The Shifting Landscape of FX Execution for Fund Managers
14 July 2021
The FX exposure might arise from share class hedging for overseas investors, acquiring foreign currency assets, a currency mismatch between management fee income and expenditure or an indirect exposure at a portfolio company.
Whether it is an occasional FX spot transaction, a rolling hedge program or a highly bespoke solution, fund managers with foreign exchange exposure not only have to navigate the sometimes complex and volatile world of foreign currency trading, but also decide what organization to partner with to help them go about it.
In the noisy marketplace of FX execution, a fund manager has a long list of potential counterparties, advisors and electronic trading platforms available to them, so it can be confusing to know the best way forward.
As dry powder and investment activity start to pick up in a post-pandemic World, we have highlighted what we believe every fund manager should consider before choosing an FX partner.
Best Execution and Price Discovery
Best execution has been in the spotlight for some time. MiFID II regulation requires investment firms take all "sufficient" steps to obtain the best possible result for the client on an on-going basis. Further, the FX Global Code of Conduct applied principles for dealing with market participants in a consistent and appropriately transparent manner. There are many factors to take into consideration in the quest for best execution and one of those is price, or in FX markets, the best available exchange rate.
Long before MiFID II, a fund manager with only one FX counterparty at their disposal might have used FX spot mid-rates to apply some ‘price tension’. The difference between the price quoted to them and the mid-rate online could help to determine the spread (A.K.A. the fee) charged by their counterparty, and the General Partner (“GP”) could then assess whether the cost is ‘fair’ in exchange for the service they receive. However, price tension does not give way to best execution and best execution is simply not possible with a single counterparty.
Streaming online rates are only indicative and thus unlikely to be tradeable at that moment in time for the GP’s exact trade nominal. There are many factors that can affect the quoted FX rate; trade size, liquidity of the currency pair, market conditions, credit charges, delays from using non-electronic execution routes, and forward points, among others. FX execution should be a partnership in understanding and then applying an optimal way of executing each client’s business for the ‘best possible outcome’, whether this is utilising benchmark execution or other methods, and a lack of transparency can leave the fund manager in the position of being none the wiser whether what they are getting is a competitive rate or not.
For this reason, to get an order executed at the most advantageous rate, fund managers commonly look to diversify their pool of FX counterparties. That way, with multiple prices to choose from, GPs can pick the rate that is best for them, hence best execution.
However, the quest for best execution raises many questions. How many FX counterparties do you need to achieve best execution? Is best execution just about the best FX rate or are there other considerations? What’s the best process for price discovery – should it involve multiple inputs from streaming rates, quotes in an e-mail, calling around? What’s the operational process involved and does ease of use become a factor? How should a GP demonstrate best execution to their investors on an ongoing basis?
Ongoing, Independent TCA
Before reviewing their current price discovery process, a fund manager must first understand how much they are being charged for the execution of their FX transactions.
Transaction Cost Analysis (TCA) goes hand-in-hand with best execution and can be used as an ongoing audit of FX practices as well as to hold existing FX counterparties accountable. The goal of TCA might not just be to gain a competitive advantage when trading FX but potentially to comply with a best execution policy that is reported back to partners and investors alike.
To perform a TCA, historical trade data is required – currency pair, volume, product (spot, forward etc) and time stamps. To calculate the transaction cost on a trade, the actual rate the trade was executed at is compared to the independent mid-market rate at the point in time of execution. This difference multiplied by the trade notional equals the execution cost on that trade. A fund manager might consider using an independent TCA provider that can assess the performance of their FX counterparties in a consistent manner over time.
The information above is for illustrative purposes only. Source: MGTS, BestX (04.06.2021)
Typically, a TCA will show the overall portfolio cost over a given time period, a detailed breakdown of costs for each currency pair, and changes in costs depending on the type of FX product used. A GP can then use this data to assess the performance of counterparties. Ongoing, quarterly TCA analysis can also be embedded as a new operational practice to ensure consistent FX execution performance.
If a fund manager is considering a TCA, they must first ensure they are collecting the necessary FX data from their counterparties – it should be fully transparent and broken down according to product, price, currency pair and including as detailed a time stamp as possible.
Efficient Use of Capital
We already know that having the ability to put trades up for competition is typically central to best execution. However, FX pricing shouldn’t be the only thing a fund manager considers – credit facilities for FX trading should also be taken into account.
Fund managers who hedge, using forward contracts for example, must also consider that placing a hedge typically requires margin to be posted against that position as collateral. Further, if the initial margin no longer covers the mark-to-market of a hedge, due to movements in the spot rate, the GP may be required to post additional, variation margin. Any capital posted as collateral, sitting dormant in a margin account and not invested, potentially earning higher returns, can cause a drag on fund performance. The FX risk, being mitigated with forward contracts, has been replaced with a potential liquidity risk.
One way around this issue is to trade via an uncollateralised FX facility so that the GP can hedge (using forwards) and not worry about posting margin. If the facility is uncollateralised up to a pre-determined figure, there is a cap on how far in the red your mark-to-market can go before your counterparty has no further appetite to trade with you and starts calling for variation margin. This can result in fund managers spreading trades between different counterparties, with FX rates being a secondary consideration, to keep sufficient headroom on trading facilities and eliminate the need to post margin altogether.
For a fund manager, we know that best execution requires multiple counterparties, but before price discovery comes the search for eligible FX counterparties. Incumbent banking relationships are the logical place to start, and custodians, prime brokers or lenders may be able to offer FX trading services too. Where it could get challenging is establishing new relationships for FX only, as there is no guarantee a counterparty will want to onboard a client that only requires one of their services.
And then there’s the setup phase. After negotiating the finer points of a non-disclosure agreement, a GP must fill out paperwork, locate and share ‘know-your-customer’ documents and then go through a credit approval process. Credit approval can be particularly challenging; you should expect your chosen counterparties to look through investor commitments and underlying assets with a fine-tooth comb. Respective legal teams will need to work through ISDAs, CSAs and any other trading agreements before setup can even begin.
Once setup is complete, the process of price discovery can happen in a number of different ways – telephone dealing, onscreen quotes, chat messages and e-mails. With multiple counterparties at a fund managers’ disposal, it can soon turn into a time-consuming, team operation to get the best available price from your chosen counterparties. Depending on how a fund manager goes about price discovery, there may be a tradeoff between inefficient booking systems versus the number of counterparties.
For all of these reasons and more, the private capital market is moving towards solutions that assist in onboarding the fund manager with multiple banking counterparties and obtaining credit facilities with each bank simultaneously. Fund managers might also consider more centralised, digitised solutions that consolidate price discovery in one place at one time.
Now, GPs can go one step further. Beyond streamlining onboarding and credit with multiple counterparties and centralising price discovery, fund managers can even outsource the complete end-to-end workflow from calculating the FX position, to execution, to margining and settlement. Fund managers should also be able to request bespoke reporting or information flows to additional third parties such as Administrators and Regulators.
MillTechFX by Millennium Global is the FinTech affiliate of Millennium Global Investments, one of the largest specialist currency managers with c.$20.7bn AuM and c.$600bn annual FX transactional Volume*. MillTechFX’s independent solution helps institutional investors and managers significantly reduce both FX costs and operational burden associated with FX execution and rolling hedging requirements.
We believe our innovative approach provides access to a transparent marketplace for comparative FX execution from 10+ counterparty banks, while harnessing a unique and significant pricing efficiency for our clients.
* Heritage information specific to Millennium Global Investments Limited (MGIL – FRN 171039). AuM refers to the USD 20.7 billion notional amount managed as of 30th April 2021. FX volume shown is an average of years ending 2018/19/20.
This document, including the information provided herein, is provided for information purposes only and does not constitute an invitation or offer to subscribe to or purchase any of the products or services mentioned. The information contained is intended for Professional Clients (or elective professional clients only). MillTechFX does not target retail clients as the products offered by MillTechFX are not suitable for, or made available to retail clients. The information herein is not intended to provide, and should not be relied upon for, accounting, legal or tax advice or investment recommendations. You should consult your investment, tax, legal accounting or other advisors.
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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.