are acting in their best interest and behaving appropriately in the face of any conflicts of interest. This is particularly important given the dual role many providers play as both Algo providers and principal market-makers.
With this in mind, Algo providers often take the following steps:
1. Providing execution data and performance metrics: Comprehensive trade data and performance metrics (including TCA) allow clients to evaluate the Algo’s effectiveness. Analysis of performance in the context of the broader market (sometimes in conjunction with external data providers) can give clients further confidence by looking at larger sample sizes.
2. Disclosing fundamentals: Sharing as much as possible about the Algo’s core principles and the factors that influence its behaviour, without compromising competitive advantage.
3. Acknowledging limitations: When certain aspects cannot be shared for proprietary reasons, providers can be upfront about these limitations and explain why such information is sensitive.
4. Fostering trust: Open communication is crucial. Providers can proactively share relevant information and address client concerns about Algo behaviour and performance. This is particularly important regarding how potential conflicts of interest are managed.
5. Adding context: Even when specific technical details cannot be shared, providers can offer context about market conditions, general strategies, and alternative outcomes to help clients understand the Algo’s behaviour in different scenarios.
These are just some of the ways that providers can offer meaningful transparency that builds client trust and satisfies their need for information, while still protecting the proprietary elements that give their Algos a competitive edge in the market.
The FX Global Code, Algo due diligence and TCA templates
After considering feedback received during the 2020/21 review of the FX Global Code, and a 2020 BIS report, the Global Foreign Exchange Committee (GFXC) concluded that there was a lack of information available to allow participants to make an informed decision when selecting Algos, and that the information that is shared lacked standardisation.
To help address this, the GFXC published an Algo Due Diligence Template which contains a set of questions covering key topics: conflicts of interest, order routing policy, data segregation, safety features and TCA. While the template is not formally part of the FX Global Code, Principle 18 encourages Algo providers to share disclosure information in a standardised format, such as the Algo Due Diligence Template, to allow clients to more easily compare and understand the services.
The GFXC also created a TCA Data Template to address the high bar for participants in evaluating Algo performance via TCA. This standardised approach should help make the TCA process more accessible to all participants.
Importantly, the GFXC does not ask for the disclosure of any proprietary information, and allows providers to determine the appropriate level of detail in their disclosures.
Considerations for the buy-side
When engaging with FX Algo providers, buy-side firms should look to maximise the value of information that is shared with them while also considering how their own choices may affect the level of transparency that can be provided.
1. Motivations for transparency: Seek sufficient information to make informed decisions and gain confidence that providers are acting in the best interest of the client. However, keep in mind that providers must keep certain proprietary information confidential to provide the best possible Algos.
2. Balancing sophistication and transparency: More complex Algos may offer superior performance but come with less visibility into their decision-making processes. The buy-side must weigh the potential benefits against the level of transparency provided.
3. Interpreting performance metrics and disclosures: Develop the capability to analyse and interpret trade data and performance metrics, asking providers or an independent voice for guidance when needed. Similarly, try to process all the provider’s disclosures and open further dialogue if anything is unclear or unsatisfactory. Even with standardised templates, there is still room for different interpretations and varying levels of detail.
4. Understanding conflict of interest management: Managing conflicts of interest is a crucial responsibility for all providers, so it is reasonable to expect straightforward descriptions of how it is done and satisfactory answers to questions.
Conclusion
Successful relationships between Algo providers and their buy-side clients will be built on more than pure Algo performance – the challenge lies in fostering an environment of trust and mutual understanding. Providers must effectively communicate the value of their proprietary elements while still offering meaningful transparency that enables their clients to make informed decisions for their businesses.
In the ever-evolving landscape of FX Algos, expert guidance can be invaluable. Hilltop Walk Consulting combines in-depth market knowledge with years of hands-on experience to offer valuable perspectives. Our team works collaboratively with clients, turning complex challenges into opportunities for enhanced performance and informed decision-making across financial markets.
