Impaled by FX Rates
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Foreign Exchange

Impaled by FX Rates

This quarter Nick Fitzpatrick assesses data that suggest custodians are selecting which of their clients receive the best and worst rates on FX transactions

This article appears courtesy of Global Investor.

Institutional investors could be losing out due to poor foreign exchange (FX) rates if they do not monitor and challenge the performance of their custodians. Evidence suggests that certain custodians could be making unreasonable spreads on some of their clients' FX trades. Data provided exclusively to Global Investor by Amaces, which runs the CMS custodian benchmarking service, show that FX rates vary enormously. However, the variations are not just between custodians - but between clients of the same custodian. This suggests that custodians are determining which of their clients receive the best rates.

The 'Key Performance Indicators' table shows the range of rates that clients received in the three months to April this year on various currencies. FX trades that are carried out by custodians under 'standing instructions' – usually small trades and income repatriation – are compared to the trading high and low of that day. When the deals are weighted, the weighted average should fall within the day range 90 to 110. Anything over 110 could represent too high a rate. The worst deals are as high as 143. This table shows trades under US$200,000. But the situation is just as similar for trades between $200,000 and $1 million.

Amaces analysed 50 trades executed on behalf of one asset manager in one month. Although only two trades could be considered poor because they broke the 110 upper market average barrier, a fair number of trades hovered close to it; an adequate but not great experience. Even more revealing, though, is the 'Client vs Universe' chart, in Global Investor's June magazine, where all the trades are weighted and compared to the experience of all other clients, as well as the market.

In this chart, the top line (red) shows that one client received poor deals above the average market high virtually all of the time. Yet another client of the same custodian received FX rates that consistently beat the custodian's universe average.

Clawing back revenue

Why is this? One answer may be that custodians take advantage of clients who are not aggressive enough in their scrutiny. Another reason could be that clients who are receiving a bargain in overall service fees are being impaled on their FX rates as custodians claw back revenue."It's perfectly fine for a custodian to earn a spread on FX but the question is, is it reasonable?" said James Economides, one of the founders of Amaces. Determining what is reasonable, however, is not straightforward. "Clients have to step back and look at the whole relationship holistically and not just FX," he said. A client could get a good fee schedule, but be clobbered on FX. Whatever the reason, the data reveal a potentially serious best execution issue for all clients of custodians.

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