From Famine to Feast: FX Options

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As returns plummeted during the financial crisis, asset owners focused in on one line of their balances sheets that they could control: fees. Yet one business expense most deserving of scrutiny—foreign exchange (FX) transaction costs—appeared nowhere in the typical fund’s records. Most had never even received a bill. 

Then, a year and a month after Lehman’s collapse, California’s attorney general unsealed a lawsuit and forced FX fees out of hiding.

Custody bankers “committed unconscionable fraud by misappropriating millions of dollars that rightfully belonged to California’s public pension funds,” then-Attorney General Jerry Brown said in October 2009. “This is just the latest example of how clever financial traders violate laws and rip off the public trust.”

Yet, as lawyers hashed—and in some cases, hash—out the matter in courts, funds still need to change yen for euros and sterling for dollars. CIOs have four options for securing reasonable, knowable rates, according to FX experts.

One: Have the fund’s custodian handle FX—with very explicit standing instructions. “Custodians will always charge a premium for convenience, but asset owners can take control by adding teeth to their contracts and reminding banks that they’re being watched,” says Vikas Srivastava, the former head of fixed-income e-commerce at Citigroup and currency risk management at Barclays Global Investors (now BlackRock). Srivastava presently leads business development for Integral, a do-it-yourself FX trading platform for both buy and sell sides. Which leads us to option number…

Two: Bring FX in-house. The California Public Employees’ Retirement System (CalPERS) chose this route after Brown hauled its custodial provider to court. Several years on, the fund’s internal team executes nearly all of CalPERS’ currency trades via a custom platform from FXall—and does so “in a superior manner to third parties,” according to an annual review by its consultant. Opinions are divided on the feasibility of this option for small and mid-sized funds, but this much is clear: In-house currency trading is a lot easier than it used to be. “Technology that was previously available only to the very, very big players is now open to any fund,” Srivastava says. “It’s easy; it’s accessible; it’s cheap.” Integral charges its users roughly one-tenth of a basis point per transaction, with no set-up or licensing fee. “We only get paid when clients use the system, which incentivizes us to make it great,” he says.

Three: Give asset managers the mandate. This has been a popular alternative to custodial servicing since the California scandal broke, according to Michael DuCharme, a senior currency strategist with Russell Investments. But that’s not to say that it’s the best approach. “In my experience, some equity managers struggle as FX providers,” he says. “Equity managers are great at picking stocks—that’s why their clients hired them.”

Finally, four: Hire an execution agency. At least one major lawsuit over custodial FX transactions—Louisiana Municipal Police Employees’ Retirement System v. JPMorgan Chase & Co.—hinged on the question of fiduciary duty. The retirement system claimed its custodian had some; the court disagreed. Funds seeking convenience can instead hand off their FX operations to third-party execution agents. In exchange for a few basis points per transaction, these firms act as fiduciaries and transact at best-available rates. “We collect orders from external managers and funds, net the orders, have banks bid competitively, and manage the trading, settlement, and regulatory aspects,” DuCharme says. Fees amount to a few basis points per transaction, whereas Russell data shows that indirect trading, or standing instructions, used to cost 15 to 25 basis points on average before the custody bank lawsuits. Those fees could top out at 100 or even 200 basis points per transaction, according to Srivastava.

Before 2008/2009, the institutional FX industry wasn’t just stale—it might even have been rotten. Yet, as California’s current attorney general prepares to face off in court with pension custodians, its largest fund has slashed fees and added alpha by turning to technology. Where outsourced currency managers once shirked legal responsibility, firms are lining up to call themselves fiduciaries. At long last, CIOs have a wealth of sound options for handling FX. Now, it’s just a matter of choosing.