FX pooling for LGPS: the netting opportunity
A key part of the pooling process is the “Collaboration in Action” initiative under the LGPS framework, which sets out a number of targets for reducing costs arising from duplication of functions in areas such as custody, accounting, actuarial and investment consultancy.
In the 2015 budget announcement, the UK government reaffirmed its commitment to working with local government pension schemes (LGPS) administering authorities “to ensure that they pool investments to significantly reduce costs, while maintaining overall investment performance”. This pooling process is seeing 89 separate funds in the UK consolidated into six so-called ‘wealth funds’, each with assets of at least £25 billion.
HSBC’s Nic Jones, Director, FX Fund Solutions Sales, says that even in the absence of these LGPS pooling initiatives, it was becoming increasingly apparent that pension schemes in the UK needed to identify and control the costs of their FX exposure. It was this, twinned with regulatory pressure to reduce costs, that led HSBC to explore ways in which LGPS could enhance efficiencies by pooling their FX execution. “We believe FX should be regarded as an integral part of the Collaboration in Action initiative,” says Jones. “When the LGPS framework was being established and began sourcing collaborative solutions for the schemes, we were invited to apply to act as a pool custodian. In that capacity, we looked for ways that we could add value for the pools, and one of the solutions we developed was an initiative allowing these schemes to collaborate with one another in FX execution.”
The rationale behind this initiative was simple enough. As Jones explains, pension funds in the UK have traditionally mandated FX execution to multiple investment managers. “This can create a situation where manager A may have been buying sterling versus US dollars, while manager B may have been selling sterling versus dollars at exactly the same time, which can result in potential inefficiencies ,” says Jones.
Many of these unnecessary costs have been eliminated by custodian banks such as HSBC by netting and offsetting trades across multiple managers for each asset owner. “This helps reduce the bid-offer spread for each LGPS and gives them more oversight of their FX execution,” says Jones.
Opportunities for leverage among LGPS
With the advent of the Collaboration in Action initiative, says Jones, the next logical step in this process was to develop ways in which individual schemes with similar sizes, demographics, cost structures and asset allocation strategies could leverage off each other to control costs still more efficiently. HSBC’s first pitch, in 2014, was to three LGPS which had issued requests for services as part of the pooling programme.
“We explained to these LGPS that we would not only provide a service for netting across managers within their individual scheme,” Jones recalls. “We said that we would also be able to net against each other’s schemes. In other words, we explained that if scheme A is buying euro-sterling and scheme B is selling the same currency pair, we would offset the two trades, reducing both schemes’ total cash flow and thereby reducing their costs.”
Counterparty risk is reduced because none of the schemes involved take any exposure to each other. HSBC, which is one of the highest-rated and most strongly capitalised banks in the world, acts as the counterparty in each trade, with the details of each underlying position remaining confidential.
The concept has rapidly gained popularity. Jones says that the pooled LGPS netting process was effectively initiated in October 2014 with the participation of four schemes. This has since risen to seven UK LGPS. “That may not sound like a huge number, but in total they represent 18% of the LGPS assets,” says Jones.
The seven schemes now participating in the HSBC LGPS FX netting platform are members of five of the seven regional pools in the UK, and Jones says that HSBC has active dialogue with schemes in the other two pools. “So we believe we are very well-positioned to offer this service both to individual schemes and pools,” he says. “We have already presented the LGPS platform to one of the regional pools, where it was well received. As all of the pools need to be at least partially funded by early 2018, we expect to see more traction in demand for the LGPS platform over the next 12 to 18 months.”
Reduced flow and lower costs
Several aspects of HSBC’s fully automated pooling platform can be appealing to pension schemes, individually as well as collectively. Jones says that in the first half of 2016, the average netting across the participating schemes was 29%. “Some achieved higher rates than this, but on average they were able to reduce their FX [cash] flow by about a third, which has a big impact on total execution costs,” he says.
Jones explains that execution costs for participating schemes are based on a guaranteed and transparent synthetic risk spread around the WMR “Mid”. Netting takes place once daily, with HSBC executing against the WMR 4pm London fix, which most UK pension schemes are comfortable with, given that it is monitored and overseen by the Financial Conduct Authority.
The cost benefits are compelling, according to Jones. “The synthetic spread we apply is invariably inside what the WMR 4pm fix bid/offer spread would be, especially in major currency pairs where LGPS are most active, which are sterling-dollar and sterling-euro,” he says.
“So in summary, as well as reducing their flow through this netting facility, pension schemes can also see exactly what spread they are paying off the mid-price, giving them much more control over their FX execution costs,” says Jones. “The feedback we have had from clients is that it is an efficient netting facility with reduced costs.”
Growth potential beyond the LGPS space
To date, HSBC has focused principally on the compelling benefits that the netting facility offers for LGPS. But Jones says that HSBC has also been engaged with a number of consultants and corporate pension schemes in the UK that are attracted by its efficiency and transparency. “The wider potential application of the platform is clearly in pension pools. As regulatory requirements for best execution are extended to investment managers, we think there could be much more scope for pooling among pension funds and asset owners with similar profiles,” he explains.
The transparency enabled by this automated process is one of its key attractions. HSBC has developed a suite of reporting tools allowing schemes to provide clear and granular information on their FX trading to their trustees and investment boards. This could become an increasingly valuable resource as pressure intensifies on pension funds and other asset owners to provide an enhanced level of accountability.
Moving forward, one of the potential developments could be to expand the pooling platform beyond UK pension schemes. As Jones says, a potential next step for the initiative would be for UK, US and European funds to pool their FX execution via the platform, given that there would be a natural offset among schemes with different home currencies.
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