PRACTICAL THOUGHTS Asset Owner Foreign Exchange Trading After the Scandal November 2012 Harbor Analytics, LLC
Jerry Brown is a polarizing figure. The outspoken Brown, who is still crafting his legacy in his second stint as governor of California, is known for his anti-establishment politics, multiple failed presidential runs not to mention his high profile relationship with Linda Ronstadt in the 1970 s. Whether you agree with Governor Brown s politics or not, a press conference he held on October 20, 2009 has had a lasting effect on the financial services industry, with billions of lost revenue, multiple lawsuits and a giant spotlight cast on a portion of the industry that was rarely discussed. In October of 2009, then California Attorney General Brown announced a lawsuit against the custodian of the state s two largest public pension funds alleging, amongst other issues, unconscionable fraud. The charges centered on standing instruction foreign exchange ( FX ) trading, also referred to as custody FX services or indirect FX trading. In short, standing instruction FX gives the custodian blanket instructions to execute a FX trade any time there will be security settlements in different currencies and/or for dividend and income repatriation. Governor Brown accused the custodian bank of taking large undisclosed spreads from the pension funds it was not entitled to. We have no opinion on the legal merits of the charges, although the case opened a can of worms that has had lasting effects on foreign exchange trading businesses. Brief History While custodians are the poster children for current FX issues, the Asset Owner s investment managers, not the custodian bank, are hired as Fiduciaries by the Asset Owners and as such, required to achieve best execution for all asset classes, including FX trading. (Note: The custodian could also be a Fiduciary) One would think the managers of the pension plan would be in hot water for not achieving best execution. Equity managers are generally well versed in stock selection and equity trading. Yet historically, many viewed the FX trading that accompanied equity trades as an operational exercise that would be best executed if outsourced. This would eliminate two important issues for the manager itself: Operational Risk Incorrect timing of FX trades can lead to overdrafts or settlement failure that can lead to significant additional costs and/or penalties. Contractual settlement, which is typically offered as part of standing instruction FX services, eliminates this risk. Operational Costs Building a state of the art FX trading desk requires systems investment and experienced FX trading professionals in addition to costly real time market data. These costs are borne by the money manager. Elimination of these two issues was often thought to be a no brainer for the investment management firm operational risk is eliminated in addition to costs that affect the bottom line. Because of this, for many years custodians enjoyed a near monopoly with respect to their long-only investment manager s foreign exchange trading. While money managers were not forced to use the custodian, and in fact had access to a variety of execution methods (including electronic execution products or sales traders accessed via phone), many managers used standing instruction services due to the outsourcing benefits detailed above. Custodians would justify the additional cost of the services by using a convenience store analogy you pay a little more for a gallon of milk although you avoid the hassles associated with large stores. Fast forward to today. The infrastructure investment associated with building and maintaining an effective foreign exchange platform is large and will only grow, particularly with the impending changes associated with Dodd-Frank. The question of whether equity only managers are better served by outsourcing of FX activity will continue to be asked by Asset Owners. Regardless of who is responsible for execution, what is clear to all is that the cost that Asset Owners have historically incurred is not acceptable. The benefits of technology have significantly reduced trading costs in many asset classes, including currencies, mainly due to transparency of markets. Additionally, agency FX providers are competing for business offering a competitive execution platform and real time transparency. Investment banks who traditionally served their prime brokerage clients are gaining market share by offering best of breed technology in addition to the ability to trade FX simultaneously with the corresponding equity transactions thus eliminating timing costs. Historically, there was no motivation by the custodian bank to move clients into more efficient (i.e. cheaper) products given the lack of competitive offerings and the huge profits they were earning in FX. Everything changed in October of 2009. In this paper, we will show the changes that have occurred in the industry, the transaction cost results, and what still needs improving. 2
Custodial Usage Many industry professionals believed this would be the end of most custodian bank s FX desks. This is far from the case. Many custodians offer their clients a variety of executions platforms and still have the benefits of the operational infrastructure that was built to support standing instruction FX practices amongst other products. Harbor Analytics has aggregated data from our client s long only money managers (bond and equity) who trade FX. In short, while our data history is short prior to the October 2009 announcement, it is apparent that custodians have maintained a good portion of their market share. Chart 1 % of FX Trades Executed 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Custodian Market Share Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211 Q311 Q411 Q112 Q212 Q312 In Table 1, we have detailed the average percentage of trades executed with the custodian by investment managers in our database. The table demonstrates that while some managers have changed their practices, most have not. Prior to the announcement, managers either used custodians for nearly all FX transactions or very little to none with no middle ground. In Q3 2012, fifty percent of managers still executed over 75% of their FX trades with their custodian. This does not speak to the execution methodology (i.e. standing instruction vs. negotiated trading) but rather who managers chose as the counterparty to their trading. Only 10% of managers have moved from using their custodian nearly exclusively to a more diversified panel approach. As an aside, approximately 40% of managers used their custodian exclusively (100%) for execution in Q2 2009, while no manager in our database used their custodian exclusively in Q3 2012. Custodian Cost vs. All other Executors As custodians still execute the lion s share of trading in our database, the next important question is how do they perform? Harbor Analytics uses implementation shortfall to measure the execution quality of FX trading. Implementation shortfall compares each execution to a benchmark struck prior to the start of trading. Therefore, timing costs (which can be positive) and spread costs are included. In Chart 1 above, we have detailed the share of FX trades executed by the custodian of the assets for Harbor Analytics clients. (We omitted managers with emerging markets benchmarks due to the idiosyncrasies of the currencies associated with these mandates.) Prior to Governor Brown s announcement, custodians executed approximately 75% of investment manager trades, a percentage that is staggering when compared against fixed income or equity trading where 20% would be considered high. This declined, in our database, to just under 60% in Q1 2012 although it has rebounded to just under 70% in Q3 2012, indicating a 10% drop in market share across the period. Chart 2 0.20% 0.15% Actual Cost 0.10% 0.05% 0.00% -0.05% -0.10% -0.15% Direct Trading Custodian Third Party Q209 Q309 Q409 Q110 Q210 Q310 Q410 Q111 Q211 Q311 Q411 Q112 Q212 Q312 Table 1 Percent of Trading by Managers Q2 2009 Q3 2012 Use Custodian for >75% 60% 50% Use Custodian for between 50-75% 0% 0% Use Custodian for between 25-50% 0% 10% Use Custodian less than 25% 40% 40% In Chart 2 above, we have detailed the quarterly shortfall of custodian direct trading versus third party direct trading. In essence this compares the cost of trading using the custodian, stripping out standing instruction or non-negotiated trading. The results show that the costs, while random for any quarter, are close over time, although custodians are more expensive. 3
To demonstrate this more effectively, in the table below we have detailed the annual transaction cost of execution for the custodian versus non-custodian trading: Table 2 Execution Method 2010 2011 2012* Custodian Direct -0.02% -0.07% -0.07% Third Party - Direct 0.04% -0.03% -0.06% Variance -0.06% -0.04% -0.01% Through September 30, 2012 While 2010 demonstrates a large difference (6 basis points), we suspect this was somewhat due to the data not being as clean as compared to 2011 and 2012. As disclosure of spreads for indirect trades was a new practice in the industry, we suspect 2010 custodian direct trades include some indirect (non-negotiated) trades in the custodian direct calculation. The data presented above has not been normalized for expected costs of trading. All the trading is in developed currencies although there can be a wide dispersion of expected costs based on the currency pair, current market conditions, and also the size of the trade. However, using Harbor s proprietary FX cost model, we did not see material differences in expected costs amongst data sets. Standing Instruction Percentage In general, we are only able to compare standing instruction percentages and costs if properly labeled from our data providers (money managers and custodian banks). In general, we are comfortable assuming that all trades labeled as standing instruction were labeled correctly, however we suspect there could be trades that were executed via standing instructions that were not labeled properly. Due to the newness of the labeling, we have only detailed trading from 2011 and 2012 in the charts and tables relating to indirect trading. In the Chart 3 below we have detailed the percentage of developed markets trading that was executed via each execution method. Chart 3 Percent of Trading 100% 50% 0% Indirect Trading Direct Trading Q111 Q211 Q311 Q411 Q112 Q212 Q312 The chart demonstrates very little change in FX trading habits over the past seven quarters. Standing Instruction Cost vs. All other Execution Methods As standing instruction trading seems to be constant at approximately 10% of all manager s FX trading, it is important to compare how standing instructing services perform against all other executions methods. We have compared the cost of each method using the same methodology, implementation shortfall. Similar to prior tables and graphs, the numbers are not normalized for expected cost, only the prior seven quarters of data have been analyzed and only developed markets transactions are being considered. Chart 4 Implementation Shortfall 0.10% 0.05% 0.00% -0.05% -0.10% -0.15% -0.20% -0.25% -0.30% -0.35% Direct vs Indirect Costs Indirect Direct Q111 Q211 Q311 Q411 Q112 Q212 Q312 In Chart 4, the higher cost of indirect trades is apparent with the average incremental cost being 12 basis points per quarter. Not surprisingly, standing instruction trades have the following three characteristics when compared to other trading: 1. Small in size 2. Large in number of trades 3. High in cost Points one and two above demonstrate why this practice was outsourced at a high cost for many years. We suspect that the remaining ~10% that are still executed via indirect methods are related to income and dividends received. 4
Dividend and Income Repatriation Managers are still using standing instruction FX for dividends and income earned near universally resulting in higher cost for Asset Owners. It seems as if industry participants have accepted the cost of these services as a necessary evil. Imagine if your equity manager said they had found a broker to trade all their small share lots for 15 cents per share and they were going to use this broker due to the operational efficiencies associated with outsourcing small orders. More than likely, this manager would be terminated immediately. Managers would argue that the trade size for dividends and/or income receipts are extremely small, it is difficult to get good pricing for these size orders and it will take an inordinate amount of time to perform these services in-house so best to outsource. They are correct that these trades are very small, although we would disagree that good pricing is difficult to receive for small orders. Many trading platforms now offer streaming quotes from a variety of dealers that allow for best execution. We would also argue that there is no immediacy to repatriating these amounts. Holding US dollars in a strategy designed to track/outperform a global un-hedged benchmark only increases tracking error. Interest associated with US dollar deposits is certainly not a reason to hold US dollars. Why do it? Solutions When selecting a manager, Asset Owners need to determine if that manager s FX platform will allow them to achieve best execution. For some managers, outsourcing the activity to a third party may be best practice. Managers are often reluctant to admit they need help, therefore Asset Owners may need to determine this for them using detailed FX measurement techniques. As a minimum, Asset Owners should: 1. Ensure their investment managers have a robust FX process with multiple dealing counterparties. 2. If a manager s infrastructure necessitates outsourced FX services, negotiate a better standing instruction service that is based off of a liquid time of the market (i.e. not the Australian open) with a small but manageable mark up for the provider. If that fails, utilize agency FX providers in lieu of standing instruction FX services if a manageable fee cannot be negotiated. Agency FX providers are a suitable comparison for standing instruction services with some notable product differences. 3. Opt out of dividend and income repatriation strategies and manage the currency actively holding USD in an EAFE or EM based strategy only increases tracking error 4. Negotiate with custodian on ticket charges for FX trades executed with third party banks A long standing practice for custodians is to maintain high ticket charges for unaffiliated FX transactions as a means to drive order flow to their own desks. Summary Regardless of with whom money managers are executing, the large mark-ups that exist in the industry need not be tolerated. Vetting the FX process with your current or potential providers in advance will avoid the issues that currently exist in the industry. Foreign exchange trading should be monitored and measured not unlike any other asset class as poor execution leads to incremental cost to Asset Owners. About US Harbor Analytics is a consulting firm that provides expert quantitative support to Asset Owners and investment consultants on investment manager s equity and foreign exchange trading, in addition to end-to-end support during the transition management process. For more information: Contact: Ross McLellan, CFA ross@harboranalytics.com 781.875.1451 Legal Disclaimer You may only use this communication for internal purposes and you may not amend or forward this document without written consent from Harbor Analytics. The communication is background information and should not be considered a solicitation for any investment strategy. The data presented is historical and past performance is no guarantee of future results. The data in this report comes from multiple sources and we are not responsible for any errors in the document whatsoever. Harbor Analytics, 2012 5