- Execution algorithms (EAs) – designed to buy or sell foreign exchange according to a set of user instructions – have contributed positively to FX market functioning.
- As EAs change the way market participants access the FX market and how trades are executed, they also give rise to new challenges.
- Central banks and market participants must have access to the necessary data, skills and tools to allow them to assess the opportunities and risks of evolving markets.
Execution algorithms – designed to buy or sell a predefined amount of foreign exchange according to a set of user instructions – have seen a rise in usage amid an increasingly decentralised and fragmented trading environment according to a report published today by the BIS Markets Committee.
This has helped support price discovery and market functioning but also has the potential to create new risks, said the report, FX execution algorithms and market functioning.
The report examines the drivers and implications of the increase in EA usage in FX markets. It draws on a unique survey of 70 sophisticated market participants globally and extensive industry-wide outreach, and provides distinctive perspectives on the use of EAs, including by central banks.
Prepared by a study group led by Andréa M Maechler, Member of the Governing Board of the Swiss National Bank, it concludes that while EAs improve market functioning, they also create new challenges. In particular, they transfer execution risk from dealers to end users; contribute to changing liquidity dynamics and the underlying market structure; and raise the bar for market participants in accessing the data, skills and tools required to navigate this market successfully.
“The report provides an insightful stocktake of the growing use of FX execution algorithms by a broad range of participants in FX markets, and highlights both the benefits and the potential risks of such execution algorithms. This will help market participants gain a deeper understanding of such elements, which are becoming increasingly important in FX markets,” said Jacqueline Loh, Deputy Managing Director, Monetary Authority of Singapore, and Chair of the Markets Committee.
EAs may also create self-reinforcing loops and exacerbate sharp price moves, although initial observations from the Covid-19 pandemic suggest that these risks may be less acute than expected. Still, further research is needed.
“While the focus of the report is on the FX market, many of the findings are also of broader relevance to other fast-paced electronic markets experiencing similar trends. As those markets continue to evolve rapidly, access to high-quality data, novel skills and adequate tools becomes key in this context,” said Ms Maechler.
These issues require broad-based collaboration between the official and the private sectors. The Global Foreign Exchange Committee (GFXC) has already established workstreams on algorithmic trading and disclosures to examine them in detail.