Mispriced Foreign Exchange (FX) transactions cost the
European fund management industry and their underlying clients approximately
€1.5 billion per year, according to a paper published by The New City
Initiative (NCI), a think tank representing the interests of asset managers.
The paper – “The Changing Face of Foreign Exchange” –
estimated conservatively that $590 billion of institutional investor FX
transactions were at risk of being mispriced on a daily basis. As such, the
paper highlighted institutional investors and their fund managers had an
obligation to ensure they are obtaining the best FX pricing and execution from
Custodian banks will often provide ancillary services such
as FX pricing on behalf of clients. There have been concerns that a handful of
banks have accrued significant or excessive profits from undertaking these
transactions on behalf of institutions. Identifying these profits on a trade by
trade basis has been challenging due to the lack of time-stamped trades.
However, institutional investors are increasingly being given time-stamped data
by custodians if requested. The paper also
advised institutions utilise independent FX transaction cost analysis (TCA)
during the investment process as a means by which to “improve trading
strategies and practices and reduce trading costs.”
Part of the FX challenge lies with the London 4.00pm FIX,
which determines the benchmark rate based on trades taking place in a set time
window. “Market activity around the FIX is irrational and generates a spike in
volatility resulting in an increase in market spreads. Trading FX at the London
4.00pm FIX is predominantly one directional skewing market pricing and adding a
false premium to market pricing,” read the paper.
There have been reforms. In February 2015, the fixing window
on the 4.00pm FIX was widened to five minutes from one minute as a mechanism to
curb manipulation of FX prices during the fixing process. The Financial
Stability Board (FSB) published a report outlining the progress around FX
benchmark reforms and praised London for making significant improvements to the
FIX. It said the improvements had been most noticeable among the largest market
participants and the most used benchmarks, “but elsewhere there is scope for
The Fair and Effective Markets Review (FEMR)
published recommendations in June 2015 aimed at restoring confidence in the
Fixed Income, Currencies and Commodities (FICC) markets. FEMR recommended the
Bank for International Settlements (BIS) and national Central Banks compile a
Global FX code, outlining a set of principles governing trading practices
covering market integrity, information handling, treatment of counterparties
and standards for venues.
Charles Gubert is a freelance writer who also contributes to New City Initiative's regulatory update.