FX: the last great hurdle in the search for cost savings

Daniel Birch
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(Pictured: Daniel Birch)

Foreign exchange transactions represent, perhaps, the final challenge for pension funds around the world as they look to improve efficiencies in the implementation of investment strategies. And from all accounts, it’s worth the effort to study the common practices in this market. A lot of money can be saved … or wasted.

A recent paper by Russell Investments, focusing on just one part of the FX conundrum to do with benchmarks, has enlivened the whole discussion, in Australia at least. The paper, ‘Does Trading at the Fix fix FX?’ was written by the firm’s global head of FX, Michael DuCharme, and initially published in May. It was distributed this month in Australia with some local commentary.

Australia’s big funds should take more notice of FX than most for two reasons: the Aussie dollar is volatile and super funds have a higher-than-average allocation to offshore investments. There have been some celebrated examples of big super funds writing out cheques for hundreds of millions of dollars to cover their positions after sudden moves in the Aussie.

But while the hedging position, which requires a view on the direction of a currency, will always be the most important, there is also a lot of money at stake in the way fund managers execute the strategies on behalf of their clients.

The Russell paper argues that investors should reconsider their point-in-time transaction strategy, which most commonly involves a trade at the London 4pm close, known as the Fix. The Fix offers “apparent transparency” Russell says, but this may be outweighed by higher transaction costs. A volume-weighted average price (VWAP) will usually deliver a better outcome. This is determined by comparing the actual trades executed on behalf of that investor during the trading period with the outcome of the average for total trades during the same period.

While this sounds logical, critics say Russell is talking its own book. Russell uses an agency model for FX trades for its own funds as well as offering this as a standalone service to other clients. The most commonly used benchmark for the London Fix is the WM/Reuters service, which is part-owned by State Street, both a big custodian and FX service provider through its FX Connect business. FX Connect is the largest provider of its kind in many countries, including Australia. Of course, talking one’s own book does not necessarily make it incorrect.

The Russell paper refers to Morgan Stanley research in 2010 which approached the common use of any point-in-time benchmark from an intuitive viewpoint: if exchange rates are random, then it is unlikely that the best price of the day will consistently be observed at a particular time. Plus, selecting the best price for anything will usually mean skillful trading and perhaps market insight, both of which are absent if an investor follows a rigid rule of when to trade. Morgan Stanley estimated that “regret” (missing out on the best price) occurred at least half the time. Morgan Stanley said that at less liquid times of the day, such as at the London 4pm and 8pm Fixes, prices can vary by as much as 40bps compared with other times of the day.

However, Jeremy Armitage, State Street’s head of FX for Asia Pacific, says that it is not by chance that investment managers most often use the London 4pm Fix. This is also the benchmark used by other index producers for their performance measurement and therefore what the investment managers will tend to be judged by.

“If you’re an investment manager and you know your client is going to use that as a measure of your performance, it stands to reason you’ll use it too,” he says. “If you use a different benchmark you are almost certain to introduce tracking error and therefore investment risk. Portfolio managers are acting rationally.”

He says that, from the client’s perspective, State Street can use any benchmark for its execution.

Taking a step back, what the discussion does which may be of greater value to super funds is to focus on FX as something worth studying. Daniel Birch, head of implementation services for Russell in Australia and New Zealand, says that Russell developed its agency model for FX trading after performing a major review back in 2001, which involves the use of a panel of banks – currently more than 20 – including State Street’s FX Connect.

“About 85 per cent of FX trading is done by custodians,” he says. “Even though it may cost only 2bps, often less, in the market there are invariably add-on costs. A typical charge may be 10-15bps.”

The three main types of costs are:

  • costs associated with trading a stock, called ‘auto FX’, which is typically the 10-15bps figure.
  • costs associated with dividends, say, where the client wants them in $A, which may be a further 35bps
  •  the ‘auto FX checkbox’ whereby a custodian sweeps the account for extra cash every month or whenever requested, which may cost another 45bps.


“When we looked at this in detail in 2001,” Birch says, “we decided to set up our own FX desk to save money.” After working in Europe between 1999 and 2010, he believes that Australia is a high-cost country in terms of its FX trading.

Rather alarmingly, he also believes that it is more difficult to obtain data to perform post-trade analyses. “When we get it, it’s messy. They often don’t have date stamps. The quality of data is poor.”

The issue of regulation often comes up these days when talking FX. The Russell paper points out the area involves over-the-counter trading in an unregulated and decentralized market. There have been well-publicized lawsuits which highlighted the difficulty of managing transaction costs when the time of trading was not provided.

Greg O’Sullivan, institutional sales manager for FX trading platform 360T in Australia, agrees that there is little regulatory oversight but it would be good for reform to come from within the industry. For instance, he says, there is still a reluctance to push the case for time stamping and the effective post-trade analyses measuring the activity against both time of execution and various relevant benchmarks.

O’Sullivan says: “Any improvement in trading will actually add alpha. With effective Transactions Cost Analysis, (TCA) historical transactions can be analyzed to calculate the real dollar impacts and lost alpha that has been traded away. This is important as it empowers funds to validate the decision to make changes to the way FX is viewed.

“The question remains though: are service providers doing enough to support the oversight and governance requirements of the funds? The post-trade review and being able to provide real insight into the trading decisions and the impact that these activities have had on the portfolio has been a gap in our market,” O’Sullivan says.

“360T has developed reports for their global clients that provide unparalleled analysis into FX trading activities and we are now introducing these to the local institutional sector.”

He points out that there are other impediments to change for super funds, such as the bundling of a custodian’s offering. It has been observed for a long time that custodians tend to reduce their core custody charges when they are also given the ability to oversee cash, FX and perhaps securities lending. In effect, cash and FX services subsidize custody. The contract may include an extra charge if the client deals away from the custodian in an FX transaction.

The 360T system allows managers to effectively engage in a live auction of counterparties to obtain the best price for a currency at any point in time. Participants are restricted to institutional investors.

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