New Change FX, an independent FX consultancy, found typical costs of almost $18 million a year in hidden FX charges, in a study of asset managers with an average of $10 billion under management.
The study also found these charges could be cut by almost three-quarters (72.8%) to around $5 million, over several months.
Andrew Woolmer, managing director of New Change FX, says: “We find that problems like this are common and look daunting at first sight, but can easily be solved by good initial analysis which provides a strong basis for re-negotiation with your banks.”
Hidden charges are wrapped up in the spread, which is expressed in basis points. These can be added in when least expected, such as in a netted FX transaction.
Woolmer describes an example of a client that was charged not only for the tail of the order, but also a spread on the underlying trade. Say a client needs to buy $10 and sell $5 - this would mean a netted order to buy $5. The other $5 to buy and $5 to sell should be netted off, incurring no cost.
“Unfortunately our client was paying a full spread to sell five as well as a full spread to buy 10, and yet the bank said the trades had been netted,” says Woolmer.
Do the maths
The Financial Conduct Authority published a report in July on best execution, which stated that every basis point of cost saving could translate into £264 million in additional client returns each year.
Over a 30-year period, a meagre one basis point improvement in trading costs could represent an extraordinary £37.5 billion in client returns.
This calculation is important when it comes to foreign exchange, as FX trades are often a secondary trade linked to another asset class, such as equities, and as such are frequently outsourced to a third party such as a custodian bank.
As such, asset managers have not historically always scrutinized the trading costs for these trades.
|Source: New Change FX|
A number of US custodian banks were sued by angry investors for overcharging on foreign-exchange transactions, and were forced to settle out of court for tens of millions of dollars.
Since then, asset managers are more clued up on understanding the true cost of their FX trades, but recent data suggest they are still paying over the odds.
A report from ITG, a brokerage and technology firm, analysed tradable foreign-exchange data between London and New York before and after the 4pm London fix, and found that the costs from the order arrival time until trade execution are on average 17 basis points, 20% of the time. This translates into millions of dollars of un-invested funds.
TCA is a concept borrowed from the equities world, whereby asset managers can analyse their FX trades to see if they paid a fair price.
“[We look] very much at the hidden costs of trading which can be far greater than the explicit costs of things like settlement,” says Michael Sparkes, director at ITG.
“Regulation in Europe such as Mifid has focused institutions’ attention on best execution, the need to achieve it and demonstrate it.”
A number of providers offer TCA solutions, but, since the FX benchmark scandal, the focus has shifted to offering asset managers independent benchmarks.
Leading FX benchmarks, such as the WM/Reuters (WMR) 4pm London fix, have come under scrutiny since it emerged last year that dealers were allegedly trading ahead of the fix and colluding to generate a fix rate to profit from the fix trading.
"We need independent benchmarks so that people can see trade by trade what they’re paying,” says Woolmer at New Change FX. "[It is a] new paradigm that we’re living in. Retrospective TCA has probably had its day."
New Change FX calculates an independent live benchmark mid-rate for 42 currency pairs in the spot market, while ITG launched its FX Trading Cost Index app in July to allow investors to quickly check whether their estimated trading costs are reasonable before trading.
The app estimates the average cost of liquidity for 20 common currency pairs, taking into consideration the intended time of trade and notional trade value.
Ultimately, the future of FX TCA will be to analyse foreign exchange in relation to other asset classes, says Henry Yegerman, director of TCA at Markit.
“The future is a multi-asset class approach, to think of how we can use signals from other asset classes to help manage FX trading strategies,” he says.