The conduct of transition managers has been closely scrutinized in recent years following a number of cases where firms were found to have overcharged clients.
While processes have been revised since these scandals came to light, Michael Gardner, senior managing director and global head of portfolio solutions at Cantor Fitzgerald Asset Management, notes that the continued application of undisclosed mark-ups in currency transactions depends on the business model of the transition provider.
“If the provider interprets their activity as having a fiduciary responsibility, one aspect of that recognition is that there should be no undisclosed revenue,” he explains. “If they view their activity as an ‘arm’s length’ transaction more typical of dealing or brokerage, the same restrictions no longer apply and mark-ups could occur.”
Bo Abesamis, executive vice-president and manager at Callan Associates, an investment consulting firm, refers to three categories of transition managers and their FX capabilities: affiliate FX execution; custody FX execution; and the agency approach.
“There are transition managers that prefer to utilize their own FX broker affiliate for control and expediency,” he says. “Unless they can transact on an agency basis seeking multiple bids, they have to prove that they are not creating additional revenue on the FX side in addition to the commissions generated by the actual securities in liquidation or transition.”
In other cases, managers who lack expertise in FX might prefer to use the custodian of the client as the default venue for FX execution.
Although not yet prevalent across the transition management industry, there are managers that are able to transact on an agency approach by excluding their own FX broker affiliate and seeking multiple bids to determine competitive pricing, adds Abesamis.
John Halligan, president of Global Trading Analytics, a best execution consultancy, says: “I would love to say that undisclosed mark-ups in currency transactions are a thing of the past and we have certainly moved in that direction, but to ensure that trading is occurring at the correct and most efficient levels, due diligence through trade cost measurement will always be necessary.”
According to Andrew Woolmer, managing director of New Change FX, banks make money from clients by using transaction cost analysis to understand the clients' business patterns and price them accordingly.
“Each bank will conduct this process in more or less the same way – a yield curve is created for the P&L decay of each the client's trades over around 30 seconds,” he says.
“As a result, clients usually see reasonably consistent pricing across their selected banks. Banks will then make the price that the client sees as attractive as possible in order to win the deal. Depending on the client's profile, the bank then hedges the deal to maximize their profitability.”
Steps that asset managers can take to ensure they are getting a better deal on their FX transactions include acquiring an understanding of the timing and size of FX transactions up front, says Cantor Fitzgerald’s Gardner.
If the event benchmark is to be T-1 – where security trades are set to start trading on trade date ‘T’, and the benchmark for all transactions becomes the prior closing price – it is reasonable to expect 90% or more of the currency transactions to be executed as soon as is practical after the establishment of that benchmark, to minimize the risk of market movement.
Ensuring that FX exposure is hedged as soon as is practically possible is another consideration; volatility with some pairs can be high relative to the underlying fixed income or equity volatility of the transition, and in such situations FX risk management is critical, says Mark Dwyer, Macquarie’s head of portfolio solutions EMEA.
“Given that the transition of the underlying assets can take several days, you need first to estimate the daily FX exposure during the event,” he says. “Then the timing for the hedge needs to be determined. From an implementation shortfall measurement prospective, hedging the FX risk at T-1 is common, but it may be better to consider hedging the FX as the underlying assets are traded.”
Graham Dixon, director of transitions at Inalytics, a firm that helps asset owners choose transition managers, adds proper due diligence of contractual terms to the list of factors to be considered. He refers to a wide degree of disparity in the FX trading approaches adopted by transition services providers.
“Some have made no changes, instead relying on regulators to improve market behaviour," he says. "However, the leading transition managers have taken steps to remove conflicts of interest, introduce more thoughtful execution strategies and provide evidence of best practice.”
And according to Mercer Sentinel Group principal Andrew Williams, the majority of firms are able to provide time-stamped execution data along with counterparty information.
With the decrease in use of the ‘pure dealer’ model, multi-bank quotation has increased, enabling improved price discovery and making fix points less necessary, says Gardner at Cantor. “An additional observation is that more experienced and operationally flexible providers understand order types better and with that the appropriate execution venues.
“This is still very much a bespoke business and while some providers have gained market share over the last couple of years, it may have been to some extent at the cost of individual event flexibility.”
Dwyer at Macquarie observes that many of his EMEA clients prefer trading on the appropriate WM/Reuters fix rather than undertaking a competitive tender for each FX execution.
Electronic trading cannot always achieve best execution, so those transition management providers with dedicated traders who act as agents on behalf of the underlying client should be able to improve the FX service delivered, says Chris Adolph, head of transition management EMEA at Russell Investments.
“Additional challenges have recently been introduced with the changes to the mechanism by which the WM fix is calculated,” he concludes. “We have co-built a peer-to-peer trading platform to match trades at the WM fix mid-price, as one can no longer expect midpoint pricing when trading with principals.”