A fragmented approach to currency management and foreign exchange (FX) execution can be a drag on performance for asset owners and fund managers. Glenn Pangilinan, Associate Director of FX Product at RBC Investor & Treasury Services, shares his insights on opportunities to improve the efficiency of FX execution.

The best price may not be the optimal choice

FX transaction costs are often invisible to asset owners, yet such costs have the potential to negatively affect fund performance. With more firms now subject to best-execution requirements, the industry is starting to acknowledge the effects of suboptimal currency management and inefficient execution on investment performance. But more needs to be done.

The industry is starting to wake up to the effects of suboptimal currency management on investment performance

As a first step, many managers are now using transaction cost analysis (TCA) to analyze their FX execution and see how they stack up against the market execution. While this is a good start, an additional layer of analysis needs to be considered, as mentioned below. This is particularly important, given asset owners’ increasing diversification of investments across multiple fund managers, which is leading to more fragmented currency management.

Even if you are looking at the TCA and getting competitive rates for each individual FX execution, fragmentation within the overall currency management approach may outweigh any gains from competitive prices. And that's something asset owners are not, at this point, sufficiently incorporating into their thinking around the performance of their assets.

Fragmentation and FX spreads are affecting returns

As asset owners continue to diversify their investments, and engage a wider range of fund managers and investment strategies, they are faced with increasing exposure to spreads across positions. Owners can, for example, be long on one side of a currency trade with a particular fund manager and short on the other side with another manager. If there is no coordination between the managers, the asset owner could sacrifice the bid-offer spread that is being executed by the two managers, even if best execution can be demonstrated by each manager.

Increased market volatility, stemming from central bank policy changes to address inflationary pressures, is also affecting the performance of FX execution. Higher volatility throughout the trading day means there is a higher risk of wider spreads in multiple execution points throughout the day. These costs, incurred at different points and embedded within the execution rate, can be difficult to disentangle and are not easily captured in the TCA. They may not be obvious unless asset owners and managers dig deep into their data, perform a ‘what if’ analysis or make use of a third-party execution analysis service. This is where centralized execution comes into play.

Increased market volatility is affecting the performance of FX execution

Centralized FX execution can drive efficiencies and cost savings

Consolidating FX execution with a single counterparty can benefit asset owners. This approach enables owners to net across different funds, thus eliminating the bid-offer spread across multiple funds. It delivers the efficiency of a single transaction and a single execution rather than multiple executions—each with a different spread and margin.

Netting can allow asset owners and fund managers to centralize risk, and understand their net open position and overall currency risk profile, rather than piecing together fragmented risk profiles across different custodians. The risk associated with daily volatility can also be handled more efficiently, as managers limit their exposure to intra-day volatility and spreads on multiple execution points in the trading day. Managers can net and execute during the most liquid trading hours, helping to ensure competitive execution while taking advantage of netting opportunities.

Netting can allow asset owners and fund managers to centralize risk

One less obvious benefit of centralized execution is a stronger understanding of the performance of various investments. Centralized execution allows for a better picture of the true costs of FX execution and, once quantified, these costs can then be stripped out to give a more reliable picture of the true investment performance of funds. Asset owners will be able to compare the funds more accurately on the basis of true performance.

Better FX execution requires a willingness to change

Convincing fund managers to explore a centralized approach to FX execution can be a challenge. Under the traditional method of execution, managers have relationships with specific banks that are often hesitant to give up their independence over currency management. As a result, much of the drive to consider centralization as a more efficient approach will likely need to come from asset owners.

Having multiple banks in competition with one another means that the fund manager will often get a better rate. However, the manager may not realize that the asset owner holds assets across different fund managers and, while a specific rate might appear to be favourable, it may not be the most efficient way to execute an FX transaction. Once this is taken into account, asset owners are likely to start encouraging managers to take a closer look at their FX processes.

Centralizing FX execution has the potential to deliver significant benefits 

As asset owners increasingly assume the role of “change drivers” in bringing about centralized FX, they will need to work closely with their fund managers to leverage technology and other resources required for a centralized model. Larger managers with the technology and diversity of investments to reap immediate benefits are likely to be leaders in centralized FX. While consolidation of execution can be more of a challenge for smaller players, they are able to outsource FX execution and take advantage of economies of scale from larger institutions.