Whether it be the evolving regulatory environment, or the introduction of new electronic trading platforms and algorithmic trading strategies, the foreign exchange market is more complex than ever. Add to this an evolution in the FX vendor space which has created more choice for efficient FX management, and the result is leaving many asset managers confused about how to optimize their approach to FX.
There are two distinct types of FX activity: Strategic FX and Operational FX. ‘Strategic’ FX is a key driver of fund performance, a deliberate decision to take currency risk in an effort to generate returns. This type of FX is often integral to fixed income and multi-asset funds, and of course, funds that focus on currency as an asset class.
By contrast, ‘operational’ or ‘transactional’ FX is currency activity executed outside of the core investment strategy. Two examples are (i) trade settlement FX that supports equity investment strategies, and (ii) share class hedging where a specific rules-based currency hedging service aids fund distribution. Neither is an attempt to add performance, but if handled poorly, both can erode the ‘alpha’ generated by a fund manager.
Due to its deliberate nature, strategic FX usually receives the attention it deserves. However, because operational FX is not instigated to generate fund returns, it is often an afterthought for asset managers. A historic lack of focus on this type of FX activity has at times led to operational and execution inefficiencies.
This can hurt fund performance and lead to inconsistencies across funds. Firms that handle operational FX in-house are challenged with the costs and risks of managing all stages of the FX lifecycle for what may not be a value-added activity. Managers that use automated FX programs offered by custodians may have concerns that a lack of true rate transparency is masking excessive FX costs, or that execution may be inefficient and inconsistent across funds and investors. As a result, operational FX is drawing increased scrutiny from institutional clients, fund boards, and even regulators.
MITIGATING UNCOMPENSATED RISK
Many managers reviewing their approach to operational FX are only evaluating the execution stage, when pre- and post-trade activities are just as important. Considering factors other than price should not be a new phenomenon for managers as many may already be subject to regulatory obligations for their equity trading.
Accurate pre-trade calculation is critical to meeting the fundamental requirements of trade settlement FX and funding the associated security activity. This drives a manager’s ability to make decisions around netting opportunities, which can provide a compelling efficiency gain in a well-calibrated operational FX program.
In the post-trade environment, timely and accurate settlement for third-party trading is paramount. Clear and informative post-trade reporting is required to demonstrate the effectiveness of the execution process to all stakeholders, in particular trading costs at the time of execution and full transparency for cash management. When considering execution specifically, there are two important considerations for managers: when? and how? When is about balancing access to effective liquidity, maximizing netting to reduce costs, while minimizing time to market or latency. How is about understanding the appropriate trade execution method and benchmark. This includes whether to use single or multi-bank platforms, sophisticated aggregators, or Electronic Communication Networks – all creating further complexity for asset managers.
Managers that use active trading desks to handle operational FX flow are increasingly evaluating the how, and whether the risk and resource requirements associated with strategic FX are appropriate for operational FX. Concerns over inconsistent treatment and uncompensated risk for investors have prompted many such managers to move towards a more automated, rules-based approach for this non-core activity.
OPTIMIZING THE FX PROGRAM
Regardless of the way an asset manager handles operational FX, recognizing that it differs in purpose from strategic FX can help ensure there is a consistent, efficient and justifiable approach to the FX process.
The rise of specialist third-party providers offering security funding FX solutions gives managers a compelling option to cover the full 360 degree FX process outside of the traditional in-house or custodial solutions. These providers are blending pre- and post-trade operational efficiency and automation with more execution choice, consistency and transparency than ever. While each manager’s view of operational FX may differ, many that see it as a distraction from higher-value strategic FX are leveraging specialists to deliver an effective end-to-end process. This is freeing them up to focus on their core investment competencies in a fiercely competitive industry.