Insights on...
FOREIGN EXCHANGE
John Turney
Northern Trust Senior Vice President Global Fund Services [email protected]
Investment managers must use a foreign exchange workflow that provides tools to achieve trade execution consistent with investment objectives.
F O R E I G N E X C H A N G E T R A D I N G :
E X E C U T I O N E F F I C I E N C Y C O N S I D E R A T I O N S
The unique structure of the global foreign exchange (FX) market poses a range of challenges to investment managers and their clients. As the marketplace continues to adapt to the effects of regulation, litigation and technology, investment managers must carefully align their FX workflow with investment objectives to achieve efficient FX execution. Failure to understand the challenges in FX execution, or the various tools FX providers offer, may negatively affect performance and returns.
The efficiency of FX execution is never far from the minds of international investors or investment managers stewarding client portfolios. Investment managers must adapt to shifting central bank policy and increased regulatory requirements while navigating other market developments.
The multi-year lows in volatility we saw in early 2014 quickly dissipated, and volatility has actually accelerated into 2015. Central bank actions, such as the Swiss National Bank’s removal of the peg to the euro and the People’s Bank of China’s decision to allow more market influence over the value of the renminbi, are two prime examples where action by the authorities raised uncertainty in the market. In addition, all these changes leave the industry struggling to develop responses to a wealth of new regulatory expectations. For instance, the introduction of
non-deliverable forward trading via swaps execution facilities helped split the instrument’s liquidity, catching market participants less than prepared for, or divided about, participating (Watt, 20132). In addition, these vehicles launched barely a month after emerging market FX
volatility had peaked following a rise of more than 80% from its May 2013 low.3
Mutable environments such as these require investment managers to stay vigilant and use an FX workflow that provides tools to achieve trade execution consistent with investment objectives.
REGULATION’S EFFECTS
Regulatory concerns not only affect liquidity but also touch trading relationships as market participants work to comply with the U.S. Dodd-Frank Act and European Market Infrastructure Regulation (EMIR). Investors and investment managers view complying with foreign laws differently, and regulators have been slow to clarify and coordinate around extra-territoriality. In particular, post-trade reporting obligations under EMIR proved challenging. Some buy-side firms did not possess the infrastructure necessary to comply with reporting obligations and had to seek outsourced reporting that sometimes directly affected counterparty selection.
One must consider the regulatory obligations inherent in a particular FX workflow, in light of available resources and investment objectives. Some FX programs require keeping legal agreements – typically a master International Swaps and Derivatives Association (ISDA) agreement – across multiple counterparties. Maintaining proper documentation and compliance information with third-party vendors can consume substantial internal or external resources. Despite hopes for extraterritorial relief around regulatory obligations, in reality a proliferation of country-specific regulations – in Europe, Australia, Hong Kong, Canada and others – have added to the complexity and challenge of compliance.
Custodial banks have enhanced post-trade reporting capabilities to meet client needs for measurement.
MARKET DEVELOPMENTS
Yet even as regulatory oversight increased, the FX market continued enjoying steady growth. Average daily volume rose to US$5.3 trillion in 2013 from US$4.0 trillion in 2010 and US$3.3 trillion in 2007, according to the triennial survey from the Bank for International Settlements4.
However, this growth has not come without challenges. Litigation surrounding standing instruction practices at some custodial banks has resulted in increased scrutiny of non-negotiated (standing instructions) trades across the entire industry. Custodial banks have enhanced post-trade reporting capabilities to meet client needs for analysis and trade execution.
As market participants sought detail on the pricing of non-negotiated transactions, much of that trading migrated to execution via third-party benchmarks, such as those published by WM/Reuters and, most popularly, the “4 pm London Fix.” While trading at this reference rate has long been popular with index managers seeking to minimize tracking error, third-party pricing broadened the appeal of executing at the fix. However, an article published in June 2013 by Bloomberg News called into question the practice of fix trading, alleging that some traders at the largest banks manipulated these popular benchmarks (Liam Vaghan 20135). In fact, following
ensuing investigations, banks fired or suspended 30 traders and regulators handed down substantial fines to numerous banks for failing to prevent traders from trying to manipulate the fix (Reuters 20146). In June 2014, Reuters reported that the European Central Bank (ECB) found
that “the fact that the FX benchmarks are often computed with a single primary data source does not fully ensure that benchmark calculations best represent the market during the fixing point of time or window,” (Reuters 20147). The transparency offered by fix trading proved to be a siren’s
call, as market participants who initially thought the fix provided adequate transparency are increasingly seeking alternative mechanisms.
ALTERNATIVES TO THE FIX
The question remains: What better alternatives exist to a point-in-time fixing or one calculated across a short interval? In its “Consultative Document on FX Benchmarks,” published July 15, 2014, the Financial Stability Board recommended that “the fixing window be widened from its current width of one minute.”8 On November 14, 2014, WM/Reuters responded to the feedback
from the regulators and market by announcing changes to its calculation methodology and by widening the calculation window to five minutes (WM/Reuters 20149). Algorithmic execution
tools, available for some time in FX and other asset classes, are gaining popularity (Riksbank 201310). Strategies such as time- or flow-weighted average price, which spread execution over
longer intervals, might serve as useful alternatives for execution. However, algorithmic execution is not a panacea and faces its own challenges. Executing very small tickets via algorithm is not efficient, so maintaining a workflow for those trades makes sense.
It certainly seems possible that the FX market could evolve to become more like the equity market, with banks acting in an agency capacity as brokers to FX clients (Euromoney 201111). In
fact, there currently are a limited number of agency offerings available in the FX space. However, Michael Lewis’ 2014 book “Flash Boys: A Wall Street Revolt,”12 made it tough to argue that the
equity market, with its dark pools and the mandate in Regulation NMS for best price, is a model that FX should rush to replicate. And it remains to be seen how much traction agency solutions might get in FX. Because FX agents are non-market makers and do not warehouse any risk, they end up trading with principal FX dealers. Determining whether an agency approach, with its attendant fee, could provide any cost benefit and efficiency over dealing directly with a FX dealer would require thorough analysis. Ultimately, regulators may determine the fate of agency dealing. While the efficacy of Reg NMS might be in question, regulatory forces could hand a similar
While price is certainly an essential element of efficient execution, the approach must be holistic and balanced.
dictate to the FX market. Alternatively, hybrid models like matched principal, pairing bank credit and clearing with non-principal dealing could gain popularity.
TRANSPARENCY AND COSTS
Efficiently executing trades in the FX market is not a simple task; investment managers must act deliberately and carefully. Participants in the FX market must be thoughtful and ensure that their FX executions are not parochially driven by a singular focus on price that discounts other important considerations in an efficient, multi-faceted FX program. While price is inarguably the most important factor in execution quality, it isn’t the only one. Investment objectives, fiduciary obligations, the expertise of staff, operating workflows, controls and credit risk are all important factors in a holistic execution measurement model.
The lack of centrally reported volume and price data in the over-the-counter (OTC) FX market, as well as the nature of principal dealing relationships, mean that a supposedly simple concept like price transparency is, in fact, a complex topic. The ECB noted in June 2014 that “the FX market is getting more fragmented with pools of liquidity concentrated in a number of trading platforms,” (European Central Bank 201413). The increase in fix trading in recent
years reflects this complexity, as the market turned to an available third-party price to deliver transparency. Without a national best bid and offer, or NBBO, like that used in the U.S. equity market, there is no consolidated tape to reference in FX (Szalay 201314). Investment managers
face a difficult challenge to achieve transparency, one that is only partially addressed by dealing on third-party prices, through negotiated trading and by accompanying post-trade reporting. And even in a negotiated setting, errors can negatively affect FX execution and investment performance. Ultimately, investors pay these costs either directly via poor pricing or indirectly through unnecessarily high management fees caused by a costly, inefficient trading infrastructure at the investment manager. Regardless, measuring those costs remains important (Borkovec, Domowitz and Escobar 201315).
In recent years, transaction cost analysis (TCA) has been one of the fastest-growing segments of the institutional FX service industry (Mangat 201216). FX industry veterans have established
firms or TCA specialists have moved into FX from other asset classes to provide measurement. Dealers guard proprietary flow information closely, making it difficult to take a clear picture of volume and price across the market. The increasingly fragmented liquidity landscape in FX is making it difficult for investment managers to access, accumulate and store enough data points to conduct precise TCA. Data services like those available from Bloomberg and Thomson Reuters make it possible to take baseline measurements for FX prices at points in time. But for many investment managers, the most cost-effective option may be a partnership with an external provider having the scale to offer a robust TCA service. Effective measurement requires establishing benchmark prices that accurately reflect an individual firm’s unique and available liquidity pool. Again, due to the OTC market and bilateral credit relationships in FX, extremely broad measures of the market can be poor benchmarks. While Transaction Cost Analysis (TCA) is necessary, outputs and analysis must be considered carefully before drawing conclusions and changing execution practices (Smith 201417).
CREDIT, RISK AND SKILLS
Just as the OTC nature of the FX market makes execution and measurement idiosyncratic, the fact that principal dealers dominate the FX market further complicates the picture, largely due to credit considerations. Credit and its availability can be significant factors affecting the pricing available to a unique market participant. Simply stated, credit relationships define the available
pool of liquidity and pricing. In terms of counterparty risk, investment managers must consider credit strength, whether the FX activity involves long-dated tenors as part of a hedging program, or is nearly all spot activity. Investors should expect their managers to have a good understanding of the credit profiles of their counterparties and any arrangements in place, such as a master ISDA Agreement or a collateral arrangement under a Credit Support Annex, to address counterparty risk. Additionally, settlement risk mitigants such as CLS Group’s multi-currency cash settlement system and netting should also be considered.
A critical question that investment managers must ask is whether FX execution is a core competency of the existing in-house team. Certainly, the answers that individual managers reach largely reflect each firm’s or fund’s investment strategy. It is simply unreasonable for investors to assume that all investment managers can efficiently transact FX in the same manner; individual investment manager definitions of best execution in the FX space will necessarily vary. Investment managers will naturally allocate resources based on the relative importance of FX to the underlying strategy’s expected return; variance across asset classes and strategies is expected. Simple factors like assets under management and head count should not be discounted because they factor significantly into the decision to use a particular method of FX execution. Regardless of available resources, investment managers should pick a method of FX execution that does not distract from core functions and aligns with the mandate’s investment objectives.
FX RESPONSIBILITY
The underlying nature of FX flows and trading objectives often depends on how critical FX is to the underlying investment strategy. This largely boils down to one key distinction within the investment process: Is FX a required cash-management function supporting investment activity, or is it a primary or secondary way to generate alpha? Both approaches can deliver efficient execution, depending upon the investment objectives. Investors, investment managers and FX providers must collaborate to support workflows appropriate to the unique needs of individual market participants. Whether employing an active or passive workflow, investment managers must have a view into the end-to-end costs to their investors. This includes understanding the operational costs around different trade types. Investors can face different settlement expenses across currencies and from hedging, trade-related or income-repatriation flows. For instance, a certain workflow might make sense for trading large hedge transactions, but could incur costs that would make repatriating income via the same channel inefficient. Again, it is incomplete and inadequate to focus solely on best price. Third-party transaction fees and settlement fails can affect the overall efficiency of FX trading for investors, and investment managers should not ignore these factors.
For investment managers that view FX as cash management, where FX is likely handled by operations, key considerations might include execution cost; measurement; minimal latency versus internal netting opportunities and operational workflow. The technology FX providers offer provides a rich selection of services to support passive flows. Investment managers can work with their providers to create bespoke, rules-based programs addressing trade size, netting, execution times and even algorithmic execution options to maximize the efficiency of FX executions. Whether the underlying market FX rate stems from a point-in-time, a third-party fix, algorithmic execution or something else, detailed reporting, defined spreads and TCA can help managers verify and track execution costs within a passive FX program. Where FX is not adding alpha, the workflow must be designed to ensure that FX errors or fails do not detract from performance. Maximum use of straight-through processing should be a focal point to eliminate human touch points that might result in error. Automation also allows the head count
Investors should expect their managers to have a good understanding of the credit profiles of their counterparties and any arrangements in place.
Whether employing an active or passive workflow, investment managers must have a view into the end-to-end costs of their investors.
supporting the FX program to remain lean and appropriately allocated for a non-core function of the investment manager. For investment managers with FX programs intended to generate alpha, flexibility and broad connectivity gain in relative importance. However, robust controls remain important; a duplicated or wrong-way trade can have an instant negative impact on performance, wiping out gains that might be achieved by a more capital-intensive, actively managed FX program. In terms of workflow, active trading programs are necessarily more complex than their passive, operational alternative. Execution systems must be connected to order management systems, and internal staff must master their use. Depending on the services the vendor provides, some support tasks may fall to internal staff. Trading technology and its constant evolution also pose a unique challenge for managers actively trading FX. The fragmented market structure of FX further complicates the technology and connectivity aspects. Operational staff and systems must be in place to handle the intricate relationships of a multi-bank panel from new account set up through confirmations and trade settlement. Further, FX traders must understand how their order flow can affect the market and seek opportunities to minimize this impact in order to achieve efficient execution. Given the amount of recycled liquidity in the FX market and resulting mirage of liquidity, understanding market structure is critical to achieving efficient, active execution (Siers, 201318).
TOOLS, TECHNOLOGY
The market unsurprisingly offers a broad suite of tools to meet the unique needs of individual clients. Selecting the right platform, technology partner and workflow suited to the manager’s assignment of FX to a trading desk or operations is critical to efficient execution. Scalability, frequency of use (volume) and ease of integration with other in-house systems also are
important. A wide range of up-to-date electronic solutions for FX execution is available to replace outdated spreadsheet-based FX workflows that lack adequate controls and scale. Besides vended products, investment managers can use electronic portals or operations-based workflows offered by banks. Among the options for execution are standing instructions with the custodian; single dealer platforms; multi-bank platforms; electronic communication networks; and outsourced FX execution. These channels offer differing levels of functionality, implementation costs, ongoing use costs, pricing and analytics. Counterparty selection, while often a credit consideration, can be another significant driver of the trading workflow, as the solution must provide the desired breadth of connectivity.
Achieving efficient FX execution requires investment managers to thoroughly examine their capabilities, objectives and the unique circumstances of their investors in a holistic manner. The FX market offers participants a multitude of options to conduct FX trading; while the available flexibility and choice are empowering, they are simultaneously risky. It is not hard to misstep when establishing a FX trading workflow. Such an error could lead to either direct or indirect costs, but ultimately it adds up to inefficient execution for investors. In all cases, investment managers should expect to enjoy disclosure around their pricing, though differentiation in price should be expected. In all cases, efficient execution requires the alignment of the trading workflow with the investment objectives of a particular mandate. While the considerations we’ve identified for an appropriate FX workflow are nearly universal, their relative importance and application can clearly differ as investors and their managers arrive at the solutions that best meet their needs.
Achieving efficient FX execution requires investment managers to thoroughly examine their capabilities, objectives and the unique circumstances of their investors in a holistic manner.
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To learn more, please contact your Northern Trust representative or visit northerntrust.com. ENDNOTES
1 JPMorgan G7 Volatility Index hit an all-time low of 5.38 on June 20, 2014, “Bloomberg News.” 2 Watt, Michael, “FX Week.” (November 25, 2013)
3 JPMorgan Emerging Market Volatility Index, “Bloomberg News.” 4 Press release, Bank for International Settlements (September 5, 2013)
5 Liam Vaghan, Gavin Finch and Ambereen Choudhury, “Bloomberg News.” (June 12, 2013) 6 Regulators fine global banks $4.3 billion in currency investigation, “Reuters” (November 12, 2014) 7 ECB Says Basis for Forex Benchmarks Can Be Too Narrow, “Reuters.” (June 18, 2014)
8 Foreign Exchange Benchmarks, Financial Stability Board. (July 15, 2014)
9 WM/Reuters Spot Rate Service - Launch of Methodology Changes, The WM Company. (November 14, 2014) 10 Algorithmic Trading in the Foreign Exchange Market, Riksbank, (2013)
11 FX and Equity Markets Converge, “Euromoney.” (May 2011)
12 Lewis, Michael, Flash Boys: A Wall Street Revolt, WW Norton & Co. Inc. (March 2014) 13 FX Benchmarks: State of Play. Frankfurt am Main, European Central Bank. (June 2014)
14 Szalay, Eva, Foreign Exchange: Fix Scandal Might Herald the End of Voice Broking. (November 8, 2013) 15 Borkovec, Milan, Ian Domowitz and Christopher Escobar, Thought Leadership. (September 2013) 16 Mangat, Joti, “FX Week.” (July 4, 2012)
17 Smith, Robert Mackenzie, “FX Week.” (December 1, 2014)
