The Grey Costs of FX Q&A
Posted by Colin Lambert. Last updated: December 20, 2021
Earlier this year, The Full FX published a report on a survey looking at the hidden costs of FX trading for asset managers. Colin Lambert talks to one of the authors of the report, Matthieu Herbeau from HD Financial Consulting, about some key takeaways, and what the report says about buy side attitudes to FX.
CL: I read the report and saw what could be termed a benign negligence on the part of the buy side when it comes to their FX operations, is that fair?
MH: I would probably nuance that statement because we can see different levels of sophistication across participants, a broad spectrum of behaviours, from very demanding players to actually clueless firms. I would not necessarily blame the latter, because FX is often an unwanted consequence of investment decisions, a pain the neck and definitely not a core business for the large majority of buy side firms.
The level of awareness in between the two extremes of the spectrum varies significantly.
What is disturbing though, is that all firms can access tools, solutions or advisors to help them address FX operations in a better way. The negligence is to do nothing while everybody knows a better outcome is at reach.
CL: What are the different attitudes to FX by different sectors, i.e. passive and active managers, asset owners?
MH: This ties back to what we just discussed and the level of awareness. Obviously, if you consider the top 10 asset managers, most manage FX actively, have a full team to oversee FX execution and portfolio hedging (although share class hedging seems largely outsourced and if we believe past studies from Lumint and New Change FX, the grey costs can be massive and probably neglected), access liquidity easily and probably achieve a good outcome. On the opposite, some firms don’t really know what happens on their FX flows, how they are managed and at what price. In the middle we have firms who believe they do a good job (and don’t get me wrong, some do) but if you scratch the surface, you realise that much more could be done to the benefit of the end investors and asset owners.
Another highlight of the survey is that asset owners are even more in the dark when it comes to FX costs than managers who are more aligned with the sell side in their understanding of the cost structure. It does not come as a surprise though, as FX definitely isn’t something they master.
CL: You ask the question in the survey, whether managers have unrealistic expectations around outsourcing, or if there is growing momentum – what do you think the answer is?
MH: I genuinely think there is growing momentum, and it is the result of history. Since the late 90s, we have seen non-core activities being outsourced: it started with operations (clearing, settlement, custody), moved to accounting, fund administration and middle office, and logically, now comes the turn of non-core front office activities. Trade execution for bonds or securities, as well as FX can now be covered by specialist firms or custodians. Looking specifically at FX, the move was initiated by outsourcing securities trades-related FX and share class hedging, which was often managed in operations or middle-office and the risk reward clearly advocates for outsourcing in my view (provided the process is transparent and benefits from adequate reporting and oversight through performance tracking). Portfolio hedging naturally follows suite.
This is even more true as we see that spreads and settlement costs represent a diminishing part of FX costs now, and the room for manoeuvre to improve there is limited. In parallel we see confirmation that staffing and other costs will rise in the short and medium term, building the case for more outsourcing.
CL: I was interested in the tech spend findings, namely a majority looking to add technology to existing infrastructure. Does this solve the problem or kick the can further down the street? It seems to me that an integrated technology infrastructure is what is really needed?
MH: It is all very well to add technology (it makes solving the problem easier – although does not necessarily solve it), but what is tech without understanding of the underlying issue? There should not be an over reliance on tech because what happens if or when the tech breaks down?
I am convinced that you always need individuals who understand the mechanics to check that the tech delivers what it was implemented for, and up to expectations. Remember that senior managers are accountable and they need to be able to demonstrate oversight, which comes from a thorough understanding of the requirement and the solution used to cover it.
CL: There was also interest in counterparty consolidation – does the benefit of this to managers trickle down to the service providers who have fewer peers to connect to/compete with?
MH: The weight of regulation pushes towards counterparty consolidation because if you need to place initial margin and manage variation margin with multiple brokers, it creates a new layer of complexity to deal with. We have already mentioned that FX is not a core business, nor an area of expertise for most firms, so add collateral management with several counterparties and it gets really awkward. This is why FXPB is still quite popular, and also the wave on which some specialist firms are surfing to offer an all-in FX execution and hedging service (FX brokers, order routing or end to end custodial FX services). Custodians now even offer to execute securities related FX or currency hedging across funds custodied by different service providers.
One of the obvious benefits is the potential for netting orders, but this generates a debate on the fact that the smaller funds are the recurring winners versus the larger funds which determine the side of the FX price being applied, and this does not sit well with the “treat your customer fairly” objective.
CL: What changes would you like to see occur on the buy side as a result of this report?
MH: I would like to see more engagement to deal with the lack of transparency, rather than seeing it swept under the carpet. Since the CalPERS / CalSTRS stories, no one can say “I did not know” or “I did not realise”. It is perfectly fine to admit that you do not master the FX component of your investment decision, but there are plenty of solutions available to achieve a better outcome: better execution, alternative benchmarks, better reporting (TCA, hedged share class performance tracking), and in the end a better return for the final beneficiaries, the current and future pensioners.
Asset owners should ensure that FX is not used by asset managers as the adjustment variable to minimize management fees by passing execution or hedging costs to the funds.
At the end of the day, it really goes down to education: the best way to monitor and oversee something is by understanding it thoroughly and the FX ecosystem offers resources to get there: specialist consultants, state of the art, plug-in TCA solutions, transparent execution software. No excuses!