FX Transaction Costs Plugging the Leakage in Returns

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1 Executive summary FX Transaction Costs Plugging the Leakage in Returns Custodian banks provide a service to their clients to safeguard their assets and undertake ancillary transactions as required. Some of these transactions require an accompanying FX trade: this necessity has proved to be a hidden source of revenue for custodians for at least a decade. Plan Sponsors do not necessarily see custodians as requiring to be monitored on a regular basis, nor do they typically consider the possibility of transferring FX execution responsibility to an independent agent; this paper argues that they should. While custodians may be entitled to profit from FX transactions, the extent to which they do so will seem excessive to most, especially when custodians fail to provide proper disclosure of actual profits. As they have not historically provided time-stamps for their trades, it is difficult to determine these profits on a trade-by-trade basis. However, a methodology developed by Record gives a statistically significant indication (provided a large enough sample of trades is used) of any poor pricing, by comparing trades with the highs and lows of the trading day. In many cases, custodians execution by this measure exhibits a skew to either the day s low, or indeed outside the trading range, to the ultimate cost of Plan Sponsors. Moreover, revenues from FX for custodians are significantly greater than those of other banks (for the equivalent volume of transactions), suggesting that for similar activities custodian banks are profiting excessively. This document offers several suggestions to limit or eliminate such activity the publication of time-stamps for each trade; a regular audit of FX execution; and execution of FX by an independent agent. In short: greater pricing transparency and/or elimination of conflicts of interest is required. The relationship between custodian, asset manager and Plan Sponsor, in theory A Plan Sponsor hires a custodian bank, whose principal task is to act as the safe keeper of the assets. In addition to this core responsibility, custodians typically undertake ancillary services, such as the execution of foreign exchange arising from the purchase or sale of foreign stocks and bonds, or indeed from dividend and coupon payments. The custodian will either undertake these transactions itself, or through a third party. Since in these transactions the custodian may act as a principal (unlike the asset manager who is an agent), it may be entitled to profit from the FX activity it undertakes on behalf of its clients. This is explicitly stated in some custodian s documentation for example: and As a custodian, [Custodian 1] facilitates the processing of foreign exchange transactions at the direction of its custody clients or their independent investment managers. These foreign exchange transactions may be executed with either third party dealers or with [Custodian 1 Markets], a separate division within [Custodian 1] in which our foreign exchange business is conducted. [Custodian 1 Markets] acts as principal (i.e. not as an agent) when effecting foreign exchange transactions, taking principal positions and risks. RECORD CURRENCY MANAGEMENT LIMITED MORGAN HOUSE, MADEIRA WALK, WINDSOR, BERKSHIRE, SL4 1EP, UK 44 (0) Fax: 44 (0) Authorised and Regulated by the Financial Services Authority in the UK and Registered with the Securities and Exchange Commission in the US Registered in England No Registered Office as above VAT No

2 We acknowledge that, unless you and we agree otherwise for particular accounts or trades any transactions subject to this authorization and standing instruction may be placed with [Custodian 2] s foreign exchange desk and [Custodian 2], acting as principal, may profit from such transactions. The relationship, in practice Profits from FX trading are a hidden cost to pension funds, in addition to fees already paid to custodian banks. When a foreign security is bought or sold, or a payment is repatriated to the base currency, foreign currency needs to be bought / sold. Profit is made through the bid-ask (offer) spread [Custodian 1 Markets] is taking principal risk when it purchases and sells currency in the foreign exchange market and the bid and offer spread around each foreign exchange transaction is compensation for taking that risk. The pricing of any transaction by [Custodian 1 Markets] is not determined by reference to its actual costs. Excessive profit can come from an excessively wide spread, or from booking the trade at a poor rate. An unbiased, ideal series of executions ought to be evenly distributed around the mid (adjusted for normal spreads), and within the days high and low. Certainly, if it is significantly skewed towards the low, or well outside the range against the Sponsor, this is raises questions about the competence or integrity of the execution process. The managers and Sponsor are often unaware of this hidden cost, either due to misplaced trust in the custodian, or simply a failure to obtain adequate disclosures from the custodian. A manager often has have a duty to ensure best execution for the FX it instructs a custodian to undertake (as for any transaction). Where the Custodian prices FX trades as principal, the only check available to the Sponsor is the Sponsor itself. Without expert analysis and advice, few Plan Sponsors are capable of holding Custodians to account in this specialist area. Evidence of mispricing At the time of writing, there are a number of lawsuits filed or taken over on behalf of state funds in Arkansas, California, Florida and Virginia, amongst others, against custodian banks. Furthermore, State Street Corporation has disclosed that the Securities and Exchange Commission, amongst other regulators, is investigating its foreign exchange pricing. Record has undertaken many audits of clients FX executions, revealing varying degrees of mispricing. A recent audit for a pension fund produced the profile below. The analysis looked at the spot trades which the custodian had executed, compared them to the respective days high and low, and generated a score. For each trade, a rate which corresponds to the day s best rate (from the point of view of the client) is attributed a score of +100%, while a rate which corresponds to the day s worst rate is given a score of minus 100%. This score is then adjusted for an estimate of the market s bid-ask spread, so that completely random market-price execution with enough observations would generate an average score of zero. An ideal set of executions would not only have a mean of 0% (i.e. on average, trades are made at the day s mid) but also be completely within the bounds of -100% and 100%. There is sometimes some question of the date if the time-zones for execution and the public pricing data are very different, and this can in theory produce idiosyncratic executed prices apparently outside the day s range. The audit in question followed a somewhat different profile, with a good deal of executions Page 2

3 at, or close to, the -100% mark, implying that the client had consistently been getting rates corresponding to close to the day s low. The probability of such a profile occurring randomly (assuming that we expect the average score to be zero i.e. deals to be traded on average at the day s mid-price) is very small indeed (p<0.001%). The profile is represented in the chart below (Graph 1) a histogram, representing the number of occurrences within 10% ranges for the trades analysed (the orange line represents an ideal custodian). Graph 1 Example of recent audit for US pension fund Custodian FX execution Profile of 'ideal' execution Observations % -120% -100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140% Score The example above operates broadly within the range -100% to 100%; many do not. It is not unknown to find trades executed at multiples of -100%, with the below as an example profile (Graph 2). Graph 2 Example of a particularly poor custodian Proportion of trades 12% 10% 8% 6% 4% 2% Custodian FX execution Profile of 'ideal' execution 0% -600% -500% -400% -300% -200% -100% 0% 100% Score Record also ran an audit of the spot transactions within one of its own programs. Graph 3 illustrates that, with market bid-ask spreads taken into account, a broadly balanced profile is achievable in practice. Page 3

4 Graph 3 Record in-house trades Record in-house trades Ideal execution Observations % -120% -100% -80% -60% -40% -20% 0% 20% 40% 60% 80% 100% 120% 140% Score Source: Sample client; Mar 2007-Feb 2011; spot trades only It is worth asking at this point why the above methodology is used why go to the length of comparing the executed rates with the corresponding highs and lows? Why not compare the rate to that at the time of the trade? The reason for this is that, for most of the audits undertaken, timestamps have not been made available for the trades: the custodian is unable (or unwilling) to provide them. Clearly, with time-stamps, a process of auditing a report would be much simpler, and the results clear cut. To give custodians their due, practice does appear to be improving in terms of willingness to provide time-stamped data, at least going forward (historic data may still be unavailable). A consolidated analysis in 2005 of Record s audits to date looked at various parameters, including the type of currency, size of trade, and whether transactions were instructed by a manager, or undertaken automatically by a custodian. This analysis showed that trades instructed by the manager, rather than undertaken automatically by a custodian, show better execution. Not only is the distribution of trade scores more balanced, the patterns above are less pronounced (although there is still some pattern, implying that manager s fiduciary duties do not fully eradicate the problem). Form of FX Execution Custodian-delegated Managers discretion Number of audits Aggregate number of trades 10,320 9,984 Aggregate FX volume (USD millions) 5,200 74,717 Average divergence from Mid Rate 24.2 bps 10.5 bps Page 4

5 In all cases, a positive sign indicates execution at rates that were beneficial to the bank / expensive to the bank s client, and a negative sign indicates rates that were disadvantageous to the bank / cheap to the bank s client. The final exhibit (Graph 4) takes a top-down view: the observation that custodians FX businesses generate significantly higher revenues than comparable businesses in other (non-custodian) banks. Record s research team looked at custodians and other banks Annual Reports to estimate revenues from FX activity, and scaled this to reflect the respective custodians and banks market share. These market shares may be under-estimated in the case of the custodians, but even so the results are telling: the revenues from banks per percentage of market share are dwarfed by those of custodians. This is in spite of both institutions having the same tools at their disposal to profit from FX: to charge a bid-ask spread. Graph 4 FX revenues of custodians and banks compared FX revenue per 1% market share 10,000 8,000 6,000 4,000 2, y Average Custodian 1 Custodian 2 Custodian 3 Bank 1 Bank 2 Bank 3 Source: Bank/Custodian Annual Reports ; Euromoney FX Poll : annual FX revenue taken from bank/custodian financial reports; bank/custodian FX market share taken from annual Euromoney FX ; average FX revenue / 1% market share calculated across a four year period to give an indication of the relative profits of three sample banks vs. three sample custodians Solutions to the problem The pricing of custodians FX transactions can act as a hidden cost to beneficiaries of pension funds and other plans under management. Over time, these can compound to very large sums of money. Some measures can be taken to mitigate these risks, all involving a greater level of transparency on the part of the custodian, and permanent vigilance on the part of the Plan Sponsor. The only measure that will eliminate the problem is to separate the pricing function from the principal (the Custodian in this case), to ensure that FX pricing is undertaken by a party with no conflict: Time-stamps should be recorded with each FX trade. This eliminates the need to compare the traded rate with the respective day s high and low, a strategy which although producing statistically significant findings (provided there is an adequate sample size), is less certain than Page 5

6 knowing the exact corresponding market rate. Custodians have been resistant to giving timestamps for currency audits, but practice may be improving. Plan Sponsors and / or managers should regularly monitor and audit their FX execution. The obvious advantage to this is the incentive it gives to custodians to undertake their FX execution in a more balanced manner, given the expectation of future comparisons with market rates. The Plan Sponsor community should consider whether a better long term solution is to encourage the emergence of best execution undertaken by agents on a fiduciary basis. The caveat to these suggestions is that custodians revenue expectation from their core business is clearly based not only on agreed fees, but also profits from FX. If the latter revenue stream were to be adversely affected, custodians may seek to recoup this through increased explicit custody fees. Whilst this would appear more expensive in the short term, bringing greater transparency to pricing and fee structures should increase the ability to manage these, and so be to the long-term benefit of pension plans and their ultimate beneficiaries. All this material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. Published in the UK for Professional Clients and the views contained within are correct for date of publication and may have changed since that time. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guarantee of future results. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Page 6

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