Industry Spotlight

Autumn 2014

Foreign exchange trading volumes

are rising, driven by non-dealer

!nancial institutions, making

the price paid for FX trades a

more pressing issue than ever.

For hedge funds and other investors, higher

trading volumes emphasise the importance

of making sure they’re not being overcharged

for FX trades.

Trading in FX reached an average of

US$5.3 trillion a day in April 2013, up from

US$4 trillion in April 2010, according to

the Bank for International Settlements’

latest triennial FX survey. FX swaps were

the most commonly traded instruments, at

$2.2 trillion per day, with spot FX following

at US$2.0 trillion. But the survey named

smaller banks, institutional investors,

hedge funds and proprietary trading !rms

as propelling the 35% growth in global FX

turnover.

FX execution as part of a bundled

o"ering has been hugely pro!table for some

service providers. #ey have delivered core

brokerage, custody and administration

services at very low margins and then made

signi!cant pro!ts on areas with less pricing

visibility, such as FX, banking and credit.

But one has to wonder whether – in the

wake of decreased treasury margins, lower

demand for credit and now the intense

scrutiny of FX brought on by litigation for

overcharging and market-rigging – the busi-

ness model of these traditional providers has

broken.

Hidden costs

For institutional investors and fund

managers, monitoring their FX counterpar-

ties to understand the true cost of trading

is a challenge. Several US court judgements

in 2013, ruling in favour of FX providers,

showed clearly that the !duciary responsi-

bility for ensuring best execution lies with

the investor/asset owner. Indeed, since

these rulings many service providers have

speci!cally stated, even on their web sites,

that they have no !duciary duty or obligation

regarding FX execution.

Unfortunately, many of these service

providers continue to su"er con&icts of

interest when delivering best execution. FX

trading remains a pro!t centre for them, with

spreads and revenues hidden from clients.

Our previous articles have highlighted

areas for investors to focus on as they

seek to reveal FX trading’s hidden costs.

In particular, we have mentioned currency

hedging transactions, not least ‘point-in-

time’ trading, which has subsequently hit the

headlines with accusations of market-rigging

on the grandest scale.

Pricing transparency

Many of our clients have teams dedicated

to overseeing FX execution e"ective-

ness. But while one would expect this of a

sophisticated FX investor, is it a good use

of resources for managers that are simply

hedging? Even if the service provider doesn’t

have a !duciary obligation to ensure best

execution, without pricing transparency

relationships can’t be based on trust and

partnership.

A robust and transparent infrastructure

and process can help ensure ‘best execution’

– however, even this is no guarantee. Indeed,

we believe managers need to go one step

further. Only independent validation of the

e"ectiveness of FX execution gives complete

assurance. Transaction cost specialists, who

access random sample trades on a large scale

every quarter, can provide an Execution

Quality Report that reveals the fairness of

execution.

Such independent validation con!rms the

quality of the FX trading process, in compli-

ance with regulatory requirements from the

SEC, FCA, BaFin and others. An independent

report reveals transaction costs compared to

other market participants, as well as execu-

tion quality by currency pair, by volume and

by time of day.

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Discovering the true cost of FX !"#$%!&'('!&'!)$*+"%&+)%,!$-+!$.'*'+"$)/'$'0'-)%*'!'11$and quality of foreign exchange trading and hedging

by Kieran Dolan, Managing Director, Citco Alternative Investor Services (CAIS)kdolan@citco.com