How fund managers could cut their FX costs by 2,500 per cent

Buy-Side FeaturesFund AdministrationInvestorsOperations
18 Apr, 2016

An asset owner recently agreed with its custodian bank what fees it would pay to buy and sell currencies. The charge was 10 basis points to execute trades in pairs of Group of Ten (G10) currencies and 15 basis points for all other currency pairs - plus market spread. In other words, the asset owner agreed to pay the custodian bank at least $1,000 per $1 million of business in the most liquid foreign currency markets in the world. The bid-offer spread will have lifted that price to, say, $1,250 per $1 million. On a $500 million trade, which is not unusual for a large fund, that toll amounts to $625,000. Nice work if you can get it.

The curiosity is that, despite high profile law suits issued by end-investors against their custodian banks and lurid revelations about how banks manipulated exchange rates to their own advantage, banks are still being paid to do this sort of work. According to Andy Woolmer, CEO of New Change FX, an independent calculator of mid-rate prices for foreign exchange, asset owners should be paying not $1,250 per $1 million to execute trades in G-10 currencies but perhaps as little as $50 per $1 million. So why are major institutional investors paying 25 times more for foreign exchange services than they should?

The answer to this question is partly structural. Between individuals saving for their retirement and foreign exchange traders lie multiple intermediaries. Most people do not save directly, but instead allow their employer to deduct contributions directly from their salary, increasingly into defined contribution funds whose value they do not underwrite. The investment of the funds is entrusted to one or more professional fund managers, appointed on the advice of investment consultants, and which execute trades with investment banks. The safety of the assets, and the settlement of transactions in them, is entrusted to custodian banks. The custodian, the fund manager and the consultants are answerable to the trustees, who are appointed by the employer.

This extended chain of intermediation is a structure in which the individual saver is invisible; the employer is not responsible for the outcome; the consultant is not answerable for the quality of his advice; the fund manager has little incentive to control costs which can be charged to the fund rather than the management company; and the custodian is concerned mainly to attract assets into custody, precisely in order to exploit them in the money and foreign exchange markets. “There are end-investors and asset managers out there who are doing a spectacularly good job of getting their foreign exchange costs down, but they are the exception rather than the rule,” says Woolmer. “It is a pity their example is not followed by others.”

One reason their example is not more widely followed is that there is no convincing means of measuring the foreign exchange costs charged by banks – until now. This month sees the launch by New Change FX of NCFX Ultimate, an Excel Add-In app which fund managers and end-investors can use to measure the cost of their foreign exchange transactions on a daily basis. For users that download the app and feed their transactions into it, it measures transactions against an independent price feed that calculates mid-rates in 65 currency pairs 20 times a second, based on millions of real FX prices sourced from multiple electronic trading networks (ECNs).

The prices are stored on a 32 terabyte storage area network (SAN) controlled by New Change FX, as well as in the Microsoft Cloud. The data is then accessed in real-time via the app, allowing users to benchmark their own trades against the database. “The app polls our tick database, values each transaction submitted against the corresponding mid-rate to deliver a report of the costs in basis points back to the client,” explains Woolmer. “Being able to see instantly the cost of every single spot transaction is extremely valuable to end-investors running their own money, asset managers, brokers, private banks and corporates. It will be even more valuable once we have added forward foreign exchange data as well."

In fact, Woolmer is so convinced of the value of the service that he is prepared to offer any interested party a free trial. “We are so confident that people will agree that the tool is a convenient way of understanding their foreign exchange costs that we are happy to give it away,” says Woolmer. “People can then decide for themselves whether they have got a problem or not.” Those that decide they do have a problem to solve will pay either a fixed subscription price (which will suit less transactional users, such as corporates, or clients with CSAs) to use the app or a small ad valorem charge per trade. It is pricing which makes every conventional transaction cost analysis (TCA) service look inordinately expensive.

Ultimate has the further advantage over the conventional TCA services offered by banks and bank-controlled foreign exchange trading platforms of allowing the transaction data of users to remain private, eliminating the risk that the information finds its way into the market. “Existing TCA services oblige you to send your data to a conflicted third party that can then use the data to map out how you trade and use that against you in the future, or promise to solicit prices from a panel of banks and to execute at the best price, without disclosing whether the best price is determined by the bid, the offer, the spread or the size of the trade,” explains Woolmer. “Investors and fund managers using our tool, on the other hand, do not have to have a relationship with us at all to make use of it. They can buy the app from, download it, and start using it on their desktops immediately. We do not see the trades at all.”

This simple, private and independent tool, which works in Excel, has potentially revolutionary implications, because it breaks the bank monopoly of understanding the real costs and opportunities of foreign exchange transactions. That monopoly is in fact more like an oligopoly. Foreign exchange trading today is dominated by less than a dozen market-making banks. The vast majority of banks are pure price takers that simply inflate the rates that they are offered before passing them on to customers. Inevitably, this concentration of market-making activity provides ample scope for manipulation of the prices of currency pairs, as evidenced when the scandal concerning the behaviour of market-making banks ahead of the 4 o’clock WM-Reuters fix erupted in 2013. In light of this issue and due to regulatory pressure, the fixing window has been widened from 1 minute to 5 minutes which has done little to improve the situation.

Despite the lavish coverage given to the scandal, official investigations, the jailing of a rates trader and the decision by the European Central Bank (ECB) to deter manipulators by postponing for over two hours publication of its own 1.15 p.m. fix, buy-side participants in the foreign exchange markets are still using the 4 o’clock fix to benchmark the costs of foreign exchange transactions. Of course, there are real reasons for fund managers to value a benchmark. A benchmark is essential to passive investment strategies that seek to track investment performance, and useful to any manager wanting to value, re-balance or hedge a multi-currency portfolio. But reliance on the 4 o’clock mid-market rate as a source of transparency into costs is wrong in principle (it equates an accounting measure with price discovery) and ruinous in practice (it gives traders multiple opportunities to manipulate exchange rates in their favour, notably by banks matching offsetting orders ahead of the fix).

“People who are still using point-in-time execution like the 4 o’clock fix by choice need to consider their fiduciary responsibilities,” says Woolmer. “It is crazy that, after everything that has happened, people are still choosing to use a point-in-time fix. Speculators find it hilarious that there is still money to be made every day of the week thanks to the fact that people continue to use fixes like the 4pm to transact business.”

He adds that a portfolio analysis for a pension fund client who continues to use the 4 o’clock fix found a difference between the New Change FX trade-weighted average price and the 4 o’clock mid-rate of 1.38 basis points, or $138 per $1 million, even without taking fees and spreads into account. That difference rose to 5 basis points, or $500 per $1 million transacted, when comparing the executed trades to the NCFX mid-rate 30 minutes before at 3:30pm. “That skew is clear and predictable,” says Woolmer. “You can have a good guess what the market is going to do at 4 o’clock every day. It is strange people still choose to use it. They are not doing the right thing for their clients.”

The desire to do the right thing is not the only reason end-investors and fund managers have started to work with New Change FX. There is doubtless some competitive advantage in doing the right thing, but there is no competitive advantage at all in over-paying for foreign exchange. After all, only a handful of banks have any interest in currency speculation, in the sense of taking positions in expectation of profiting from changes in value, and no bank is offering additional services to its highest paying clients.

Woolmer says New Change FX finds that the average cost of the portfolios of foreign exchange transactions that it has examined vary between $50 and $500 per $1 million. Many clients of the firm are now paying as little as $50 per $1 million, and a number are paying as little as $20 per $1 million. “If the cost is not material, nobody is going to change their behaviour,” says Woolmer. “But the portfolios we have examined show that foreign exchange costs are material, and the impact is significant enough to warrant the analysis.”

Which begs the question why more end-investors and fund managers are not doing exactly that. Part of the explanation is the continuing ability of banks to take advantage of the opacity of the foreign exchange markets. “Even today, some banks are still making 20 to 30 per cent of their total revenue from foreign exchange,” says Woolmer. “It does not require many people nowadays, because it is very technology-intensive. And you can continue to take money off clients, because nobody gets sent a bill at the end of the month. The clients cannot see what is happening. Lots of clients are rightly concerned about what they are paying in equity brokerage, or custody, but in foreign exchange they simply cannot see what is happening, even though it is often their biggest transaction cost. Some clients have clearly decided to remain in the dark anyway. They have no reason to care. The money comes out of the pockets of savers, but not in a way that the savers can actually see.”

There is also a degree of cynicism about the value of conventional TCA services, which are not based on independent price data. "If you try to do TCA using much commonly available platform data you quickly run into issues with data quality and data gaps," explains Woolmer. "But the fundamental problem is a lot of people use aggregated trading platforms and then take TCA from those platforms so that there is a circular relationship between your execution and your measurement. The whole point of the technology used by the price makers is to figure out what the client is going to do, what their appetite for the deal is, and what the price needs to be to maximize the profitability of the trade to the price maker. A TCA service based on prices formed by that process is an entirely circular discussion in which clients’ trades are being measured against themselves. It is like asking a builder to check his own work."

The New Change FX mid-rate data feed, being based on aggregated prices from ECNs rather than banks and other price makers, and not available to be traded and so manipulated, does not suffer from that self-fulfilling circularity. “You have to measure your trades against an independent rate in order to establish what the foreign exchange cost is,” says Woolmer. “And our database enables people to understand their foreign exchange costs, simply and accurately, against independent data that has nothing to do with the bank, the broker, the algorithm, or the platform that they choose to use. This means that the client can assess the strengths and weaknesses of suppliers accurately and objectively."

The important question, of course, is what buy-side firms choose to do once they have understood the real costs of their foreign exchange transactions. So far, most New Change FX clients have decided to do something rather than nothing. They have a range of choices. One is to confront existing providers with concrete evidence of less-than-favourable pricing. Another is to ask existing providers to benchmark transactions against the mid-rate, and measure the impact over time. A third is to pay a disclosed fee to peg orders to the New Change FX mid-rate, and reduce the spread paid by insisting providers match trades wherever possible against offsetting client orders. A fourth is to change completely the way foreign exchange business is executed.

Here, New Change FX cannot help. The firm does not offer an execution service of its own. In fact, it is not regulated to offer one, and does not intend to apply for a licence either. “We supply data, and a TCA tool to use that data, only,” explains Woolmer. “We supply the data to pricing platforms, and some of those pricing platforms do provide the capability to match trades at our mid-rate. Obviously, matching at the mid-rate has no impact on the rate, or the liquidity available. The counterparts are simply agreeing that an amount of currency will be exchanged at our mid-rate. But it works for the clients. Why pay for transferring risk to a bank when you do not need to? You can just put an order into a system and let it sit there until it is matched at the mid-rate. You pay no spread, so your costs collapse.”

Getting foreign exchange costs to fall, if not collapse, will soon become a business imperative for fund managers when the second iteration of the Markets in Financial Instruments Directive (MiFID II) comes into effect in January 2018. It obliges firms to disclose the rates they achieve in order to demonstrate best execution. “If you are trading currencies on an aggregation platform, and you are aggregating ten rates, you will still have no idea what your cost really is,” says Woolmer. “You will know what the spread was, but you will have no idea what the skew, i.e. how much you are being read by the supplier, is. The platform cannot tell you what the real total cost was without reference to an independent rate.” To help fund managers understand that reality, New Change FX is now working with a number of consultants advising firms on various aspects of the new compliance landscape.

Bringing meaningful transparency to foreign exchange costs is likely to prove the start of a longer journey into the future for New Change FX. The firm looks to have positioned itself on the right side of the digital and cultural revolution now sweeping through financial services as whole. A group of large asset owners that no longer want to transact foreign exchange with banks at all have approached New Change FX to explore setting up a platform in which they would trade multi-laterally with their peers, offsetting foreign exchange trades with each other and tapping bank liquidity to execute net amounts or manage difficult trades only. What the asset owners need to make such a platform work is exactly what New Change FX has built: an independent source of mid-rate price data.

If you would like to know more about the New Change FX TCA application, then please contact Andy Woolmer on 020 3745 5221 or by email at

©Dominic Hobson

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