The 6 hidden FX costs every fund manager should know about
7 November 2023
In our newest blog post, we are highlighting some of the costs associated with FX execution and hedging that fund managers should be aware of and rank them in order of transparency.
FX Execution Costs
Execution costs are often the first thing fund managers will reference when speaking about FX costs. Think of a bank as a currency wholesaler, who will then discount away from their wholesale rate to incorporate a profit margin or ‘spread’ when they quote their clients.
The spread will be impacted by various factors including, but not limited to:
- how much a fund manager trades per annum
- the size of a particular transaction
- the liquidity of the currency pair
- the tenor of a hedge
- any other revenue generating products within the broader, holistic relationship with that fund manager
In theory, this cost should be easier to monitor and manage than all the other costs in this list. However, in practice, and even to this day, many fund managers cannot say explicitly what they are being charged.
One of the best ways for a fund manager to understand their current execution costs is by carrying out regular Transaction Cost Analysis (TCA) via an independent specialist. TCA is to FX execution what an audit is to annual accounts – third party analysis ensures that your FX counterparties are not ‘marking their own homework’.
Forward points arise in certain FX risk management products such as forward contracts or FX swaps and are a universal market cost that is largely influenced by the interest rate differential between two currency jurisdictions.
Forward points can be negative or positive, and may be to the hedgers’ favour or detriment, depending on which currencies are being bought or sold.
Nothing can be done to avoid forward points, but fund managers should understand that the forward curve isn’t always linear.
The tenor of a hedge can be altered to take advantage of a non-linear forward curve in certain circumstances such as when the trade expiry date doesn’t need to match a pre-defined exit date.
Any spread that is incorporated into a forward rate, or the far-leg of a swap, can be monitored using TCA, in much the same way as other Over The Counter (OTC) FX products.
The Cost of Cash Drag
If you’re a fund manager who hedges FX risk using products such as swaps, forwards or non-deliverable forwards, then you may have experienced first-hand a hidden cost of hedging that isn’t often spoken about – the cash drag associated with placing margin.
When placing a hedge, a bank may request cash collateral (initial margin) to be held as security until the hedge matures and is settled.
Further, movements in the FX market may result in more collateral (variation margin) being requested, to cover the new mark-to-market of the hedge.
If a funds’ investible capital is held back for initial margin, variation margin, or contingent liquidity to cover potential variation margin requests at short notice, then deployed capital must work even harder to hit the target internal rate of return (IRR).
It’s almost impossible to know, with any degree of certainty, where FX markets will move and to forecast total margin requirements throughout the life of a hedge – this means, that on day 1, it’s impossible to forecast how placing margin will impact a funds’ investment returns.
For this reason, fund managers tend to seek out uncollateralized hedging facilities with each of their FX counterparties with a view to freeing up investible capital.
However, hedging on an uncollateralized basis might introduce additional costs that are built into the exchange rate in the form of a credit valuation adjustment (CVA).
Credit Valuation Adjustment (CVA)
If a fund manager successfully negotiates uncollateralised hedging facilities with their counterparty banks, they should be mindful of the potential for additional FX charges when hedging.
Uncollateralised hedging means that the executing bank is taking additional risk on a client when they hedge.
After all, that bank has no security against that hedge and in the event of a client default the bank could potentially face a mark-to-market (MTM) loss. CVA is an adjustment in the FX rate to account for the possibility of default. CVA is not zero when FX hedges are collateralized, but it is heavily negated when compared to uncollateralised hedging.
CVA will vary from bank to bank, for different clients and might be influenced by prevailing market conditions. This means when a fund manager is executing a longer-dated trade that induces CVA, they can’t know exactly what their hedging costs will be in advance.
Although, generally speaking, as the tenor of a hedge increases, so does the potential mark-to-market loss and, therefore, the CVA charge.
In order to maintain FX transparency and cost control, fund managers could explore using shorter trade tenors (e.g. 6-months or less) that don’t incur CVA.
Historic Rate Rollovers (HRR)
HRRs have been around for a while but get a mixed reception from different global regulators and are not generally considered best practice.
The appeal of HRRs for fund managers comes from the fact that in theory there will be no cash movements that might normally arise from rolling FX forwards.
Standard practice is for any mark-to-market (MTM) gain or loss to be crystallised at each roll date and for the fund manager to receive or instruct a cashflow accordingly.
Instead, with HRRs, the single FX counterparty that holds the current hedge incorporates any potential MTM loss into the new hedge rate and the hedge ‘roll’ is performed ‘off-market’. It’s the FX equivalent of kicking the can down the road.
HRRs should be considered more of a lending product than an FX product, because any accrued MTM losses are subject to a lending rate being applied to them before the new, off-market hedge rate is decided.
HRRs are not considered best practice for the following reasons::
- The fund manager foregoes transparency of execution costs and cost oversight through TCA, because the new rate is agreed off-market.
- All subsequent rolls must stay with the original counterparty that traded the hedge, meaning the fund manager may also forego best achieving the best price from the available counterparties.
- Crucially, banks will trade HRRs at their own discretion and they can be withdrawn at any time potentially leaving a fund manager open to a large liquidity risk at short notice.
Fund managers should pay particular attention to the discretionary nature of continued access to HRRs every time a hedge is rolled forward, because it relies entirely on the credit appetite of the FX counterparty.
HRRs are at their most valuable to a fund manager when they carry a significant MTM loss in the hedge rate, which is conversely when the FX counterparty’s credit appetite will come under most pressure.
For example, a ‘Black Swan’ event that has led to significant volatility in FX markets (and a large MTM loss on a hedge) might also be the time an FX counterparty reassesses how much FX credit they extend to their book of clients as risk appetite decreases and they adopt a more conservative stance to weather the storm.
In our view, the FX cost centre that is the least transparent and most challenging to quantify is the ‘opportunity cost’ of the time and operations associated implementing and managing the FX function day-to-day. Here are just some of the potential operational costs:
- Onboarding a new FX counterparty – KYC, AML, ISDA and CSA negotiation, reverse due diligence, all put significant strain on legal and compliance resources.
- FX transactions– cumbersome price discovery, navigating multiple systems or platforms, trade approvals, data entry and payments / settlements all could potentially take their toll on finance and operations teams.
- Manual processes and human error – if FX transactions are managed manually then this can place more strain on finance teams and often makes the process more prone to errors. Errors can be extremely costly, especially if they involve cancelling and rebooking trades, or if a deadline is missed.
- IT systems and integration – to help overcome the operational drag that arises from manual processes, a fund manager might decide to invest in various IT systems. However, to truly ‘future proof’ the FX function, systems need to be integrated to help ensure that workflows are automated.
- Counterparty monitoring – Following the collapse of Credit Suisse, SVB and First Republic Bank - something that captures the FX zeitgeist of 2023, is counterparty diversity and due diligence. Some resource must go towards monitoring counterparties, otherwise a fund manager risks going back to step 1).
To overcome these operational hurdles, fund managers could explore new solutions in the market which provide access to a multibank FX execution framework, while minimising operational burdens through automation.
How MillTechFX can help
MillTechFX by Millennium Global is the FinTech affiliate of Millennium Global Investments, one of the largest specialist currency managers globally. Our FX-as-a-Service model helps fund managers significantly reduce both FX costs and operational burden associated with FX execution and rolling hedging requirements.
We provide an end-to-end solution, from onboarding with up to 15 counterparty banks to execution, settlement and reporting of FX transactions, including TCA, across multiple funds.
Get in touch today to find out more.
Joe McKenna, Head of Institutional Solutions
Joe has over 15 years of experience working in FX markets and has held various senior positions both in the UK and overseas. Most recently, Joe was on the Investec Fund Solutions team, helping fund managers with bespoke lending and derivative solutions, covering each stage of the fund lifecycle and multiple layers of the capital structure.