Legal cases against custody banks in the United States over currency trades puts the issue of foreign exchange outsourcing in the spotlight, writes Nicholas Pratt.
The list of activities that investment managers are willing to outsource extends even to foreign exchange (FX). Typically, FX dealing has involved appointing third parties – often a custodian bank – to carry out the execution. But there is another option: to appoint specialist FX agencies to oversee the investment managers’ FX process and, hopefully, get the best possible value.
“Historically, we’ve seen investment managers have a patchy interest in employing a third party to do their FX better than they can,” says James Wood-Collins, chief executive at Record Currency Management, a UK-based independent currency manager.
“Few equity fund managers would claim that FX is a core competency for them, although a fixed income manager might. But we are seeing an increase in interest from investment managers.”
One reason is the growing awareness over operational risk, says Wood-Collins, and a realisation that a currency trade that is part of a big hedging programme can involve considerable sums – for example, €20 million of stock n an overseas company is also a potential €20 million currency trade.
Another reason is the long-held suspicion among buy-side firms that the banks have not always been acting in their best interests. This suspicion has grown in recent years, especially in the US, where a number of pension funds have launched lawsuits against their custodian banks alleging that they were offered unfavourable rates for currency trades.
Consequently, the market-making model, where the bank acts as a principal in the trade has become less popular with investors and there has been an increasing interest in employing agency-style specialists.
“It is about extending the fiduciary reach,” says Lloyd Raynor, a senior consultant at Russell Investments.
“When a trustee board is looking after an asset pool, there are a whole range of decisions to make – such as asset allocation – and implementation is often at the bottom of the list and the manager is happy just putting their FX trades through their custodians. Why not have an agent that is on your side and will go to a number of counterparties that will bid against each other and compete for your trades?”
In addition to the independent currency specialists and agency brokers, another option for managers is to appoint an independent dealing desk to execute on its behalf.
As head of fixed income and FX dealing at BNP FinAMS, Carl James heads up eight dealing desks globally that act as an outsourced execution service not only for BNP Paribas Asset Management but also other asset managers. There are five people on the FX desk which trade all FX products. BNP FinAMS can be considered as a specialist outsourced buy-side dealing desk offering FX dealing capability that is neither in the custody space or the agency broker space.
“There is clearly a greater focus on what execution the custodian is providing,” says James. “We are now able to get better data because of technology and there is now transaction cost analysis (TCA) available for FX. We do a monthly review of our executing brokers and also a more formal quarterly review that includes qualitative as well as quantitative information regarding execution. Our top five executing counterparts have remained pretty static.”
The fact that the broker review looks at qualitative as well as quantitative data reflects that it is important not to judge execution quality solely on the lowest possible price.
“Price is at the centre of everything we do for our clients, but it is part of a larger process,” says James. There are implicit and explicit costs that managers have to consider when retaining their own internal trading desk – the explicit cost of that trading desk which includes salaries, technology and oversight; and the implicit cost of the trades themselves. “You need to be able to measure them to manage them,” he says.
Rapid developments in TCA have helped cast more light on an opaque world but the structure of the FX market compared with other more centralised marketplaces means there will be limits to transparency.
Similarly, the growth of electronic communication networks (ECNs) where multiple bank prices are aggregated on single venues has gone some way to limiting the disaggregation that exists in the FX market. But ECN trading still has to be actively managed and no single ECN has a dominant market share.
Of course, some managers may decide to keep using their custodian for FX. Custodians have made efforts to provide more transparency about execution and some managers may consider the custodian relationship to be central and one that might result in savings elsewhere.
The important issue is not necessarily who the manager employs for FX execution, just as long as they look, says Raynor. “It’s about keeping an eye on the quality of execution.”
There are a number of agency-style providers out there, although the importance of scale in the FX business, both in terms of technology and broker relationships, makes it a difficult market to get into. So while FX outsourcing may grow, the number of providers might not necessarily increase, says Raynor.
“In theory, anybody can try and be more efficient in this space, but which providers have the scale? How many counterparties do they have and what risk management systems do they have in place?”
The scale aspect will also be a crucial consideration for those managers with their own internal trading capability and ambitions of keeping FX execution in-house.
“Technology is a big differentiator, you need to understand the capital spend involved in keeping an FX trading desk, like any other asset,” adds James.
“Regulation will also play a part in that it will have a big impact on the broking community and they may become fussier about the business they take on. They are likely to focus on the customers with the biggest flow and if you are a manager working on your own with less than €5 billion, it will become more difficult to get the tightest price.”
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