Plan Sponsors: Take Charge of Forex Trading Costs

Watch the watchers.

That’s the mantra of a growing number asset owners, who are depending on fund managers and custodians to protect their financial interests.

These asset owners are now adopting — or should be adopting — a “trust but verify” philosophy when it comes to choosing who executes and how their foreign exchange transactions should be handled, according to transaction cost analysis (TCA) specialists.

The reason: they are paying way too much for their forex trades, and inefficiencies are eating into performance results. By just how much is anybody’s guess, but anecdotal evidence indicates the amount could be substantial, depending on the number of forex transactions, their size, the currencies involved and, especially, who is executing the orders. Operations executives at five US fund management firms contacted by FinOps Report naturally declined to specify just how much money is being siphoned off fund profits, other than to say it could easily be an annual “multithousand dollar figure.” All agreed they could — and should do a better job. They just don’t want to be the only ones responsible.

These days, plan sponsors and other asset owners have no excuse for being lax in fulfilling their fiduciary responsibilities. There are plenty of data and complex mathematics which can be used by external experts only too eager to help them verify they are getting a fair price for their forex trades, suggests a new Aite Group report on transaction cost analysis in the forex market.

Not all providers of transaction cost analysis (TCA) are equal in quality and detail of reporting. The fund managers surveyed by Aite Group had a range of views on the merits of their TCA providers. At a minimum, some TCA analysis can provide a level of reassurance that foreign exchange transactions are being executed at a fair price.  Of course, the expectation that fair price can be identified depends on the assumption that a reference rate or benchmark is available or could be available to the asset manager.

Data Scarcity

Although there may be plenty of data floating around, TCA providers are limited in what they can do with the available market data which is not always viewed as accurate enough or fair by the asset manager being evaluated. With no regulated exchanges available, forex trading is often done either over the counter or through multiple trading venues so executable prices simply don’t exist in the public domain. TCA providers must tap a variety of data sources, some of which don’t represent rates that are achievable, such as executable benchmarks, or are not sufficiently granular to reflect the market at the time of the trade. And even if achievable benchmarking rates are used, they may not cover a sufficiently broad range of all currency pairs.

Such limitations aside, TCA providers have aggressively moved forward over the past few years to foster more transparency around order-taking decisions, algorithm performance, peer group reviews and increased support for multi-asset class trading activities including forex, says Aite Group’s senior analyst Howard Tai in Kansas City, Missouri in a new report entitled “FX Transaction Cost Analysis Service Providers: Brave New World.”

Buy-side firms now need to do their part: “Step up the pace in hiring FX TCA providers which can truly improve their investment performance over time,” recommends Tai, who evaluated ten TCA providers.

When it comes to responsibility for FX performance, fund managers also insist that they shouldn’t carry all the weight. Plan sponsors must start paying attention to best execution for forex trades, rather than leaving it to fund managers. It’s just too risky and too impractical to do so, because fund managers may not have either the capabilities or necessary control over all of the forex transactions. “They are often presuming we handle all of the forex transactions or have the time and expertise to monitor each one when we don’t,” one operations executive at a US fund management firm tells FinOps.

Plan sponsors — typically pension plans, endowments, and insurance plans– historically relied on their asset managers to know what they were doing when it came to executing their forex trades. After all, they were experts in trading a range of asset classes, so how hard could forex trades be? And with many of the trades executed through their custodians, who they presumed would fulfill their fiduciary obligations, they couldn’t go wrong.

Nothing could be further from the truth as shown in a string of lawsuits against some of the world’s largest custodians since 2009. They earned far too much on spreads, thereby violating their fiduciary responsibilities to their clients. Or so pension plans alleged. Custodians, who downplayed the disputes to differing interpretations of contracts, ultimately settled up or are still in litigation. At a minimum, they have changed their policies to ensure greater transparency — or reporting of what price they are executing orders at and how much they are making.

Far From Perfect

Is the new scenario ideal? Not exactly. “Custodians are still not providing timestamps on their trades, so it remains difficult to measure whether they are executing the trades at the fair price,” explains Jon Fatica, director of analytics for Trading Screen, a forex execution platform and TCA firm based in New York.

It’s a common complaint, although there is no clear explanation for why custodians won’t step up to the plate. Is it just too technologically difficult or are they trying to hid their excessive profits? Regardless of the rationale, with a fair chunk of foreign exchange trades still executed by custodians, plan sponsors need to protect their interests — and those of their investors — by increased oversight of transaction quality.

Blind reliance on the fund manager alone to ensure best execution may also be an expensive exercise in misplaced trust. Depending on the trading strategy, size of the asset manager and technological sophistication, it it may or may not be possible to analyze quality of execution. Or the fund manager may just be passing the buck to custodians as well.

As a rule of thumb, if a fund manager does all of its forex trading through electronic platforms operated by broker-dealers, plan sponsors may be in luck. With competitive bidding, there will be sufficient information on when the trade was executed and at what price to allow for comparison to available benchmark market rates. The elements of best execution, such as the effectiveness of the timing of trades, the cost of crossing, the quoted bid/ask spread, and the comparison of dealers can be more easily determined.

“There has been a real breakthrough in TCA for forex trades as sell-side firms can provide evidence of executable quotes so they can provide some transparency,” says Fatica. “Plan sponsors could certainly ask for transaction cost analysis reports from their asset managers and brokers and have some comfort they are getting correct information.” In fact, he adds, it should be a requirement in the request for proposal selection process for fund managers and as a no-cost option for plan sponsors. Operations managers at three US pension plans contacted by FinOps confirm they have changed their policies over the past few years to now require fund managers to provide them with “best execution” on all of their asset classes, including forex.

Fund managers also need to take proactive advantage of these transaction cost reports, using them to arm their traders with the necessary information to change their strategies. With real-time TCA now available for forex trades , they don’t have to wait for days to receive post-trade reports from compliance departments. “At a minimum, real-time TCA on multi-dealer execution platforms offers the monitoring of best available rates for various sized trades and the ability to execute and monitor a series of smaller lower spread trades,” says Fatica. “TCA can measure the cost of liquidity in a market that is professed to be the most liquid.”

Negotiating Transparency

However, when it comes to forex trades executed through custodians, transparency is thrown out the window, bemoan fund managers and plan sponsors. Custodians often execute forex trades to make dividend or interest payments in an asset manager’s local currency and bulk up multiple amounts in a single lump sum when executing an order. Depending on just when they have executed an order — such as the end of a business day — they may not be getting the best price. The reason: rates are far too volatile at the “London close.”  That’s the price at which net asset values for portfolios are struck and a fund manager’s returns are benchmarked.

Ultimately, plan sponsors will need to step up to the plate and assert pressure on custodians to follow more explicit methodologies for executing forex trades because they are the ones holding the contracts, recommends Amarjit Sahota, chief executive of Klarity FX, a foreign exchange transaction cost analysis provider in San Francisco.

Even the most diligent fund managers may not be able to get accountability from custodians without that extra push. Until recently far too many plan sponsors have been willing to let their custodians run the forex trading show under so-called “standing instructions,” leaving asset managers out in the cold. “We were often told not to make waves and disturb the relationship with the custodian so our hands were tied,” one operations specialist at a US fund management firm tells FinOps Report.

Why was that? Apparently, custodians might be selling plan sponsors two rather flawed arguments. The first is that they are holding their assets and are getting such good fee structures on other asset-servicing activities that they should just keep their forex trading with the custodians. The second is that the custodians will charge what is coined a “trade-away fee” — or a fee each time asset owners chose to execute a forex trade through another party.

It might not sound legit, but custodians argue that they have the right to do so because they bear the administrative or recordkeeping costs. Custodians won’t disclose just how much the takeaway fee is, but Sahota says it is between US$15 to US$35 for each trade. That might sound like a big incentive to let the custodians do the trading when added up to numerous trades each day, but it could still be less expensive for the fund manager to simply do the trading through an automated multi-dealer platform, such as an execution management system.

Case in point: “We have found that about US$20,000 can be saved by dividing a US$50 million order in EUR/USD — the most competitive currencies,” says Fatica.

Of course, relying on multi-dealer platforms presumes that the fund manager has alternative forex banking relationships, so it can competitively bid the transactions alongside the custodians used by the plan sponsor.

At the very least, custodians will likely be more inclined to reduce the basis points spreads they earn on forex trades, if push comes to shove from plan sponsors. Apparently, the historic language used in forex transactions with custodians has been far too lax in giving them leeway to do as they wish.

Custodians have responded to criticism — and litigation — by adding more pricing models which have helped lower transaction costs by 50 percent in some cases, fund managers tell FinOps. Instead of only providing pricing models based on the trading session range, they are also now offering clients the option to sign up for hourly price services where custodians are publishing hourly rates and guarantee clients a 10 to 15 basis point spread from the fixing price.

If plan sponsors can’t get their trades timestamped, they can at a minimum insist that custodians execute their forex orders through specific fixing times, rather than at the end of the day or at the discretion of the trading session range, recommends Sahota. The reason: the new scenario will limit a custodian’s ability to “load the price” to suit itself, as alleged by lawsuits filed by asset owners. The downside to the the custodians’ offered correction: the plan sponsor may miss the opportunity to benefit from trading efficiencies such as netting and bundling of transaction flow. Still, as Sahota notes, most plan sponsors are just concerned with achieving a fair execution price.

Are plan sponsors beginning to pay enough attention to their forex deals? Maybe not as much as they should, but the tide appears to be changing, says Sahota. Chief investment officers and compliance managers are starting to see the merits of doing so and reviewing forex TCA reports more closely. That’s a good thing, considering how much money is to be made, and lost.