Currency overlay programmes range from the basic to the very sophisticated, but they all depend for their effectiveness on the counterparties being used to implement the transactions.

The banks trading in the forex markets and providing the in-struments and facilities are clearly key to the implementation of any overlay programme.

There is universal agreement that the overlay client should be the principal in these transactions and that the overlay manager act as agent in all the dealings. To have it any other way would just compound the problems," says Colin McClatchie of PanAgora Asset Management in London, referring to the credit risk, which overlay managers see as a main issue in selecting counterparties.

The overlay managers may like to pass the risk cake to the client, but they like to eat it too, since most are keen to be involved in the counterparty selection process. They have the day-to-day task of dealing with counterparties when running their programmes. Says Ray Dalio of Bridgewater Consultants in Connecticut: "We find counterparties vary substantially in the quality of their execution, depending on the currency and the time zone they are operating in." His company uses a set of benchmarks to grade counterparties.

Dalio adds: "We have found generally that clients will specify the standard of the counterparty - not in specific name terms but in specific re-quirements. They may even exclude certain ones by name." The issue of established relationships clients have with banks cannot be sidestepped in the view of A G Bisset's Ulf Lindhal. "Clients are usually happy with these and ask why don't we use them - un-less we have an objection." Generally these banks are among the major in-ternational operators with full forex capabilities. Clients often have their own internal rules about the extent of exposure not just for their pension plans, but for the corporate activities world-wide, he points out. "Even the banks may have limits for their exposures to different corporations."

"But where the client wants advice about choosing partners, we will recommend a number of those banks giving good execution and having sufficient credit rating," says Lindhal. Trades will be spread around to minimise the risk, however miniscule, of one of these major banks going under.

At GK Capital Management in Illinois, Dermot McAtamery looks at the counterparty question of one of "standard fiduciary responsibility". Any deviations by a counterparty from standard business practice should set off alarm signals. "A client may indicate a certain bank, but we would indicate that we would prefer certain trading partners. To the extent we run a 24-hour desk, we do have our favour-ite banks in different countries".

One way to resolve any tensions that can arise in counterparty selection is to offer an arrangement such as that set up by New York manager FX Concepts. Clients have the option of having FX use their counterparties, or they use a facility established with international insurer AIG. FX president Rod Porter explains: "Our client sets up a line with AIG Trading, which is a triple A-rated entity as the counterparty. Then we trade with AIG Trading or with a group of around 10 major banks and use AIG's line with those banks." These banks, which AIG accepts, are among the major in-ternational banks selected for their liquidity and execution and information flows. "This provides our clients with the best of all possible worlds by giving access to the best in the market with the AIG risk."

The list of banks has to be agreed with AIG, says Porter. "We have de-liberately included the strongest, who are strong in the currencies of relevance to us. Some banks are better in some currencies than others and having the AIG relationship means that the client need have no concerns about going to the best bank with the best execution." Around 98% of FX clients are using this facility, he says.

Once you have worked through the credit rating questions and the ability to execute transactions to the re-quired standards, it becomes a matter of price, says Bridgewater's Dalio. "What we are exclusively interested in is net price. We are not interested in research nor in information flows, as we have good information sources otherwise!"

Lindhal believes that establishing good relationships at the trader level is key to success. "In the end if you get along with the traders at the bank, and are obtaining good service and good prices continuously, you are more willing to give them the chance to bid in competitive situations." He adds that it is a matter of building a mental database as to who gave you a good rate when the market was thin.

This is the information that only comes from being in daily contact with the markets and the players in them, as the overlay managers are. IPE"