Autumn 201310

Industry Spotlight

!"#$"!%&'()%*+)%,$+)#-.%)-/)01There are four areas to look at when

!!"#$%&'!(&)'*+#)$+,&#$&-.&/(01#$%

Many hedge fund investors,

although not surprised,

were jolted into action

by the well-publicised

lawsuits launched by a

few large institutional investors against their

custodians in relation to foreign exchange

(FX) transactions. Having negotiated core

custody service requirements down to ultra-

competitive price levels, these large investors

had not realised their ultimate costs in terms

of ine!cient FX execution. Following the

lawsuits, investors of all kinds have been

keenly reviewing the true costs.

Due to the over-the-counter nature of the

foreign exchange business, it has historically

been very di!cult for investors to measure

their associated cost of trading. One could

probably question dealers’ motivation to

provide transparency in a global market with

a daily volume of over $4 trillion.

Some investors have built up signi"cant

in-house FX expertise, with the resources

and infrastructure to calculate and execute

FX e!ciently. However, in terms of execu-

tion, there is often signi"cant reliance placed

on a single counterparty such as a global

custodian. It is in these scenarios that some

large investors have launched lawsuits.

Finding e�cient FX execution

As investors seek to expose the hidden

costs of FX, there are a number of factors

an investor can look into in order to ensure

e!cient FX execution.

■ Size of trades. Ultimately this can have a

big impact. Investors should theoretically

bene"t from trading with a counterparty

that is pooling trades in the market for the

bene"t of their clients.

■ Agency approach. Is your counterparty

executing the trades on its own book or

acting as an intermediary to seek best

execution from a panel of counterparties?

In the case of the latter, large FX players

should achieve very e!cient rates. #is

assumes an appropriate structure is in place

to check prices prior to execution with an

appropriate number of counterparties.

■ Time of execution. Point-in-time (PIT)

trading has the bene"ts of allowing

easy comparison and time stamping, so

ensuring your FX counterparty is getting

a good execution price at that particular

trading time. For example, using the

London 4pm "x is a popular PIT trading

strategy. However, statistical evidence has

thrown doubt on the overall e%ectiveness

of this strategy compared to average prices

received throughout the trading day.

■ Currency hedging calculations. Aside from

the complexity surrounding the e%ec-

tive execution of FX trades, there is also

signi"cant risk associated with the calcula-

tion of FX hedges. Any error in calculation

here may lead to investors being over- or

under-hedged on their portfolios, which

can lead to signi"cant realised losses.

Fully-integrated administrators should be

able to take away the burden of FX hedging

calculations, using integrated electronic

data &ows and experienced FX profes-

sionals within their middle o!ce teams.

What has changed?

In spite of the negative publicity surrounding

investors’ legal actions against the custo-

dians that were providing their FX trading,

little has changed in the way that FX services

are provided. But the actions have revealed

FX as an area of possible hidden cost, with

the potential to reduce investment returns.

We believe investors should look into the

issues we mention above, as guarding against

high costs through simple measures such

as time stamping to aid transparency and

independent validation of FX rates.

by Kieran Dolan, Managing Director, Citco Alternative Investor Services