Foreign exchange pricing is a particularly topical subject at the moment, given the recent press coverage of benchmark fixings and the potential issues around using them to price and execute foreign exchange activity. The dilemma for the industry is that institutional clients are currently faced with limited choices.
The majority of the larger institutional investors employ central dealing teams who typically execute business in competition using an ECN and a pre-defined panel of counterparty banks. Whilst the selection of this panel may be open to debate, in that it may have counterparties on it that recycle liquidity from others, it does at least validate that at the point of trading an investor is taking a price in competition from that panel. Many medium to smaller managers (including many hedge funds and long-only managers) either trade with a smaller panel, made up of their prime brokers or custodians, or in some cases leave the execution entirely to them.The dilemma for the industry in this scenario is how to demonstrate that a company has discharged their fiduciary responsibility by achieving best execution.
Some clients will run currency funds as an asset class and/or take strategic views on a currency, although the majority of institutional foreign exchange flow is transaction-related (funding the purchase or sale of an asset, etc.) or driven by the need to hedge the currency risk associated with an underlying portfolio. In the majority of situations this activity is rules-based and as such adds no alpha to the performance of the underlying fund, but may be a significant performance drag if it is not executed efficiently.
Across all sectors of the industry (with the exception of alpha-driven currency funds) clients execute and value a varying percentage of their foreign exchange activity using a benchmark. Historically benchmarks have been used to ensure that the valuation point and the pricing of the respective foreign exchange activity, associated with subscriptions and redemptions into and out of a given fund, use the same pricing/valuation point, thereby avoiding any issues with cash flow or disadvantaging existing investors. This situation has created an element of inertia, in that the investor community recognizes that the current benchmark process is sub-optimal, but at the same time is tied into such, by virtue of existing client mandates and the lack of an effective alternative.
Possible forthcoming changes to the benchmark process may widen the valuation window from two to five minutes, but will not address the issue of establishing the actual cost to investors of executing business in this way, as the process will largely continue as before, albeit with a wider window. The regulator will likely require banks to execute foreign exchange activity to cover orders placed at the benchmark in an orderly fashion, to avoid unnecessary distortions in the foreign exchange market ahead of the fix, but it will probably not prohibit institutions from covering orders ahead of the relevant benchmark. This situation is made worse because the market currently channels a large percentage of its daily fixing activity into the 4pm benchmark, where liquidity is sub-optimal, given that Europe is closing and London is close to moving its trading/liquidity books into the US. So to assess the real cost of executing business on this basis by typically comparing the slippage or spread charged by your bank to execute against a benchmark is not a true reflection of the real cost.
All banks that execute business against a fix require clients to pass the order to them at least 15 minutes before the relevant benchmark is published, and many insist on receiving the order 30 minutes before such. The true cost then should be viewed as an opportunity cost, the actual cost of where said institution covers your business, as compared to the fixing price that is then set and the business priced at, plus of course any pre-agreed margin that the institution of choice is charging you. Many large institutional investors have executed business on this basis for years and their banks have offered them the mid price for that benchmark. Realistically, any institution that has done this will have covered said business well before that benchmark is published.
Transaction cost analysis
There has been a rapid increase in the demand for transaction cost analysis (TCA) to establish the actual cost of doing business. This was initially driven by the underlying client/plan sponsor, but increasingly is also being demanded by asset managers themselves, as they seek validation that they are executing clients’ business at competitive rates. Interestingly, the requirement to validate said pricing may broaden further as potential regulatory changes may necessitate an independent validation of efficient execution.
Many of the firms involved in offering such services have grown their product offering out of the equity space, and in selecting a suitable agent to provide such services, it is very important that they have a good understanding of the above issues and reflect such in their valuation methodology. For day-to-day trading it is a comparatively simple process, simply using a time stamp at point of execution and comparing that execution price with a reference rate (provided that reference rate is an accurate reflection of where the market actually is!).
Measuring the opportunity cost in executing against a benchmark is more complex, but the correct methodology would be to use a time-weighted average price (TWAP) over the period between when the order was given to your bank and the associated actual fixing time. So in the event that a client were required to pass its orders 30 minutes before the fix, the TWAP would be run for that 30-minute time frame, ideally monitoring pricing using a number of independent sources. It will then calculate what that opportunity cost actually is.
Of course, transaction cost analysis tools only identify that the client may have a problem with the basis on which their foreign exchange is executed. They do not address the issue of how they might change this process or behaviour to ensure they do receive optimal service and pricing.
The fact that your counterparty banks cover business in this way, as described above, ahead of a benchmark fixing point, would clearly infer that the logical suggestion would be to ask an institution to price your business using the same methodology, rather than at the benchmark fixing point. This would dispense with the need to use that benchmark reference point entirely and the execution and valuation point would then be the sum of the TWAP in the 30-minute period immediately preceding the hour.
This would achieve two important objectives: firstly, the client would receive the actual cost associated with the execution, whilst secondly minimizing the slippage between the two points. Execution would therefore need to be transparent and reportable. The time window should by limited to 30 minutes only, and I would suggest that the benchmark is fixed earlier in the trading day, away from the 4pm benchmark, to optimize liquidity and reduce pricing skew given the weight of order flow at that time in a less liquid market. Obviously this would involve asset managers in re-papering their client agreements to reflect such changes and ensuring that their administrators had access to the same TWAP data for fund valuation purposes. The subsequent TCA analysis would then simply validate this process, using the same methodology, and any small variance would be subject to differences in reference rates over the relevant TWAP.
Paul Duprey was previously a managing director in global banking and markets at HSBC, with global responsibility for all the foreign exchange flow emanating from its global and local custody business. Earlier this year he set up an independent consultancy business to assist clients with all matters foreign exchange-related. firstname.lastname@example.org