FX algos contribute to thinning of order book, BIS report suggests

Research from BIS outlined that the thinning of the order book due to automation and FX algo trading could impact market functioning in times of volatility.

Execution algorithms for FX trading are contributing to the thinning of order books which could impact the ability to absorb market shocks, a report published by the Bank for International Settlements (BIS) has suggested.

The report stated that during interviews with market participants, several referred to the fact that visible depth in public order books is lower nowadays due to increased automation of FX trading and the use of execution algorithms.

It added that there is evidence that FX algorithms contribute to thinner order books as they slice orders and spread them over time, which has reduced the need to provide large amounts of liquidity.

With less large limit orders to buffer market shocks, a thinner order book leads to a lower ability of the market to absorb shocks in periods of stress from news or ‘fat finger’ trades, the report explained.

However, as the order book is often replenished quickly, market functioning as a result of thinner order books is not as heavily impacted. Although in the long-term and under certain market conditions, price discovery could be hindered.

“Although visible liquidity is likely to be thinner due to the slicing of orders into small pieces, market resilience is not affected as long as the order book is replenished sufficiently fast,” said the report. “Over time, however, by reinforcing the trend towards smaller order sizes and internalisation, execution algorithms could contribute to a reduction in visibility of depth and turnover on primary markets, which could, in the extreme, hamper price discovery and market functioning.”

Generally, the report from BIS found FX execution algorithms are beneficial to market participants in terms of navigating the fragmented landscape, with most providers surveyed providing access to more than 10 liquidity pools via their algo trading services. 

FX algos can route orders to the best available source of liquidity making them an effective tool to help match diverse trading interests.

They can also be used to construct an aggregate order book by combining information from their own transactions and market data from various trading venues for an aggregated picture of prevailing market conditions that can inform execution decisions.

This aggregated view provides traders with estimates on transaction volumes in near real-time that otherwise would only become available with long lags.

“This study clearly shows that when it comes to the use of algos in FX, the benefits far outweigh the concerns. Fundamentally, algos are enabling the end-user be it active trader or portfolio manager to deliver better execution for clients,” Hugh Whelan, global head of liquidity management at CME Group’s EBS, commented on the report.

He added that as portfolio managers devise their month-end hedging strategies ahead of the US election this week, traders are often faced with having to make execution decisions during times of significant volatility, making the cost of adding hedges potentially very expensive.

“Depending on how large major currency market swings and how long uncertainty and volatility lasts, a portfolio manager will need all the tools at his disposal to source the best liquidity and execute efficiently. In this scenario, the use of algos has become very popular and allowing the end-user to manage the situation far more efficiently than a human trader possibly could,” Whelan concluded.