A measured approach to FX
A series of high-profile lawsuits in which asset owners and money managers have sued custodian banks over alleged overcharging is increasing the spotlight on FX execution quality. But better use of transaction cost analysis (TCA) can help buy-side firms ensure they are getting a good deal without recourse to legal action.
Traditionally, FX has been a secondary concern for many asset managers. For institutions investing primarily in stocks and bonds, FX transactions are largely seen as a necessary add-on for trades involving foreign currencies – but seldom the main focus of trading. This led to a laissez-faire approach among many investment managers and the end-investors they served – with damaging results for quality of execution.
“Historically, clients haven’t measured the quality of their FX fills,” said Sean Hefkey, director, foreign exchange at agency broker and technology vendor ITG. “It’s been a trust relationship between the execution brokers and their custodian banks.”
However, a dispute between Massachusetts Pension Reserves Investment Management and Bank of New York (BNY) Mellon, in which it was alleged that the bank overcharged by US$20 million on FX trading, is helping to change that. Earlier cases also involving BNY Mellon, as well as a separate lawsuit filed by the US state of California against State Street in 2009, have called into question the wisdom of leaving FX transactions relatively unmonitored.
“FX was never an asset class for these customers,” said James Noser, president at Abel Noser Solutions, technology arm of the agency broker, in New York. “They didn’t focus on it – they thought of it as a mechanical issue, something that was just greasing the wheels of the rest of their investment operation. They may have had marginal investment in FX as an alternative asset class but they certainly didn’t look at the trading as something that was costing them a lot of money.”
Custodians charged relatively low explicit fees, but turned a profit on implicit fees – with the investor often none the wiser. The legal disputes have revealed a fundamental disconnect between what the pension funds and their advisors thought they were going to receive and what they actually paid, according to Noser, suggesting that some firms may have been under the mistaken impression they would get an institutional rate, similar to what a central bank would pay.
For Ben Gunnee, European director at the Mercer Sentinel Group, a unit of Mercer Investment Consulting, the remedy is for end-investors to ensure either they or their investment managers are monitoring FX execution – for instance, by demanding quarterly reports if necessary.
“Investors need to look at this part of the process,” he said. “They shouldn’t just assume their investment manager is looking at the FX transactions on their behalf. The good news is that if something is being monitored, performance does tend to improve.”
Mercer offers proprietary FX transaction cost software that benchmarks individual trades against market rates. The FX tool benchmarks currency forward contracts and has specialist features for monitoring currency overlays alongside more plain vanilla spot prices to ensure all types of FX trades are monitored and reviewed. FX cost analysis reports can be customised to an investor's requirement and provided at any frequency from monthly to annual. A report quantifies any excess costs and recommended action to stop a recurrence in the future.
Historically, part of the problem has rested with the quality of data available. Even when clients or investment managers requested information on the quality of their FX execution, often the custodian bank would only provide details of pricing, but with no time-stamping – making it hard to compare the price against the prevailing market value. But that is beginning to change as clients become more aware of their sources of cost.
“Ensuring a time stamp on each executed trade is important, because then you can see what that price should have been,” said Hefkey, whose firm offers a transaction cost analysis service tailored to FX in conjunction with trading platform FXall. “We’ve seen more clients taking a strong interest in terms of understanding the process better – looking for better fills and learning to trade better.”
Bid-ask spreads in FX may also provide some degree of challenge to asset managers more accustomed to equities. In FX, small transactions tend towards wider bid-ask spreads, medium size transactions typically have narrower spreads, but for large transactions the spreads are wider, due in part to the risk-transference role of FX trading.
Earlier this month, Abel Noser launched an FX TCA offering that provides access to intraday FX pricing data. Based on the firm’s analysis of FX TCA results since the start of the year, Noser believes the numbers support a definite difference in trading results between investment managers that took direct involvement in FX trades and those that simply left them outsourced and unmanaged.
“We’ve looked at trading from a few customers and have seen cases where the cost of trades that were done by standing instructions was more than two times the cost of trades negotiated by investment advisors,” said Noser. “The standard instructions have spreads that are two or three times wider than the trades executed by the investment advisor.”