Cost and time to market are two of the main motivations for outsourced FX execution.
Regulation, fragmentation of liquidity and advances in electronic trading products and services have driven up the cost of in-house execution tools, which can take 12 months or more to implement compared with outsourced solutions that can be accessed much more quickly.
In addition, the availability of independent transaction cost analysis (TCA) means firms are more aware of the costs associated with executing FX, especially those who have been paying millions of dollars a year in broker fees.
However, if an outsourced FX provider is promoting itself as an agent, buy-side clients need to be sure that the provider is fully acting as a fiduciary.
So, in cases where the service provider also has a principal business, clients need to ask whether there are proper separations in place to ensure that information does not leak from the agency side to the principal side.
This will usually mean the two sides of the business are separated in terms of operation and information, although physical separation can also be helpful.
Some asset managers will have clarity over their historic FX trading and processing costs, and will therefore have clear expectations of the costs involved, whereas others may require considerable guidance.
Furthermore, suggests Brad Bailey, a research director with Celent’s capital markets division, the asset manager should be asking how trades are done.
Once the client understands the business model, it then needs to ask what regulatory reporting capabilities are in place, says Integral chief revenue officer Vikas Srivastava.
“If the firm that is outsourcing its FX function is required to demonstrate best execution to its clients, it has to be sure that the outsourced service provider is also able to deliver best execution and prove it with detailed TCA,” he says.
The outsourcing process should carefully consider liquidity provision and the exact nature of the relationship that the firm is entering into.
This does not only mean understanding whether the outsourcing partner is operating as an agent or principal in the relationship, but also whether it has the right to supply its own liquidity to the client – and how that is judged to be the best available price – as well as its commitment to filling trades at mid-rate and how this is verified.
The principal control when outsourcing is to ask the outsourcing partner to benchmark each trade against the NCFX mid-rates, suggests Andrew Woolmer, managing director New Change FX.
“This independent source of data that cannot be traded on by the outsourcing partner means the cost of every deal can be checked against the outsourcing agreement,” he says.
Conflict of interest
If vendors provide order-level execution details to their clients, those clients will be able to uncover any potential conflict of interest by reviewing the trading data, adds Pragma chief business officer Curtis Pfeiffer.
“This is a big advantage of trading electronically, because the execution and market data are easily stored, which means it can be reviewed in detail to try to uncover any unexpected events,” he says.
“Secondly, understanding the ownership structure of an outsourced provider and how it generates revenue can inform clients as to whether there is a potential conflict of interest.”
Ideally, clients should have an automated process in place that captures every deal and compares its cost to the firm’s tolerances for the size of deal, pair and instrument, with instant alerts for anything exceeding the company’s policy for FX so that action can be taken before a trade settles.
Firms should also consider implementing a monthly review process that checks overall costs and regularly calling brokers to ensure they remain compliant with the firm’s cost targets.
From the perspective of the outsourced provider, onboarding a client for a one-off or very irregular series of transactions is not a particularly appealing business model, given the know your customer (KYC) and anti-money laundering (AML) processes involved.
“Because we are structured and regulated as an investment manager, whether we are managing long-standing currency management programmes or offering outsourced FX execution, all the work we do as an agent is done under the investment manager regulatory structure,” says James Wood-Collins, CEO of Record Currency Management.
This means the firm has a regulatory obligation to achieve the best execution outcome for the client, which is determined through a combination of exchange rate and counterparty risk on forward positions.