FX trade audits remain a financial risk despite tech advances

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By:
Paul Golden
Published on:

Despite advances in data analytics technology, foreign-exchange trade audits remain a complex process requiring access to a wide spread of information on the client as well as the market.

The common focus areas for an FX audit are execution and pricing, but the vast majority of resources should be focused on managing FX risk to avoid financial losses much more substantial than any savings on execution, suggests one payment solutions provider.

Key elements of this process include when and how to identify FX exposure, hedging policies and mechanisms for analysing risk.

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David Ullrich,
FlexTrade

David Ullrich, senior vice-president of FX at FlexTrade, adds the rationale for the trade to the list of factors that need to be assessed.

“Although at first glance the most important aspect of any FX transaction is the pricing relative to the execution, audits must reach further to understand the risk considerations of the underlying trade, such as funding or ongoing corporate activity,” he says.

The suitability of a financial instrument relative to the risk parameters of the underlying client is another critical component of an effective audit, continues Ullrich.

“While the frequency of the process may vary depending on the internal risk management guidelines, a clear separation of the back office ­– operations and legal/compliance working in tandem – and trading functions is mandatory,” he says.

The packaged retail and insurance-based investment products (PRIIPs) rules on FX transaction cost analysis (TCA) state that in calculating the costs associated with FX, the arrival price must reflect a reasonable estimate of the consolidated price and must not simply be the price available from a single counterparty or FX platform, even if an agreement exists to undertake all transactions with a single counterparty.

Regulation

The European Securities and Markets Authority has imposed this requirement so that neither asset managers nor their banks can, knowingly or unwittingly, directly influence the reference stream, and must measure their service providers on a clean, transparent basis, explains Andrew Woolmer, managing director of New Change FX (NCFX).

“When conducting an FX audit, everything else is secondary to the quality of the data,” he says. “Non-independent data and bad time stamps are the main factors that make auditing trades difficult.”

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Klaus Paesler, Russell
Investment Group

Klaus Paesler, head of currency and overlay strategy EMEA at ‎Russell Investment Group, also refers to the primacy of data. 

“If a custodian has a report that can provide all of the trades, the rates achieved and the time stamp, that makes for a good data set to analyse,” he says. “Not all record keepers have this readily available or in a format that is easy to calculate, though.”

Market participants concerned about the efficiency of their FX trades have the option of outsourcing this activity to a third party. Under an agency approach, the third party is responsible for using competition between possible counterparties to find the best deal for each set of FX trades.

An outsourced execution policy, whether by a third-party agent or underlying custodian, might offer benefits such as guaranteed settlement (in the case of a custodian) and reduced – or at least managed – transaction costs.

Smaller firms might benefit from an agency execution model, but only if the cost borne by the underlying funds is well managed and documented within a TCA process. The fiduciary role of the asset manager remains unchanged no matter who executes the transaction.

For medium- to large-sized asset managers, a factor often overlooked is the opportunity cost of not being able to coordinate FX execution with international asset trading, which can give rise to increased trading costs and unnecessary short-term FX market exposures, suggests Ruben Costa-Santos, head of FX at ITG.

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Philippe Gelis,
Kantox

Kantox CEO Philippe Gelis says relying on human FX management does not make sense in 2017. 

“It is now all about straight-through processing and automation – why would you have someone else manage your FX when you can instead set up a hedging strategy that will collect your FX exposure data, analyse the market in real time and execute around the clock?” he asks.

According to Woolmer at NCFX, using an FX agent to perform execution at 4pm incurs costs for a simple administrative function, whereas asking an FX agent to use a live benchmark and execute using skill and judgement is both auditable and can add substantial value.

“We see 4pm fixing costs at somewhere above $500/million executed, whereas a skilled FX manager will get this cost to around $100/million plus their fees,” he adds.

On the potential of blockchain to simplify the FX audit process, Russell’s Paesler observes that while auditing trades can be a simple – albeit time-consuming – process if the exact rates achieved, the exact time of execution and the type of trade are known and can be coupled with significant data points – six to 12 months of data – a real time, digitally recorded trade could help client analyse execution on an ongoing basis.

However, ITG’s Costa-Santos notes that bilateral credit extension and a complex post-trade process are the two main aspects that keep the FX market from moving closer to an equity market model and that any new technology trying to disrupt the FX market would need to address these issues.

“That is a not-inconsiderable challenge,” he concludes.