FX execution algorithms and market functioning

Report submitted by a Study Group chaired by Andréa M Maechler (Swiss National Bank)

On the back of increased fragmentation and automation in the FX market, the use of execution algorithms (EAs) has been on the rise. Prepared by a Markets Committee study group, this report examines the role of EAs in the FX market. It highlights key trends with regard to their increasing usage, and outlines the implications for market functioning and associated policy challenges. To complement available data and research, it draws on a unique survey of providers and users of execution algorithms, as well as extensive industry-wide outreach.

EAs improve overall market functioning by increasing the efficiency of the matching process between liquidity providers and consumers in a highly fragmented market. That said, by changing the way market participants access the FX market and how trades are executed, EAs give rise to new risks. For instance, they shift the execution risk from dealers to users, which implies new challenges for users, who may be less capable of managing these risks. They also reinforce the growing trend towards internalisation, which reduces the visibility of trades. This can complicate the measurement of liquidity and, at the extreme, could negatively affect the price discovery process. EAs may also give rise to the risk of self-reinforcing loops, exacerbating sharp price moves, although initial observations from the Covid-19 pandemic suggest that these risks may not be as acute as previously believed.

The report argues that central banks and market participants alike must develop the skills, tools and data architecture that allow them to capture the risks and opportunities brought about by fast-paced electronic markets. While the focus is on the FX market, many of the findings are also of broader relevance to other fast-paced electronic markets experiencing similar trends.

JEL classification: F31, G14, G15

Keywords: fx market, price discovery, execution trilemma