Fundamentals of FX

We are kicking off our educational blog series with a good, old-fashioned glossary.

To give you greater clarity – and help demystify the world of foreign exchange (FX) – we have explained the most frequently used words and phrases in our industry.

If you are already an FX expert, feel free to skip to the second blog in our series “What are the advantages of using multi-bank platforms for FX?”

• What are FX trades?
• Examples of FX products
• How does volatility impact a currency's value?
• Regulatory terms of FX

What are FX trades?

FX trades operate in pairs, and each pair has a code. Most of these codes contain two characters relating to the country and a third character relating to the monetary unit. Some famous currency codes include USD (US Dollar), EUR (Euro), CAD (Canadian Dollar) and GBP (British Pound Sterling).

Examples of FX products include:

• Spot – the purchase of a currency for instant delivery on a specified spot date. The standard delivery time for a currency spot transaction is trade date + two business days.
• Forwards – a derivative that locks in an exchange rate for a currency pair for settlement on an agreed date in the future. They are fully flexible in terms of amounts and lengths, although one-month or three-month forwards are the most used for hedging purposes.
• Swaps – a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies. The parties are essentially loaning each other money and will repay the amounts at a specified date and exchange rate. The purpose could be to hedge exposure to exchange-rate risk, to speculate on the direction of a currency, or to reduce the cost of borrowing in a foreign currency.

How does volatility impact a currency's value?

The main impact on a currency’s value is volatility. Currency volatility is characterised by frequent and rapid changes to exchange rates in the FX market.

Volatility is produced in a currency because of a range of factors including:

• Overall macroeconomic environment
• Inflation levels
• Interest rates
• Geopolitical stability
• Monetary policy
• Cross-asset volatility.

Often, volatility is unpredictable and can lead to significant losses or gains in the foreign exchange market.

To reduce or eliminate the risk of loss for a company or investor from currency movements, firms implement currency hedging strategies. This generally involves entering into forward contracts or options strategies to offset an existing risk.

Some investors will outsource their hedging requirements to a currency manager through a passive hedging or dynamic hedging currency overlay program.

Regulatory terms of FX

Best Execution

One of the most important regulatory terms firms need to familiarise themselves with is best execution. This is a legal mandate that requires an execution or investment services firm executing orders on behalf of customers to take all sufficient steps to obtain the best possible results for its clients.

Rules pertaining to best execution are stipulated in MiFID II, a legislative framework that came into force on 3 January 2018. MiFID II aims to strengthen investor protection and improves the functioning of financial markets making them more efficient, resilient and transparent.

 

FX Global Code

Another key framework for best practice in FX is the FX Global Code. Although not legally binding, the FX Global Code provides a common set of guidelines to promote the integrity and effective functioning of the FX market.

Firms are encouraged to use the code to inform corporate practice and assist in developing and reviewing internal procedures.

Transparency is central to the FX Global Code. One key tool used to gain transparency over the price a trade is executed at is Transaction Cost Analysis (TCA).

 

 

What is a Transaction Cost Analysis (TCA)?

TCA exposes any hidden costs, including those in the spread, which is the difference between the best price you can buy at (the ask) vs the best price you can sell at (the bid).

In currency markets, prices are generally quoted as net prices inclusive of any charges. The bid-ask spread is therefore an important component of the overall cost of a transaction.

For post-trade TCA, the starting point is a set of accurate data about the transactions to be analysed including precise trade timing, which is known as the ‘time stamp’. This data can then be compared to benchmark trade prices to calculate the ‘slippage’, which is the difference between the actual trade price and the benchmark price.

Independent, and frequent, TCA is one clear way that a firm can work towards demonstrating best execution regardless of which currencies or products they trade.

For a more exhaustive list of FX terms with in-depth explanations, see our FX Glossary.

How MillTechFX can help

MillTechFX by Millennium Global is the FinTech affiliate of Millennium Global Investments, one of the largest specialist currency managers globally.

We provide access to a transparent marketplace for comparative FX execution from up to 15 counterparty banks, while harnessing a unique and significant pricing efficiency for our clients. Rather than having little choice but to accept the rates offered to them by their custodians, pension funds can automatically execute at the best available rate with the simple click of a button.

MillTechFX’s market access, pricing power and operational resource enable it to deliver a tech-enabled integrated solution that delivers transparency, cost reduction and operational burden reduction for pension funds.

Interested in finding out the quality of your FX execution? Request your free, independent, TCA here.