Dollar volatility has become one of the top macro-economic trends of the past year. Having reached a two-decade high against other major currencies last September, it slid to a nine-month low in February 2023 before slightly rebounding.
Any fluctuations in the USD have major implications for the global economy because of its central role in international trade, but closer to home, it’s often US-based fund managers that can be hit the hardest.
Many commentators expect dollar volatility levels to remain high due to uncertainty around global recession risks, combined with soaring inflation rates in the US as the country grapples with ongoing widespread labor shortages and geopolitical uncertainty.
Against this backdrop, fund managers are faced with a whole host of challenges when it comes to effectively managing their foreign exchange (FX) risk – most notably, the market can be frustratingly opaque and often unfair when it comes to pricing. So, what can fund managers consider to improve the cost-efficiency of their FX set up in this uncertain environment?
Navigating FX’s hidden costs
The FX market is the largest financial market, with a daily trading volume of $7.5 trillion. A significant proportion of this volume comes from fund managers – but despite their high exposure to the FX market, they can often be treated like second-class citizens.
The first stop for fund managers in reviewing their FX processes should be the easiest to tackle: FX transaction costs. Fund managers often overpay for their FX requirements and commonly suffer from a lack of transparency, especially when it comes to pricing.
Transaction costs are hidden in the FX spread, typically calculated as the difference between the traded rate at the point of execution and the mid-market rate at that time. This is something that is easy to calculate through Transaction Cost Analysis (TCA), but all too often fund managers don’t even know this is possible.
In addition, depending on the volumes they trade and their profiles, fund managers can have limited choice on which and how many counterparties they trade with. They tend to work with only a small number of banks for their FX hedging because of the operational complexity of setting up multiple banking relationships. This makes it harder for them to compare prices in the market because they have fewer access points and a smaller number of liquidity providers. Further, as recent events have demonstrated, reliance on one or two banking partners or counterparties can be a serious risk.
Moreover, brokers and banks often provide different rates for different clients depending on their size. The most competitive rates (ie those with the lowest spreads) are typically reserved for those with the largest trading volumes.
In some instances, regional tier 2 banks will offer smaller fund managers a ‘soft dollar’ arrangement whereby they provide a discount on other services if the fund manager deals exclusively with them for FX. But if the fund manager doesn’t know what exactly it’s paying for FX execution, how can it truly know how much the bank is discounting these other services?
These factors combined means that many fund managers continue to overpay for its FX requirements and struggle to achieve, let alone demonstrate best execution.
Out with the old, in with the new
Fortunately, there are alternatives to the traditional single bank-based approach on which so many fund managers have been forced to rely. Technology and the advent of electronic trading has enabled new entrants to offer an alternative way to transact in FX that addresses the inequalities and inadequacies outlined above.
The first step is to get more transparency on pricing. The use of independent TCA exposes any hidden costs in the spread and enables fund managers to see exactly how much they are being charged for their execution.
The next step is to get access to a greater pool of liquidity. Multibank marketplaces offer fund managers access to multiple liquidity providers from a single interface. This enables them to see live rates of institutional grade quality on a single screen and to automatically execute at the best available rate. Having the ability to reach multiple counterparty banks not only is best practice from a best execution perspective, but also from a risk management perspective. It protects them from any potential fallout should a counterparty face financial difficulty as they have other counterparties to trade with.
The final step is to provide all of these benefits from a single location, providing streamlined workflow and regulatory reporting for best execution alongside TCA. These can drastically reduce operational overheads as well as execution costs.
By looking beyond their traditional brokerage or banking relationships, fund managers can get access to the kind of liquidity normally reserved for the largest trading institutions along with associated cost savings, plus the transparency to prove it.
By choosing a partner which offers a level playing field for FX, fund managers will make sizeable savings at a time when USD volatility looks set to continue, and effective hedging and cutting costs remain critical.
Eric Huttman is CEO at independent FX-as-a-Service provider MillTechFX in London