Navigating the Emerging Markets FX Labyrinth
Funding emerging markets investments through FX transactions is probably one of the most opaque process in the investment cycle, notably where currency trading is restricted. Many portfolio managers, especially those investing in emerging market debt or bonds have expressed their frustration at the way the FX was managed by their custodians. As a matter of fact, the FX in those markets tend to remain captive with the service providers, often for good reasons, but rarely with the level of clarity and transparency that investors desire. Without getting into the details of each currency, the aim of this article is to shed some light on the why and how of the FX execution in the emerging markets investment process.
First, where does the fund managers’ genuine frustration come from? As part of a fixed income portfolio strategy and asset mix, it is necessary to switch some bonds maturities ; when selling a bond to purchase, on the same day or even within seconds, the same one with a different maturity, the portfolio manager generally expects to reuse the sales proceeds to fund that purchase, or expects a simple “switch”. So when it turns out that both FX trades were executed at a different time, sometimes on a different day, having to bear both the local agent and the custodian’s FX spread, on the asset sale and purchase adds unwanted costs generating a drag on the performance.
Beyond this specific aspect, many markets where currency trading is restricted have local rules and constraints which make it very difficult to get a clear, homogeneous understanding of the FX execution process. For example, when it comes to funding the purchase of assets, some markets impose some form of prefunding (India) or the actual sight of the funds on the account, making the notion of contractual settlement null and void.
Similarly, selling the proceeds of an asset sale can prove difficult until the funds in the local currency have been physically credited on the local custodian cash account, to avoid an overdraft which in some markets is strictly prohibited.
This is where custodians hold valid arguments to justify the fact that the FX must remain a process where they keep oversight. By doing so, they ensure that they comply with their own primary duties and responsibilities: the appropriate funding of the accounts, allowing the timely settlement of the securities instructions. In many restricted markets, securities or cash instructions fails are prohibited and could lead firms to being banned from operating in those jurisdictions, a risk global custodians cannot take, and investment firms should bear in mind before asking to manage the FX process by themselves.
The above should not give a blank cheque to custodians though, and there are many areas to explore to find common grounds, and for asset managers to get the comfort of a transparent FX execution process for their emerging markets investments. Some global custodians have put a significant effort in various initiatives to enhance the process, such as:
- defining in which markets their clients can be allowed to hold long balances to facilitate the purchase of assets, using the sales proceeds (although bearing an FX risk and potentially a counterparty risk if the local custodian were to default)
- identify the markets in which netting could be applied to minimize the number of FX transactions and costs, generally with a process agreed with the local custodian
- establish an emerging markets guide, detailing settlement cycles for both securities and cash, and clarifying the related deadlines (i.e. need to have cleared cash on the account before any FX sale)
- last but not least, when investment firms have the FX execution capabilities, giving them the ability to cover their EM FX needs by themselves, although this will generally come with rigorous disclaimers from the custodian, to “relocate” the responsibilities of any incident with the FX ordering and executing counterparty
Having worked on many such initiatives, hd financial consulting has vast experience of the challenges and solutions that exist to create a favourable environment for both institutional investors and their providers when it comes to FX execution in restricted markets. We endeavour to deliver knowledge and transparency to investment firms, while also offering custodians a sound process to restore trust and confidence in their FX execution offering for these fast-changing markets. Our objectives remain to reach a better outcome for all parties, striking the right risk/reward balance.
Please reach out for an assessment of your FX process.