FX 2020: in search for a better outcome

Over the last 3 years, volumes in the FX market rose by 30% according to the latest Bank for International Settlements (BIS) triennial survey[1], confirming it remains by far the largest market with a daily turnover of $6.6 trillion in April 2019. 25% of the overall flows are generated by a mix of institutional firms and it is worth noting that the increase was largely driven by a rise in FX swaps volumes, demonstrating that FX exposure hedging, passively generally, keeps growing.

The FX risk, though, is the second largest impacting funds and portfolios after the equity, according to a recent BlackRock study[2]. For many portfolio managers, whose core competency is to make the right investment decision at the right moment, the FX is a collateral, potentially unwanted, effect of the underlying investment decision. Still, when investing in foreign assets, the entire yield could be wiped out by an adverse FX movement.

So why do some fund managers hesitate to hedge or willingly decide not to hedge the currency risk? In those times of very low FX volatility, some expect that month over month or quarter over quarter, the FX movements will overall be neutral; others find the FX market too opaque and given the various scandals from the last decade it can be understood, to some extent. But many efforts are undertaken by all stakeholders and new players in the FX ecosystem to bring much deserved transparency, best execution, benchmarking and optimization tools.

The FX Global Code, adopted by the vast majority of the sell side, is definitely a step in the right direction. With the FCA recognizing it at the end of June 2019, or the Bank for International Settlement asking for wider adherence in January 2020, it is a strong message towards the rest of the FX market participants (buy side and their providers) that all should endeavor to implement this set of global principles of good practice standards. Ultimately the benefits will cascade to the end investors and restore confidence in the biggest financial market.

What is at stake is demonstrating that the entire execution cycle and hedging process (from pre to post trade), tariffs and transparency, regulation, clients’ expectations, are all properly monitored and managed to deliver a better outcome. The FX market is made of multiple participants with a large majority directing their efforts towards providing more transparency, competitive pricing, regulatory support and efficient execution, or in one word, solutions.

Each market segment has its own priorities and objectives:

• Buy side: the size and scale of companies often determine whether the execution will remain in house. There is a point though where the question whether to outsource this function arises or will arise as the industry is facing more pressure to manage costs and deliver return. FX is rarely a core competency and it may well make economic sense to find a partner who will execute, hedge, and to some extent bear the operational risk. So, when and why should a firm outsource? What is the fair (and transparent!) price for this service? How do buy side firms then comply with their regulatory obligations, and control and oversight duties? On another note, buy side firms will come under more pressure, internally from their investors as well as externally from regulatory bodies, to adopt the FX Global Code. Not doing so could ultimately lead to reputational damage.
• Sell side: while FX is becoming more and more commoditized when it comes to execution and the consequential processes, banks institutional clients increasingly leverage the new regulations and code to transfer oversight duties on asset servicers, or at least expect their providers to take on additional responsibilities. Besides, data analytics is now becoming an offering differentiator and most banks are now working on those reporting and data tools to retain more and more demanding clients or win new mandates. In the custody world, we used to see the FX considered as an ancillary product, deriving from the core custody business; this is changing with the FX solutions being sold on a standalone basis and used as a door opener to then sell and hopefully win the core custody, TA or FA businesses. Banks and custodians need to develop best in class, turnkey FX and cash management solutions, from front office execution down to operations and reporting.
• Market infrastructures and technology providers: IT firms, clearing houses, providers of financial services infrastructures have all understood that the FX market is fast evolving to address the issues which surfaced through the scandals that shook the market in the last decade, and the regulators' answers to correct the FX market defects. Offering reporting, settlement risk or execution solutions, cleared FX products, netting of flows, leveraging on distributed ledger technology, more and more newcomers are entering the FX market with the intention to disrupt the it and its participants. Alongside these new players, some long-established firms develop turnkey products to facilitate the operational and risk aspects of the FX life cycle.

At hd financial consulting, we have 20 years’ experience of designing and delivering FX execution and hedging solutions to institutional investors and their providers. Over the years, we’ve built and keep building a strong and extended network of people and firms who all direct their efforts towards delivering a better outcome for daily FX requirements. We monitor and master the evolutions of this huge market: Global FX Code, emerging markets, development of the Renminbi, passive currency hedging (at share class or portfolio level), Fintech / Neo Banks / crypto currencies, peer to peer FX are topics we’ll be looking to address in forthcoming articles published on LinkedIn.

In the meantime, please get in touch for a high definition assessment of your FX process and a discussion on the optimizations and efficiencies that can be achieved rapidly to deliver a better outcome.

[1] https://www.bis.org/statistics/rpfx19.htm

[2] https://www.blackrock.com/uk/intermediaries/insights/portfolio-insights-asset-allocation?switchLocale=y&siteEntryPassthrough=true