The Last Look…

What is it with FX costs that’s so hard to get?

For a third of asset managers, the costs of foreign exchange deals remain unmonitored. This is despite having weathered a year during which currencies, the dollar and hedging became mainstream topics due to President Trump’s economic policies drawing attention to the $9.6 trillion a day space. These firms are well aware of the benefits of hedging, but the idea that there is a cost to executing these currency deals that protect the value and worth of these positions seems to remain abstract.

A study from French specialist institutional investment consultant Bfinance found that only 18% of the asset managers polled, regularly or systematically monitored the cost of currency deals. Even worse, 42% had no idea. (33% relied entirely on executing parties without monitoring and 9% simply had no idea if anything was done at all). The remaining parties said they performed ad hoc checks, which is something I suppose.

While less than a fifth measure their costs and ensure they get the best possible deal, 75% were “somewhat” or “very” confident that they had cost efficient deals. I’m no mathematician but I detect some tension here. If nothing else, the question arises, just how do they know? Moreover, Bfinance noted that in the same breath as admitting to having no monitoring frameworks in place, only 8% of investor respondents “suspect inefficiencies.”

“The contrast between these two findings is somewhat jarring. Confidence without evidence is not governance,” Kieran Bussey senior associate and Duncan Higgs, head of operational solutions, at the firm wrote. “Perceived inconsistencies between answers, along with a substantial proportion of “unsure” responses in both cases, also suggest a lack of clarity.”

This is not a new problem. In a previous white paper Bfinance identified significant “blind spots” and the numbers were substantial: “A $10 billion investor with a 30% hedge ratio implemented via three-month rolling forwards, for example, would have an annual notional FX volume exceeding $12 billion, meaning that a mere one basis point reduction in cost would produce annual savings of $1.2 million. Potential savings can be many multiples larger depending on the implementation approach.”

When we consider the sheer scale of large asset managers that have to hedge dollar exposures, the numbers become pretty insane. In Australia only, Superannuation funds’ collective hedge book is estimated to be AUD 500 trillion, with the number expected to double within a decade. Australian superfunds are only the fourth largest savings pool in the world and there is no suggestion that they don’t monitor FX costs any less than others. But considering the numbers it’s easy to imagine how the roughly billions of dollars of annual revenue pools on the sell-side and market infrastructure provider side add up.

Again, this is in a year during which hedge ratios were routinely adjusted and FX management became a major topic of discussion.

Low transparency is increasingly becoming a choice, not a circumstance, as benchmarking practices have evolved and technology has made it easier to detect market impact and information leakage

Anecdotal evidence suggests that FX is often considered free, costless, or just invisible when it comes to fees because it’s bundled up in the spread of holistic service prices and it’s always been an opaque OTC market where the cost of FX has never been disclosed in a standardised way.

The assumption can still be very much reliant on big fishes getting the best deals. There is also evidence to suggest that FX costs are nobody’s direct responsibility as it often sits in a grey area, neither with the investment teams or with the operations team. Meanwhile, spreads are embedded in rates or in bundled execution costs, making comparison impossible. As the Bfinance study notes, clean data is hard to normalise and expensive and sometimes inaccessible to investors, even with strong inhouse capabilities.

However, low transparency is increasingly becoming a choice, not a circumstance, as benchmarking practices have evolved and technology has made it easier to detect market impact and information leakage. Governance also has to evolve, however, as the frequency of checks also matters.

The problem is also universal, regardless of the chosen execution method. As Bfinance says while various channels have all different pros and cons, “it is important to avoid complacency: whoever the counterparty, the chances are that they are not incentivised to reduce the costs involved with FX execution in a proactive manner.”

In other words, don’t believe it just because someone assures you.

“For example, multi-dealer platforms offer multiple counterparties, theoretically enabling access to a ‘best price’, but this potential benefit can be undermined by siloed pricing (specific quotes offered for the investor that sees them), spread optimisation strategies employed by banks, and pre-agreed spreads – all based on individual client relationships and trade characteristics,” the authors note, and how right they are.

These findings are especially astonishing when considering that best execution requirements have existed for a decade, but still the message hasn’t filtered through. As they say in crypto, don’t trust, verify.

eszalay@thefullfx.com