Foreign Exchange Trading. Trading at the 4pm GMT Fixing

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1 Trading at the 4pm GMT Fixing Summary Points Many transition managers default to executing all FX at 4PM London fixing This is same rate used by most index families for daily valuation Traditionally this is the most liquid point for the FX market Primary reason for executing at this time is benchmarking of transitions and transparency with respect to execution price Trading all currency at close is no different than trading all equities at close; Transition manager is only accessing a small percentage of the volume and the benchmark price can be effected FCA is investigating the manipulation of the fixing rates that are used by transition managers and other market participants Different trading strategies for underlying physical securities and currencies creates temporary dislocation of portfolio Auditability of FX rates should be less concerning due to the availability of intraday currency rates and the growing acceptance of third party transition analytics Transition managers (or their counterparties) who guarantee mid-point fixing can be beneficial for smaller transitions Opportunity cost for transitions includes currency risk although it does not exist from a benchmarking point of view if all currency traded at benchmark price we believe this to be driving force behind international transitions being within one standard deviation 80% of the time in Harbor Analytics Transition Management Universes The trading strategy most transition managers utilize when executing foreign exchange ( FX ) transactions can best described as the path of least resistance or controversy. Since the 2009 State of California lawsuit versus its custodian bank became public, FX and the revenue derived from its trading has been a constant question that transition management providers face. The response of many in the industry was to take the least controversial approach to FX trading and execute all freely traded 1 FX at the fixing price at 4pm GMT. The fixing is the average price, as calculated by the WM Company and Thomson Reuters, surrounding the 4pm close. This price is widely used by asset owners, asset managers and index providers in calculating portfolio values and returns. Given the transparency surrounding what the fixing rates were, the transition industry has adopted the mantra that executing at this price is in the best interest of its clients and cost free as it is executed at the benchmark FX rate used to calculate transition performance. While transition managers are correct in that the price is widely available for comparison purposes, there are consequences in executing this strategy that asset owners and their consultants need to consider. Remuneration A major concern with respect to FX is solely focused on a common theme that permeates the transition management business How much money are you making? While this is important to know prior to engaging a transition manager, it is not the only question that should exist when executing FX or any asset class. The transition industry has many providers that have different backgrounds. They range from investment banks that utilize their extensive global trading infrastructure to execute global securities, to firms that act as a manager and leverage the infrastructure of many different firms, to providers who sit in the middle and use some of their own infrastructure and outsource when needed. Each one of these firms has a different revenue model for FX. The major client concern with respect to FX should be two-fold: 1. Did I get the best possible price when my provider executed? 1 Restricted currencies are still traded by the sub-custodian based on the local rules and regulations. Asset Owners should monitor these transactions to ensure they are not being processed through standing instruction services with large mark-ups.

2 2. Did the provider execute the currency trades at the most appropriate time? Was their risk management of currency as advertised? Ensuring that clients receive a fair price for their currency can easily be determined by looking at their executions and comparing them to intraday market data at the time of transaction. Simply ensuring that no or little money is made defeats the purpose best practice would dictate using the most skilled provider who gets the best executions with a sensible remuneration amount. Would you rather purchase an asset at 1.50 knowing that the provider made 2 basis points or would you rather purchase the same asset for 1.55 but the provider made no profit? A second benefit of analyzing time stamped FX data is the ability to recreate the approach the transition provider took in acquiring all assets. This creates an intra-day look into the risk profile of the transition portfolio which will provide insight whether the provider took the proper approach. Engaging a provider who intelligently approaches FX will provide better outcomes for clients. As such, a provider should receive fair compensation for their services. These questions should be at the forefront of any pre transition process. Fixing the Fix The Financial Conduct Authority recently announced it was investigating trading activity surrounding the WM/Reuters fixing. Essentially the FCA is looking into something that industry participants have long know existed in most asset classes when one trading entity has a significant enough size and the ability to trade into the benchmark price, it is quite easy to move said benchmark price. Said differently, if I am a bank and I have $1 billion EUR/USD to purchase at the fixing, it will quite easy to trade ahead of this time to move the price (unless someone else has $2 billion to sell!). (There is also speculation that the FCA is looking at other issues beyond the marking of the close). Concerns for Asset Owners I. Transition manager or its chosen counterparty profit the most when the fixing rate can be moved the most An fictional illustration is below on how this can be done: II. Example: Buy $100 million EUR Time (EST) Amt Bought Price 10:50 16,666, :52 16,666, :54 16,666, :56 16,666, :58 16,666, :00 16,666, Average Price Profit vs. Benchmark $25,000 The provider trades ahead of the benchmark price and pushes the rate higher/lower depending on if they are buying or selling currency. Their average price is better than the benchmark price and they retain the difference. Proponents of this strategy would state that there is risk in trying to trade ahead of the benchmark price due to the scenario alluded to above another market participant has a larger order in the opposite direction. While this may be true, if the transition manager is using its affiliate for execution and there is slippage in their average price versus the 4PM fixing rate, the difference will most likely end up in the client s account and not the banks account. 2 P age

3 III. If the transition manager or its counterparty is trading into the close and receiving a better price than the close, shouldn t the asset owner receive this improved price less some fixed fee? Potential Benefits I. Larger transition managers with volume scale can negotiate better rates for its smaller clients i.e. all clients receive WM/Reuters mid-rate. The downside to this is that the larger clients with the more lucrative orders are subsidizing that transition manager s smaller clients. II. Certain currency pairs are more expensive to trade outside of this time although it should be noted that the spreads at 4PM GMT time can be wider than at other times during the day. Dislocation? Consider a transition with large regional shifts between the Americas, EMEA and Asia Pacific. Region Legacy Target Variance Americas 10% 30% 20% EMEA 15% 30% 15% APAC 75% 40% -35% In current practice, all currency would be hedged out at 4PM GMT on the day prior to equity trading beginning. Equity trading would not commence until the first Asia Pacific markets open approximately 8 hours after the FX was executed. In the meantime, the client will be long US and European currency and short Asian currencies. The physical securities that underlie this exposure change will not be purchased for as much as 24 hours. This risk can certainly go for or against the client in terms of performance but the more important point is that the transition manager has created an interim portfolio that looks nothing like the target portfolio, or the legacy for that matter, and essentially the transition manager has created an unmanaged active portfolio for a short period of time. The proponents of this strategy would state that getting the currency exposure more closely aligns the interim portfolio with the target as currency is matched perfectly. If this is the goal, why not trade everything on the close in each region? Secondly, if implementation shortfall is the benchmark for all transitions, all benchmarking should begin at the same time prior to any trading started therefore, the benchmark for all assets will be the price when FX trading starts (sat 3:45 GMT Time). This would obviously cause chaos in the industry and not something we subscribe to but it is a question that should be asked providers who espouse this model. Auditability A popular aspect of trading at the WM/Reuters fixing is the auditability of the transition manager s execution prices. While this is true, intra-day FX pricing is readily available and most independent third party analytics firms provide time stamped analytics on equity and FX trading. Given the increased transparency in the industry, this should no longer be a concern for Asset Owners. Alternative Approach Restricting a transition manager from executing currency until Asia Pacific markets start the trading day is an alternative to the current approach. It will more accurately depict the cost of any event and ensure that the portfolio is acquired in a manner more reflective of the investment strategy desired. Benchmarking Anomaly that Exists Today From a benchmarking point of view, the trading of all currency prior to the start of the event gives the provider a cushion in its opportunity cost range. In general, opportunity costs are derived from the tracking error between the 3 P age

4 target and legacy portfolio. This number in conjunction with portfolio liquidity will determine how much risk exists and how long this will exist. These calculations are based on recent returns between the target and legacy portfolio. In our history we have not seen any providers who have used the local returns of the target and legacy portfolios to determine potential opportunity cost therefore the currency risk in the transition is being used to create the expected ranges. As such, the provider is estimating a range of cost that can be partly driven by currency changes, but has no currency risk as it was traded prior to the start of the transition. We believe this to be the driving reason behind international transitions being within one standard deviation more than 80% of the time in our universes versus a statistical expectation of 68% of the time. Proponents again will state that this demonstrates the benefit of this approach we are closer to our estimate. This ignores the points we have made above such as the benchmark price could have been moved due to the trading and the dislocation of the portfolio. In the chart below we have detailed the performance of international transitions versus all other transitions in our universe. Harbor Analytics EAFE Composite Size Within 1 Std Dev $0 - $100 Million 87% $100 - $250 Million 49% $250 - $500 Million 91% $500 - $1,000 Million 90% >$1,000 million 50% Total 80% Summary It was not unusual for a transition to be executed in the 1990 s or early 2000 s for free with all the equity trades executed at the closing price. The revenue for the transition manager was the difference between the closing price and where they actually executed the transaction. This model quickly fell out of favor when asset owners and investment consultants realized that executing all their orders at the close was not prudent and the opaque revenue model essentially pitted the profit of the transition manager versus the best interests of the plan. Most FX trading is performed exactly the same way today. For plans with larger orders, this can lead to higher FX costs with the additional cost flowing to the transition manager or the bank they choose to aggregate their FX orders through. It also creates a portfolio in the interim that represents neither the target nor the legacy portfolio. We believe best practice to be trading currency simultaneously with equity portfolios. This eliminates the potential that the rate received is not artificially moved prior to the price being struck and represents a more efficient risk management approach. The downside to this approach will be that costs or savings will materialize due to the timing different between the benchmark price and the actual execution price given the time lag. Trading strategies should not be designed to comply with a benchmark rather designed to implement the objectives of the client. The role of benchmarking is to measure success. Attribution of benchmark deviation will sometimes be higher than expected due to unintended timing costs. We would expect this timing cost to be close to zero over a long period of time although the savings associated from not trading at one point in time where the price may be intentionally moved to be positive for most clients. About Us Contact: info@harboranalytics.com Harbor Analytics is a consulting firm that provides expert quantitative support to clients and investment consultants during the transition process. We provide 4 P age

5 the pre and post transition analytics for free to our Asset Owner Clients and Investment Consultants. Our modest fee is paid out of the commissions generated in the transition. Contact: Legal Disclaimer You may only use this communication for internal purposes and you may not amend or forward without written consent from Harbor Analytics, LLC. The communication is background information and should not be considered a solicitation for any investment strategy nor are we providing investment advice. Our opinions are subject to change without advanced notice. Harbor Analytics, P age