FX Transaction Cost AnalysisWhat Does Radon Gas Have to Do With FX Transaction Costs?

You’ve been living in your home for the past six years, and are thinking about selling it. You consult with a local realtor to get an idea of what your home might be worth in the current market. The realtor starts asking all the standard questions: How many square feet? How many bedrooms, baths, garage spaces? What’s the lot size? All the typical stuff.

One of the last questions she asks is: “Do you have a radon remediation system in place?”

Is that really important in setting the home’s price? And how bad can it actually be? The realtor explains that it’s an odorless, poisonous gas, and that the EPA recommends that residences maintain a level below 4 pCi/L (picocuries per liter). She then explains the process of testing and remediating the radon, if there is a problem.

So you head to Lowe’s, buy a test kit for $20, run the test, and send it off to the lab. Two weeks later the results come back, and you’re more than a little curious to see where your home stacks up. After all, your family has been breathing this air for years and hasn’t had a case of lung cancer, so how bad can it be?

You open the e-mail from the testing company. Your jaw hits the floor when you read 56 pCi/L! That can’t be right, can it? That’s 14 times the EPA recommended maximum and you’ve been breathing it for years!

Currency trading costs offer a similar situation, albeit far less serious a health risk, since there are no personal health issues at stake—other than the stress some managers may encounter if the results happen to be a surprise.

FX transaction costs often go undetected, just like the colorless, odorless radon gas seeping from the soil below your home’s foundation. Because investors do not get a commission bill at the end of the month, the costs are difficult to detect. They are hidden in a mark-up to the true interbank OTC foreign exchange rates. Are the costs large enough to warrant monitoring regularly or taking action?

The reality is, like with radon gas, until you quantify it, there is no way to know.

Currency trading costs are far down the list of things that will make or break a fund’s or firm’s success, much in the same way radon gas is far down the list of things that will determine the market value of a home. Items at the top of the investment manager’s list include asset allocation, buying low and selling high, risk management, and strategic alpha-seeking trades. Those will always dominate the investment outcome far more than the relatively small currency trading costs.

However, currency costs are one thing investment managers actually can control, just like homeowners can control radon gas by testing on a regular basis and remediating if necessary.

Mark Twain said, “What gets into trouble is not what we don’t know, it’s what we know for sure that just ain’t so.” Mr. Twain’s comment captures the challenges facing investors that transact in the OTC FX market, whether to fund another investment decision or to make a stand-alone alpha trade.

Conventional wisdom in the FX market dictates that transactions costs are low, and the market is transparent. Many investors assume there is a regulation to prevent abuse to institutional investors to prevent them from being charged off-market rates. But the reality is that no such regulation exists.

In fact, the opposite exists. A regulatory loophole gives banks the green light to charge an outrageous mark-up on institutional currency trades and helps facilitate the hidden costs paid by some investors today. The ironically titled “Pension Protections Act of 2006″ contains an exemption for currency rates, allowing banks to charge up to 300 basis points in excess of the prevailing interbank market rate to the private pensions covered by ERISA law. Yes, you read that correctly, 300 basis points!

Unfortunately for investment managers, the regulators are not yet there to provide any protection on currency trading costs like the protection homeowners receive from the EPA. Today, proactive managers have a great opportunity to measure and reduce FX transaction costs the same way they did equities 20 years ago.