Are we getting the best foreign exchange conversion rate?
Pension plans and other asset owners asking their fund managers that question might hear a resounding yes, but that’s not always the case as highlighted during the COVID-19 pandemic. Not all benchmarks are created equal, according to London-based Raidne, which claims it has come up with a far better FX benchmark than the current ones operated by the London Stock Exchange and Bloomberg. Pension plans and other asset owners could save millions of dollars in lower FX transaction costs.
The first FX trade conducted in January 2021 by an investment bank on behalf of a European asset manager using Raidne’s Siren benchmark resulted in an execution performance of about US$519 per US$1 million value of a trade better than would have been achieved using the LSE’s benchmark on the same day, according to Raidne, an FX quantitative surveillance and best execution analysis firm. The improved execution performance would have come to US$326 had Bloomberg’s benchmark been used. As a rule of thumb, the difference in savings between using the Siren benchmark is lower versus Bloomberg’s benchmark than it is compared to using the LSE’s benchmark, acknowledge Raidne officials. They also admit that the Siren benchmark doesn’t outperform the other two every day; it only does so most of the time. Bloomberg and the LSE declined to comment for this article.
Asset managers need to execute FX trades to rebalance portfolios, to hedge currency risk, to make dividends and income payments to their fund clients, and to credit corporate action entitlements. Fund managers will typically decide which investment bank to use to execute their forex transactions based on quotes received. In some cases, the forex trades are executed by custodian banks based on standing instructions. However, the only two benchmarks available on which to execute trades so far have been Bloomberg’s FX Fixings rate (BFix) and the LSE’s benchmark WMR formerly known as the Thomas Reuters benchmark. The LSE inherited the benchmark through its recent US$27 billion takeover of data giant Refinitiv, which had been 45 percent owned by Thomson Reuters. Thomson Reuters sold the majority of the business in 2018 to a consortium led by private equity giant Blackstone in a deal that valued the data giant at about US$20 billion.
The issue of whether asset managers and ultimately their clients are paying too much for foreign exchange transactions is nothing new. What is new is that the COVID-19 pandemic has resurrected those concerns as quantitative hedge funds and high-frequency traders seek to profit to the detriment of other investors. By Raidne’s own estimates, market volatility during the COVID-19 pandemic has resulted in three times the savings using the Siren benchmark compared to before the pandemic. The greater the market volatility, the greater the savings using the Siren benchmark, say Raidne officials. The savings does not come from lower explicit costs such as fees, but from reduced market impact. A critical implicit cost of trade execution, market impact refers to the difference between the price when an order is placed and the time at which it is actually executed.
Most regulators have best execution requirements which mandate that investment advisers follow their fiduciary obligations to investors, including best execution requirements for all asset classes. Foreign exchange trades fall into that category. The global FX code of conduct, established in 2015, also requires that fund managers verify the quality of execution they are receiving and consider “new inventions.” However, few asset managers have embraced the voluntary recommendations, likely thinking it is the responsibility of the executing bank or broker-dealer to address the conversion rate. The result is less than ideal returns for their fund clients.
Large custodian banks have come up with their own metrics for measuring the cost of their forex transactions and appear to be doing a better job in reducing their costs. Even so operations managers at several US fund management firms, who spoke with FinOps Report, say that those analytics are sometimes suspect as transaction cost analysis for foreign exchange transactions is not as advanced as for other asset classes. “Most trade executions at banks are filed using the WMR benchmark and transaction cost analysis reports fail to provide a benchmark comparison,” agrees Jamie Walton, co-founder of Raidne who previously headed up the currencies and quantitative trading team at Morgan Stanley. None of the mega custodian banks contacted by FinOps Report wanted to discuss their foreign exchange trading metrics.
The new Siren benchmark, launched in January 2021, is calculated and published every thirty minutes throughout the day from 10PM GMT on Sunday until 5 PM EST on Friday. The Siren benchmark is also published on 4PM GMT which is the same time as WMR and BFix. All three benchmarks comply with the UK’s Benchmark Regulation (BMR) and the European Benchmarks Regulation which set standards for how benchmarks are created to avoid manipulation in the wake of the forex benchmark scandal. That scandal cost major banks a collective US$11 billion in regulatory penalties. However, the data points and methodology used in the Siren benchmark differ from those of the two legacy providers. The Siren benchmark uses spot foreign exchange prices from benchmark administrator and foreign exchange data provider New Change FX taken from multiple trading venues and from an extended 20 minute observation window. In contrast, the two competing benchmarks use much shorter periods of observation. It is 300 seconds (or five minutes) for WMR and 306 seconds for BFix.
“One of the problems associated with executing an order based on the 4PM Fix, as would be the case using the WMR and BFix benchmarks, is that the demand for foreign exchange trading is too huge for the market to absorb,” explains James Wyatt, co-founder of Raidne. “Because there is not enough liquidity — or sellers– to handle the large number of buyers, a huge market impact occurs which hurts pension plans.” By relying on a twenty minute interval Raidne’s Siren benchmark minimizes the market impact of the forex conversion by including pre-hedging by banks. The Siren benchmark also relies on optimal execution methodology. The more a portfolio’s FX trading is correlated to the 4PM Fix, the higher the cost savings from using the Siren benchmark, according to Raidne’s own research.
Raidne does not charge fund managers or their pension plan and other asset owner clients for licensing its benchmark– an actual number. The firm only charges banks at a rate of US$1 per US$1 million notional amount executed. However, asset managers are the ones which must ask their banks to give them access to the Siren benchmark. So far, banks appear eager to jump on the Siren bandwagon. Of the eight largest bank players in the FX market, seven have told Raidne they will offer the Siren benchmark based on customer demand. “Fund management firms benefit from lower transaction costs from lower market impact,” say Wyatt. Those lower costs can ultimately save basis points and increase the annual return on investment. Still, there are too few fund managers which are paying attention to their foreign exchange transactions, because not enough pension plans are holding them accountable. Change also comes with some pain. Asset managers would also likely have to make contractual changes to their contracts with asset owners as well as operational changes. In addition, not all funds or asset owners will benefit from the Raidne benchmark, acknowledges Wyatt. Raidne can calculate how much a pension plan or other asset owner would have saved if the Siren benchmark had been used to execute an FX trade based on historical data such as the trade dates, currency pairs, customer sides and notional amounts.
What will tip market interest in favor of the new Siren Financial benchmark is hard to predict. It appears to be a case of the chicken or the egg. Unless they are pressed by fund managers, banks have no financial motivation to improve their forex trading performance, because they can keep earning more money with the status quo. Pension plans and other asset owners are starting to care more about foreign exchange conversions, but are still woefully behind the curve when it comes to understanding they could be doing better. “The more the global FX code is understood by asset owners the more pressure asset managers are under to sign up,” says Walton. Some pension plans have asked their asset managers to consider executing their forex transactions against the Siren benchmark.
The COVID-19 pandemic could end up being the straw that breaks the camel’s back as the need for effective trade execution becomes apparent. For now, Siren Financial’s benchmark could have a competitive advantage over the LSE’s WMR and Bloomberg’s BFix. Should rivals decide to change their methodology, that edge could dissipate. However, at the very least Raidne will have raised an important issue at a critical time for the benefit of fund managers and ultimately investors.
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