An agency approach to FX execution promises substantial savings. Lloyd Raynor suggests that it is time to give this area more attention
Historically, many institutional investors overlooked the fees they paid for transacting foreign exchange (FX) but a number of high-profile investors have recently queried the extent to which they have received best execution, and some have even taken legal action. This is important: recent research by Russell Investments finds that many investors still pay much more for FX execution than they need to, given its commoditised nature. Such investors could benefit from adopting an agency approach to FX trading, which involves a third party ‘shopping around’ for the best deal for each set of trades. Competition between counterparties ensures that the prices are as attractive as possible, with annual savings in the order of €330,000 achievable for a €1bn fund.
Based on an analysis of over 173,000 FX trades conducted over 2010-11 on assets totalling approximately £49bn (€79bn), we found that the average cost of FX trades was approximately 10 basis points, as compared with nine basis points in a previous study using data from 2008-09. That greatly exceeds most estimates of what it actually costs to trade in the FX market, which typically ranges from 1-3 bps for the most traded developed market currencies, according to data from RBS. Some investors were found to have suffered much higher FX execution costs than 10 basis points on average: one investment manager paid over 37 basis points for trades executed with its custodian. It is clear that FX trading is not, as is often thought, a friction-free process.
To manage it, measure it
One of the most effective ways to improve FX execution is to state publicly that you will be reviewing the costs associated with its execution – and then to measure the results achieved on a regular basis. There are three key areas that investors should focus on when attempting to understand the costs associated with FX execution:
• Execution quality. It is vital that those executing FX, such as custodian banks, prime brokers or electronic trading platforms, have a clear and well-thought-out execution-quality management process in place. This will require that there are at least detailed time-stamped records available around the FX process and that whoever is responsible for choosing the FX execution counterparty can understand and assess the results of the execution process.
• Conflict management. Whoever is providing FX execution must clearly disclose any transactions executed with affiliates, and all other potential conflicts of interest. In particular, these parties must make it clear when they (or an affiliate) are involved in the transaction in any role other than as the client’s agent.
• Counterparty selection. If selection of the party executing FX trades has been delegated by the investor to investment managers, it is important that the investor understands the FX processes adopted by the different investment managers. For example, has a particular investment manager chosen to direct all FX trades to a single counterparty, or has the manager chosen to build a competitive counterparty execution programme for shopping around for the best deal for executing FX trades?
As well as measuring the efficiency of your FX execution, you could also consider appointing an agent to execute FX on your behalf. While some managers may have chosen to build an FX trading capability whereby they already shop around for the best deal, in practice most managers have not chosen to build a full FX-trading capability. Given this, you may like to consider appointing a third party agent through which all your FX trades are directed for an explicit fee, in return for ensuring you get the most efficient FX execution.
Based on our 2010-11 analysis, figure 1 shows how the average trading cost varied according to the number of counterparties used and whether an agency model was adopted. It can be seen that the net execution cost can be reduced to below one basis point if you choose to adopt an agency approach to FX execution.
Before discussing the potential savings from adoption of an agency approach, let us briefly discuss the differences between the three approaches to FX execution. ‘Indirect trading with a custodian’ represents those situations whereby you or your managers simply direct all FX trades through a single custodian. Under this approach, just one counterparty is used for all FX trading and there is subsequently less competition on price. The ‘average manager’ represents the approach of the majority of investment managers when executing FX who have chosen not to build a full FX-trading capability. While FX trading may not be directed to a single counterparty, there will be less focus on achieving the lowest possible cost for FX execution than there could be. Finally, under the ‘agent’ approach a third-party is employed for the sole purpose of keeping the costs of FX execution as low as possible. As a result, multiple counterparties are used and played off against each other in an effort to secure the lowest bid.
It is helpful to understand the impact of adopting different approaches in €m terms. If we assume that a €1bn fund has 80% (ie, €800m) invested in growth assets which include a non-domestic component, that 70% (ie, €560m) of these growth assets are invested in foreign assets, and that annual turnover averages 35% (or around €200m), the net execution cost in €m terms under each of the models specified above are shown in figure 2.
It can be seen that employing an agent could have reduced the FX fees of a €1bn fund by around €380,000 per annum before the fees of the agent are taken into consideration. Assuming a total fee of 3 basis points, inclusive of the net FX execution costs, the agency approach reduces costs by €330,000 (In practice, the fees for an agency approach can vary but we estimate that they will typically be in the range of 2-4 basis points per annum). Such savings are substantial – they are likely to cover the fees paid to many investment consultants.
Below the radar for far too long
Our analysis here suggests that investors cannot simply rely on their managers or custodians to execute FX trades efficiently. Too often a lack of expertise and resources can lead to uncompetitive execution and have a material impact on FX transaction costs for investors.
Best practice dictates that all investment decisions should be reviewed periodically and FX execution is no exception. Such a review will help you to understand and better control your FX costs, and may help you to consider more cost-effective solutions. In addition, if managers are unable or unwilling to increase their FX capabilities, you may wish to go one step further and consider the use of third-party agents to ensure ongoing efficiency of your FX execution.
Lloyd Raynor is a senior consultant at Russell