A Roadmap to Defining
an Optimal FX program
Investment managers are faced with increased pressure to assess whether their
foreign exchange programs deliver value to their stakeholders and achieve optimal
performance. Unfortunately, many managers view trade execution to be the only
factor that warrants review, while in fact they should also consider operational
efficiency, proper program calibration and the availability of transparency throughout
the entire FX process. This paper reviews each of these key factors, serving as a
roadmap to help managers define their optimal FX program.
INVESTOR SERVICES
Foreign Exchange
I
nvestment managers are facing unrelenting pressure
to improve returns, reduce costs, and illustrate “best
execution,” while keeping resources focused on core
competencies. It is not surprising that more are assessing whether their foreign exchange programs deliver value
to their stakeholders and achieve optimal performance.
Unfortunately, many managers view trade execution to be
the only factor that warrants review, and in doing so they
unknowingly establish a performance standard that is too
narrow for their program.
There is no question that execution quality is critical, but
performance can also be significantly impacted by a variety
of operational activities that occur both pre and post-trade.
A well-balanced FX program should consider many factors,
including effective execution, operational efficiency, precise
calibration of program implementation parameters and the
availability of transparency throughout the entire FX process.
By understanding these factors in more detail,
investment managers can define an FX program
designed to deliver optimal performance for the
manager, funds, and shareholders. Managers committed to investing in an in-house FX program may
find their resources aren’t being deployed as effectively as possible. Other managers who partner with
an external provider to manage one, or many, elements of the FX process may realize the need for
additional evaluation to ensure they are exercising
proper oversight and care.
While no clear trend has emerged regarding insourcing or outsourcing, one thing is certain: more investment managers are evaluating alternatives to their
current FX workflow as they begin to understand the
performance factors they had not previously considered. This paper reviews those key factors, serving
as a roadmap to help managers define their optimal
FX program.
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EFFECTIVE EXECUTION – ACTIVE, PASSIVE
OR SOMEWHERE IN BETWEEN
Today, there is a wide range of execution strategies available
to global investors. However, as recently as a few years ago,
execution choices were limited and the majority of managers fell into one of two black-and-white categories: active or
passive FX management. Within each category, there was
little flexibility. Managers executing FX trades actively had
done so by phone or through simple single-bank electronic
trading platforms that connected them to their liquidity providers. Alternatively, managers executing FX trades passively
typically used custodian standing instructions or other external service providers that offered minimal customization and
lacked transparency. In today’s FX world, there is far less
black and white.
Active dealing desks now have more execution venues
than ever, including an array of single-bank platforms,
Effective
Execution
Operational
Efficiency
Increased
Transparency
Precise
Program
Calibration
availability of skilled traders, sophistication of systems and
operational capabilities should receive consideration during
the evaluation process.
“A well-balanced FX program should consider many
factors, including effective
execution, operational efficiency, precise calibration of
program implementation parameters and the availability
of transparency throughout
the entire FX process.”
multi-bank platforms, sophisticated aggregators, Electronic
Communication Networks (ECNs) and algorithmic trading
models. Passive managers also have an increasing number
of execution options that are proving to be more competitive and transparent than ever before. These include agency
execution, principal execution with transparent spreads
and execution linked to industry fixing rates (e.g., WM Co.
benchmark).
While active FX traders may have the most control over
their execution process, they are still required to provide
their clients and internal oversight teams with reporting that
demonstrates the effectiveness of their trading decisions.
This can only be achieved through investment in technology, including ongoing system reviews/enhancements to
ensure their strategy remains relevant in a rapidly changing e-FX space. Some of these active managers focus on
adding value by timing markets, while almost all of them
look to minimize bid/offer spreads at the time of execution. Active trading can be effective in today’s environment, however a number of factors including FX volumes,
Managers who elect a more hands-off, passive approach to
FX execution also have a responsibility to monitor their trade
rates. While a passive approach typically leads to a lower
risk (via a transfer of risk from the manager to an external
provider), more cost-effective operational process, it is critical that managers who select this approach can ensure their
external providers are pricing trades at fair and appropriate
rates. For managers who a) approach FX passively, b) view it
as an operational burden or c) do not have the right in-house
trading resources, there are now more outsourced options
available which provide increased levels of clarity around the
true cost of effective trade execution to ensure their stakeholders are benefitting.
LOOKING BEYOND EXECUTION – THE
IMPORTANCE OF OBTAINING OPERATIONAL
EFFICIENCY
FX trades originate from a number of sources, including
transaction settlement requirements, income, and dividend
repatriation, hedging currency exposures and speculative
trading decisions made by portfolio managers. During the
pre and post-trade process, a variety of operational activities occur -- trade generation, validation, transmission, confirmation, settlement and reporting all represent potential
sources of error. Any miscalculated, omitted, duplicated,
delayed, failed or off-market trade can result in financial consequences that far outweigh the expected trade execution
benefits from managing an FX program in-house.
To effectively satisfy internal risk management policies,
investment managers need a robust calculation and reporting system that ensures both accurate trade generation
and post-trade settlement and reconciliation capabilities.
For more complex FX programs, it is rare that all trading
requirements are generated and monitored within a single
system. Quite often spreadsheets and other manual tools
are utilized to manage more bespoke requirements (FX
hedging is a common example). However, as firms grow,
manual processes can become unwieldy and increasingly
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INVESTOR SERVICES
Foreign Exchange
risk-prone, causing sleepless nights for the operations team
responsible for maintaining them. If the operations team is
not losing sleep, the portfolio and risk managers should be.
Furthermore, managing various tailored solutions across
multiple FX workflows creates disjointed oversight, validation and execution of those trades. The lack of a centralized
process not only exacerbates the risk concerns, but may
prevent optimal trade execution and lead to increased costs
to underlying investors.
As investment managers are seeking ways to further
reduce operating expenses and risks, many are considering whether it makes sense to continue managing their FX
in-house. They are instead looking to external partners to
develop customized solutions that cover any number of FX
requirements. These providers are achieving more scale than
ever as they leverage large trading relationships and make
ongoing investment in specialized systems and technology
to support multiple clients with similar needs.
PERFORMANCE THROUGH PRECISION - PROPER
CALIBRATION IS KEY
Implementation of the FX program is not only about ensuring the operational workflows are designed to precisely
adhere to the defined rules and parameters, but also about
properly calibrating those rules and parameters in a way that
positions investment managers to achieve their FX performance objectives. Even if your FX program is implemented
with operational perfection, the calibration of the process is
a significant driver of performance.
The list of parameters requiring proper calibration is extensive. A few common and highly-sensitive implementation
challenges include:
1. Optimizing the number of and timing of security
related FX “sweeps” per day to properly balance low
latency with maximum netting and deep liquidity.
2. Determining forward contract tenor when creating or
hedging positions to mitigate unwanted credit risk,
sizable cash flows and unanticipated interest rate risk.
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3. Selecting the appropriate hedging parameters such
as trading filters (hedge ratio filters), re-balance frequency and execution timing to minimize both costs
of trading and tracking error from an imperfect hedge.
Implementation decisions are ultimately the responsibility
of the manager, whether the function is performed via an
in-house process or an external provider. While it’s imperative that managers give careful consideration to program
structure, the information required to properly calibrate the
process is commonly unavailable. Managers are often left in
a position to make uninformed decisions, which can lead to
sub-optimal results.
External service providers are continually developing more
robust analytical tools to better quantify the impact of these
decisions and ultimately provide useful insight to optimally calibrate client programs. This is particularly helpful
as the definition of “optimal calibration” and the resulting
FX process can vary significantly by manager depending
on their FX objectives. Quantifying the impact of factors
other than execution is critical to customizing a properly
balanced program.
“Any miscalculated, omitted,
duplicated, delayed, failed or
off-market trade can result in
financial consequences that
far outweigh the expected
trade execution benefits from
managing an FX program inhouse.”
DEMONSTRATING SUCCESS – DEMAND
TRANSPARENCY FROM BEGINNING TO END
Program sophistication aside, the scrutiny and demand to
demonstrate the performance achieved through the overall
FX process is drawing increased attention. Demonstrating
success is only possible through rigorous evaluation
of and reporting on the various components, including execution, pre and post-trade decision-making and
performance attribution.
Perhaps the most prominent demand in the market related
to “transparency” is the need to demonstrate fair and appropriate trade execution. As such, the concept of “best execution” has gained traction over the past few years. A quick
Google search for the definition of best execution in FX will
provide enough results to confuse anyone, illustrating the
ambiguity and lack of global consistency on the subject.
As a result, many investment managers have developed
internal guidelines to demonstrate to their stakeholders that
proper attention is given to their trading process and that
they are exercising care and diligence during the design of
that process. While “best execution” definitions vary from
one manager to the next, transaction cost is one factor that
is most commonly considered central to the equation. The
expensive and resource intensive efforts required to properly
capture, measure and store the necessary data to evaluate
execution quality in-house is causing investment managers
to look at external partners to assist in this endeavor.
Although sell side firms, acting in a principal capacity, have
no obligation to provide “best execution,” there are increasing levels of cooperation and ability to supply their clients
with the appropriate data to enable the investment manager
to perform proper analysis. Additionally, a slew of Transaction
Cost Analysis (“TCA”) companies have developed meaningful solutions for firms looking for independent rate analysis
and increased transparency by providing verification and
reporting on execution quality. Lastly, external providers offer
execution services that seek to provide quality execution
with a focus on transparency as an alternative to developing
an in-house trading desk.
“Regardless of a manager’s
approach to FX, the ability to generate or obtain
detailed, transparent
reporting on the entire
process should never be
overlooked.”
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INVESTOR SERVICES
Foreign Exchange
“By focusing purely on transaction costs, investment managers
are missing other factors that play a key role in determining the
overall costs related to managing an FX program. Factors such
as speed of execution, netting opportunities, liquidity, custodial
or other servicing fees and an array of operational considerations should all be taken into account.”
While these services provide useful post-trade evaluation of
execution quality, investment managers should realize that
they are a complement, not a substitute, for a robust internal
monitoring process.
Finally, by focusing purely on transaction costs, investment managers are missing other factors that play a key
role in determining the overall costs related to managing an
FX program. Factors such as speed of execution, netting
opportunities, liquidity, custodial or other servicing fees and
an array of operational considerations should all be taken
into account.
An incorrect trade executed at a fair price may have a far
greater negative impact than an accurate trade executed at
a less favorable rate. Only with the appropriate controls, validations and detailed reports can one get comfort that the up
and downstream workflows have been properly calibrated
and implemented according to plan.
Regardless of a manager’s approach to FX, the ability to generate or obtain detailed, transparent reporting on the entire
process should never be overlooked.
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IS YOUR FX PROGRAM DESIGNED TO ACHIEVE
OPTIMAL PERFORMANCE?
While this paper touches briefly on the components of a
successful FX program, each one warrants a more detailed
review in accordance with an investment manager’s overall
objectives and strategy. No single FX process can be appropriate for all managers because each will fall in a slightly
different position along the continuum of FX objectives.
Regardless of where they fall, it is incumbent upon all managers to continually evaluate their FX programs against their
own definitions of execution quality, operational efficiency,
optimal calibration of program implementation decisions
and transparency. Without measurement, a manager cannot
ensure they are employing the most effective internal or
external FX process, or confirm they are achieving optimal
FX performance and providing value for their stakeholders.
Jay Moore, CFA
Senior Vice President
BBH FX
Jay Moore is a Senior Vice President and the
Global Head of Foreign Exchange Product
Development for Brown Brothers Harriman.
Prior to joining the firm in 2012, he was the
head of the Currency Management and Portfolio
Solutions Strategy teams for State Street Global
Markets. He has 15 years of experience in
the foreign exchange industry, including time
within operations, trading, research, sales and
product development.
Jay is a frequent speaker at industry conferences
and his written work has been published in a
number of prominent financial journals and periodicals. He holds a Bachelor of Science degree
in finance from the University of Connecticut and
has also been awarded the Chartered Financial
Analyst (CFA) designation.
Thomas Haimelin
Vice President
BBH FX
Thomas (Tom) Haimelin is a Vice President
for Foreign Exchange Product Development
at Brown Brothers Harriman. His primary
responsibilities include supporting the strategy,
development and sales efforts around the foreign
exchange product suite, including a focus on FX
trading technology and systems.
Tom joined BBH in 2006 as a member of the FX
Analytics Team. He has also held roles as a Sales
Trader and Relationship Manager in the firm’s
New York office and in 2010 co-founded BBH’s
FX Sales and Relationship Management Desk
in Hong Kong.
Tom holds a Bachelor of Science degree
in Business Administration from Northeastern
University.
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Foreign Exchange
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