Understanding The ECN Landscape. Technology Choices

Established participants in the equities and commodities markets view over-the-counter foreign exchange as an alpha-generating opportunity. As equity markets brace themselves for new levels Of regulation and confront an on-going period of lower return on investment traditional investing, the search for alpha is taking traders into new asset and FX prexnts a compelling opportunity.

FX is the world's most liquid market, with average daily volumes estimated at USD4 trillion, according to EBS estimates. It is a vibrant marketplace combining the professional dealing desks of the world's largest banks, regional and smaller banks, hedge funds, proprietary trading firms, hind managers, as well as a growing number Ofretail-level investors.

OTC FX is a self-regulated market and functions remarkably well as such. A recent example is offered by the 6 May 2010 EURIUSD price action on the EBS platform. Driven by volatile markets responding to the Greek debt crisis, trading volume on EBS that day exceeded $393 billion, representing nearly 255,000 transactions. The electronic EBS market provided efficient and effective access to prices at all price points, including during the most volatile I O minutes ofthe trading day.

In addition to the diversity of participants, the array of unique that make the FX market special are all understood and have been incorporated into the dealing models of the marketk most successful professional trading organizations. For new entrants, each ofthese characteristics poses a potential new challenge and set Of risks, and must be carefully understood, planned for and navigated before trading in the production environment.

What are the issues that high frequency traders must consider when entering the FX market? Primary topics include ECNmandated throttling, market-data peculiarities, slippage incurred due to the distances involved when interoperating between globally dispersed pools Of liquidity, FX-specific risk management, and simply understanding the dynamics ofwhat drives the FX market itself.

Understanding The ECN Landscape

The most widely used FX ECNs include both independent as well as bank-owned platforms. Among the independent venues, EBS handled average daily volumes of USD215 billion in May 2010. EBS began its life in 1991 as an outgrowth Of Quotron, an electronic OTC interbank trading system formed by a consortium Of major FX banks.

Beginning around 2000, a host of other electronic trading systems began to populate the landscape. The platforms vary in their but in general are more oriented toward the buyside community than EBS and Reuters.

EBS and Reuters remain anonymous pools ofprimarily wholesale liquidity. In 2005, EBS was the first to permit access to the buy-side. Hedge funds and Commodity Trading Advisors (CTAs) gain access to the market by establishing a relationship With and leveraging the bilateral credit privileges ofan ERS prime bank. In the wake of(24 2008, it is now not uncommon for a buy-side market participant to manage risk by contracting with more than one — and frequently up to three — prime banks. side participants trade on EBS using FIX-Iike API the use ofproximity hosting services near the three regional matching engines in New York, London and Tokyo is common.

The large global banks themselves have also developed electronic trading platforms and marketed them agressively to their customers both GUI and API access. For many banks, their FX portals constitute an important part of their liquidity pool. Bank portals often feature enhanced functionality via the GUI interface (for example •IAVAP, VWAP and Other forms Ofalgorithmic execution). Drawbacks to portals include a loss of anonymity and the subsequent lack ofpricing transparency, and the fact that trades Will have to be given up unless done with the cuscome/s primary prime bank.

Many high frequency players successful in equities are caught short by the throttling imposed by the larger, more liquid FX ECNs. TO minimizepotential degradation ofthe GUI-based trading experience on the platforms due to uncontrolled APIfuelled trading, both EBS and Reuters place limits on the number of orders that can be submitted within a rolling window. EBS also imposes fill ratio requirements. For the firm with strategies that operate by making markets around a theoretical value, throttling and fill ratios can be vexing. TO be successful in FX, these firms must therefore carefully and ingeniously modi6' their profitable equities exchange-based strategies to accommodate these restrictions.

OTC FX market data also poses challenges to the high