UNBUNDLING COMES TO FX.

While investment management firms are increasingly looking at FX as an asset class, they also need to be active in the foreign exchange market to facilitate transactions in foreign securities and to manage their risk. Best Execution spoke with Chris Oulton* about the multitude of considerations when transacting in FX.

What is the impact of regulation on FX?

Increasing regulation on disclosure in the FX space should serve to benefit clients who need to execute trades. Traditionally large banks and custodians have tied in clients to using their FX services as part of the provision of their general banking requirements. Payment for these services was part of the overall package. However, due to the captive nature of some of these arrangements, banks have provided poor execution rates, taking additional profits from their clients, without disclosure or the ability for them to ameliorate those costs by having an alternative.

Increased regulation should serve to prevent the banks from garnering these additional undisclosed profits by opening up the marketplace for these trades to outside agents.

Regulations such as Dodd-Frank and Basel III are also serving to push up the internal costs that banks will have to bear. This could potentially lead to them either scaling down, or exiting this market as a maker of prices directly, or by necessity, to increase margins to cover their costs.

Those banks that choose to scale down their direct FX business may themselves opt to go down the agency execution route, by offering clearing or prime brokerage solutions, but without taking principal risk on the pricing.

How would you define best execution in FX?

Best execution in FX can be defined simply as a cost-minimising, efficient process allowing the client to manage their business needs across currency pairs and settlement dates as required.

The cost-minimising element is fairly self-explanatory, but the efficiency part is also vital in the smooth running of the business. For the client to know that all of their needs can be dealt with a simple streamlined tool, without the need for multiple individual requests, gives them comfort.

Furthermore, there is also a requirement for the clients to know that they will have access to fine pricing at all times. This cannot necessarily be achieved by having a limited number of counterparties through whom they transact. If the banks choose to push up the costs of dealing, the client must have alternative strategies in place to obviate this.

Is there an increase in outsourcing and why?

FX is a simple concept where the end product, i.e. the currency, is the same irrespective of the provider. Accordingly, some clients have realised that they have no requirement to execute through their own bank. This has lead to a growth in third party providers, executing FX trades on behalf of the client, and remitting the funds back to the client’s host bank. As more and more clients see this as an efficient model, they are moving away from the old traditional, captive model. Outsourcing, to the correct provider, can also provide access to different sources of liquidity at different times, enabling the client to achieve optimal pricing.

What models does the competition offer?

The competition is twofold. In the simpler case, clients can use a simple third party, payment services company through whom to execute their trades. Where the client has a requirement for a greater volume or more sophisticated trading, they could switch to a platform-based system.

The advent of platform-based trading for these clients has helped to streamline the actual trading process. However, for the majority of users, whilst this has helped to consolidate their day-to-day trading, it has not addressed fundamental issues concerning the counterparties that they execute their trades with.

The basis of these trading systems are still, in effect, analogous to phoning up the various desks of the banks, and asking for their prices – although this is mechanised through the platform. Each of these automated feeds, and the prices that they quote, has had to have been negotiated with each of the banks, and on a bi-lateral basis. The client will then be limited to those direct feeds that they are provided with. Furthermore, traditional platforms can suffer from the ability to be tailored for each type of business, reflecting the nature and volume of trades entered into.

Can this be improved upon?

I’d like to think so. We offer a similar platform-based trading solution, but with two significant differences. The platform we use, Liquid-X, takes multiple feeds from a large number of leading liquidity providers (up to 15 depending upon the currency pair), and using fast algorithms, offers optimal pricing in up to very large order sizes. It then uses either Rabobank or Morgan Stanley as the central clearer in each of the underlying trades between both the client and the underlying liquidity provider providing the best pricing at that time.

This benefits the client in a number of ways. In effect, the client now has access to each of the prices that all of the liquidity providers offer, but without having to engage with each of them bi-laterally. Instead, the client will just face the one central clearer, and it is for that clearer to face into the market and execute each of the underlying trades. This has the benefit of minimising settlement risk, whilst providing access to greater and deeper markets.

Additionally, the Liquid-X platform is particularly bespoke. It can be tailored on a client-by-client basis to the specific dealing requirements of each client using it, through the variation in dealing spreads, settlement options and currency pairs for each client, based upon their individual profile of volumes, trade frequency and dealing size.

What are the challenges of trading in FX today?

Given the on-going financial crises and increased regulation, there is more focus than ever on achieving best execution in the FX space on behalf of shareholders, trustees (through their fiduciary responsibility) and investors. Clients should regularly review their FX execution performance in order to prevent their current solution stagnating and, consequently, being exposed to poor execution by banks who perceive little risk in overcharging for FX services.

Accordingly, clients should have specific knowledge of their trading methodologies and the costs associated with their settlement solution. A periodic trade cost analysis of trading history should be conducted to quantify the quality of execution achieved. Where this demonstrates that the current solution offers poor execution, clients can now look to alternative providers and lower their costs.