Improving Foreign Exchange

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1 Improving Foreign Exchange Transaction Effectiveness Introduction Investment advisors have a fiduciary obligation to obtain the most favorable terms in executing securities trades for their clients. For portfolios that hold foreign investments, this responsibility extends to foreign exchange (FX) trading. Institutional investors routinely conduct trade execution studies to monitor the implementation effectiveness of their managers, but until recently FX trading effectiveness has operated below the best execution radar screen. After all, the FX market is a worldwide, decentralized over-the-counter (OTC) financial market that does not require traders to publish rates to an exchange. This has enabled FX trading to exist as a largely invisible business that may result in poorer-quality execution for investors. In this paper, we will address what policies and procedures institutional investors should adopt to ensure that they are receiving good execution value for their FX transaction costs.

2 Improving Foreign Exchange Transaction Effectiveness Elements of Best Practice Dialogue with investment fiduciaries on trading practices Trading FX directly with the market, except where more cost efficient than using a custodian bank Data collection of trade volume, prices and time stamping of FX transactions Periodic cost analysis of FX transactions How FX Transactions Affect Institutional Investors Investment managers routinely use the FX market to complete transactions in foreign securities. For example, the purchase of securities not denominated in the investor s base currency may require the manager to execute an FX spot transaction (a direct exchange from the investor s base or other currency holding for the currency in which the security is priced) to settle the trade. In the case of a sale, the manager may implement a reverse spot transaction if there is no reason to continue holding the FX exposure. Institutional investors such as pension funds, endowments and foundations may also engage in stand-alone FX trading strategies where the objectives range from hedging currency exposure risks to generating profits from the movements of particular currencies without intending to take delivery. For the purpose of our analysis, we will limit our focus to spot FX transactions (not forward transactions, exchange-traded foreign currency futures, swaps or options) linked to individual foreign security transactions, although the goal of FX best execution applies to all FX instruments. There is very little cross-border regulation of FX trading; rather, there are a number of interconnected market participants primarily consisting of large international banks that continually make the market by offering both bid (buy) and ask (sell) prices. The spreads are generally minimal for pairs of currencies with a high volume of daily trades. However, since the volume of traded FX is large, incremental basis-point changes in the rates at which FX is transacted can produce a material cost or benefit to an investor. Historically, these basis points of additional cost on spot transactions related to security trades, as well as repatriation of dividends and interest payments, have gone undetected, resulting in a negative impact on overall investment returns. However, change is occurring, and there is now greater investor awareness and improving transaction transparency. Improving Foreign Exchange Transaction Effectiveness 2

3 How Institutional Investors Transact Foreign Exchange Money managers trading FX directly with the market when cost efficient, without going through the client s custodian bank, is becoming an industry standard and a best practice. When economies of scale are present, transacting through a third-party broker is typically more cost effective than transacting through a client s custodian bank. This makes sense, since managers typically block-trade securities across many client accounts. Third-party brokers offer competitive rates in an effort to win the business of FX transactions. These brokers try to profit from having a large volume of orders, crossing buy and sell orders, and making a profit on the spread. The greater the volume of FX that a third-party broker is managing, the more valuable potential crossing can be. Custodian banks offer FX transaction services to their custody clients. These trades are typically executed with an above-industry-average spread when compared to broker-executed FX transactions. The foreign currency is held in a custodian bank and is repatriated back to the investor s base currency by either the money manager transacting the securities or by the custodian bank holding the currency. The custodian bank quotes a transaction, typically building a risk premium into the rate. The risk premium, or markup, can be explicit or built into the spread that is offered. The rate that a custodian bank charges is most often based on the WM/Reuters 4:00 London Time Interbank Fixed Rate plus the risk premium markup. The markup is in addition to revenue that can be generated by earning the bid/ask spread from crossing trades. Third-party brokers typically do not charge explicit markups or excessive spreads; however, trading FX through a custodian bank may be cost efficient for some smaller accounts and smaller transactions. Historically, custodian banks have not time-stamped the FX trades, as the trades are often too small and numerous to warrant the administrative effort, and these banks may offer a rate without necessarily making a trade at the time an order is placed. This has created ambiguity around the FX rate that institutional investors receive on their FX transactions. The markup that custodian banks add to the price of FX transactions increases when the transactions are completed through auto-repatriation, a service that custodian banks offer to automatically convert dividends and income received in foreign currency to domestic currency. However, since foreign income trades do not settle until two days after the trade date, not using auto-repatriation may cause a delay in receiving foreign income into the plan account. The practice is declining since the advent of technology that can execute asset and currency trades simultaneously without using a custodian bank s auto-repatriation service. Trading through a custodian bank can help reduce the settlement failure, settlement risk and counterparty risk since these transactions go through relatively quickly, with the bank taking on the risk of transacting the security. Settlement failure is the risk of the currency not being delivered on the delivery date, causing an unintended position exposure until the currency is settled. Settlement risk is the risk of not receiving the full notional value of the trade. When trading foreign currency with a third party, it is possible for the third party to receive currency and go into bankruptcy prior to delivering the FX settlement. Counterparty risk is a presettlement risk of a Improving Foreign Exchange Transaction Effectiveness 3

4 counterparty going into bankruptcy during a forward contract. In this case, any increased value on the forward contract is lost. These risks can be minimized by means of careful counterparty credit analysis and establishment of prudent limits on counterparty net exposure. While transacting through a third party is an option for most currencies, trading directly with the market is not an option when dealing with restricted currencies. Restricted currencies are from countries that do not allow their currency to be traded offshore. The currency must be traded through a sub-custodian bank domiciled in the foreign country. It is standard industry practice to trade FX through a custodian and/or sub-custodian bank when dealing with restricted currencies. When Institutional Investors Should Transact Foreign Exchange The most common times to trade FX are (1) when the asset is traded and (2) at the WM/Reuters 4:00 London Time Interbank Fixed Rate. The WM/Reuters Fixed Rate is set by averaging all the trade rates in the time interval spanning 30 seconds before until 30 seconds after the market closes at 4:00 p.m. London time. The WM/Reuters does not necessarily reflect market conditions, since the rate is computed based on a point-in-time estimate taken during a one-minute window. Transacting FX when the security is traded avoids unintended market risk brought on by holding (not holding) a currency when the position in a country is no longer desired (when desired). Technology allows for the simultaneous trading of an asset and the foreign currency linked with the sale (purchase) of the asset, eliminating unintended currency risk that would arise by waiting until the London close to trade the FX exposure. For indexed portfolios, FX risk minimization is also a best practice. Since most major multicurrency indexes are priced using the London Fixed Rate close, this is the appropriate time to execute FX trades to minimize benchmark tracking error. In summary, the industry standard for actively managed portfolios entails trading FX at the same time an asset is traded in order to not take on unintended currency risk. The industry standard for passively managed portfolios, trying to match the performance of the index, is to wait until the London close to trade FX in an effort to match the transaction rate of the index. How Institutional Investors Can Stay on Top of Foreign Exchange in a Portfolio Investors may be able to identify cost-saving opportunities by analyzing their actual FX trades relative to the average bid/ask rates available in the market at the time of the transaction. There are two important contributing developments that make this goal achievable. First, data retention practices have recently improved, which enables investors to conduct more meaningful analysis of their transaction costs. Second, there are more industry vendors offering FX trading evaluation services and supporting analytics that can pinpoint the sources and significance of trading inefficiency. Technology has played a key role, particularly the growing popularity of electronic communication networks (ECNs), which have made it possible to capture immense amounts of heretofore disaggregated market data. ECN platforms (e.g., FXall, FX connect and Bloomberg) transmit competitive bids by making an FX market that offers best execution trades. ECNs offer Improving Foreign Exchange Transaction Effectiveness 4

5 anonymity and automatic time stamps for FX transactions and create a live market for FX, which results in recorded historical data. The historical information that is now being stored by ECNs makes evaluating FX transactions possible. An institutional investor s custodian bank or its individual managers can deliver actual FX transaction data to a vendor conducting analysis on FX transaction efficiency. Each FX transaction is then analyzed concurrently against the analytic provider s contemporaneous record of FX transaction rates, spreads and volumes to determine trade effectiveness. This methodology addresses the difficulty of transacting during a time period by capturing illiquidity and volatility of rate quotes as well as the bid/ask spread. The figure below displays the hypothetical results from analyzing the FX trades of six managers over a quarter against a universe of similar transactions. This sample graph shows the trading effectiveness of each manager as the difference between the actual FX transaction rates of each manager relative to the average transaction rate during the same time period, as well as the ranges of manager deviations from the universe average. For example, Manager A executed trades at 10 basis points below its universe average, whereas Manager F executed trades at 27 basis points above its universe average. This data can be broken down to any level of granularity, such as by manager, custodian, currency and time of day, to analyze the source of performance attribution from FX transactions. The analysis can be used to identify types of transactions that are outliers or managers that generate consistently poor FX trading results. Once detractors are identified, the analysis can be used to initiate a dialogue with the manager on their FX trading to better understand the issues and potential corrective actions. Figure. Hypothetical distribution of quartiles of the basis-point cost/savings by manager for FX transactions during a quarter Good Bad Trade Execution Effectiveness (Bps) Manager A Manager B Manager C Manager D Manager E Manager F Improving Foreign Exchange Transaction Effectiveness 5

6 Conclusion FX trading can be a significant cost to institutional investors that needs to be managed. The FX market has grown with the growth of global investing, but until recently technology and documentation practices did not enable institutional investors to bring the same level of scrutiny to their advisors FX trading effectiveness as they routinely do to other securities traded. ECN markets have made foreign currency trading more transparent, thereby reducing rate ambiguity and making competitive spreads available outside of custodian banks to those who diligently seek them. These recent innovations have brought light to this source of attribution, and institutional investors now have the ability to measure and improve their FX transactions. Institutional investors and their money managers are increasingly transacting FX directly and monitoring FX transactions to redress inefficiencies and increase overall plan performance. Disclaimer: The information contained in this article does not constitute legal, accounting, tax, consulting or other professional advice. Before making any decision or taking any action relating to the issues addressed in this article, please engage a qualified professional advisor. Improving Foreign Exchange Transaction Effectiveness 6

7 Foreign Exchange Terms Base currency: The domestic currency or accounting currency Best execution: Executing securities transactions in such a manner that the total cost or proceeds in each transaction is the most favorable under the circumstances Bid/ask quotes: A two-way price comprising a bid, or the price at which a dealer is willing to buy, and an ask (or offer) at which a dealer is willing to sell; the bid, by definition, is always below the ask and is always the first quoted price Broker: Agent of the customer that typically charges a commission or markup to the FX trade price obtained in the market Dealer: Market makers typically acting as a principal in any transaction Deliverable currency: Currency that can be traded outside of the country ECN: An electronic communication network is a type of computer network used to facilitate trading of financial products outside of exchanges FX: Foreign exchange Markups: Fees charged in addition to the spread as compensation for the risk of holding a position Over the counter: Trading between two parties as opposed to trading on an exchange Repatriation: Taking foreign currency and converting to the base currency Restricted currency: Currency that cannot be traded outside of the country due to local government regulation Spread: The difference between the rate at which an asset can be bought and the rate at which an asset can be sold Spot transaction: An FX transaction in which each party agrees to pay a certain amount of currency to the other party on the same day or within one or two days Time stamping: The process of recording the time and date of a transaction; this is not common practice due to the small size and large frequency of most FX trades WM/Reuters 4:00 London Time Interbank Fixed Rate: The rate that is quoted by the joint venture of The WM Company and Thomson Reuters as of market close at 4:00 p.m. London time; this rate is a widely used rate to quote prices Improving Foreign Exchange Transaction Effectiveness 7

8 Towers Watson Investment Services Towers Watson Investment Services, a division of Towers Watson & Co., creates financial value for institutional investors by offering independent, best-in-class investment advisory services. We are specialist investment professionals who provide coordinated investment strategy advice based on our expertise in risk assessment, strategic asset allocation and investment manager selection. Towers Watson provides investment advisory services to some of the world s largest pension funds and institutional investors, and has more than 500 associates in Europe, the Americas and Asia. In the United States, investment advisory and investment consulting services are provided by Towers Watson Investment Services, Inc., a subsidiary of Towers Watson & Co. Towers Watson Investment Services, Inc., is a registered investment advisor with the Securities and Exchange Commission. About Towers Watson Towers Watson is a leading global professional services company that helps organizations improve performance through effective people, risk and financial management. With 14,000 associates around the world, we offer solutions in the areas of employee benefits, talent management, rewards, and risk and capital management. For more information on FX transactions, visit. Improving Foreign Exchange Transaction Effectiveness 8

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