FX Best Execution PracticesFX Transaction Cost AnalysisFX TCA: Three Reasons Your Equity Broker Shouldn’t Measure Currency Trades

Equity trading volumes have been trending down for a while now, leaving equity brokers looking for new ways to make up for lost revenue. As a result, some of them recently began to offer FX transaction cost analysis (FX TCA) to raise revenues. For investment managers and sponsors, selecting an FX TCA provider is a key part of the best execution process. Using an equity broker to fill that void is a lot like calling the plumber after a bad hail storm to inspect your roof, rather than calling a roofer.

We’re not saying you shouldn’t trust the plumber. After all, you have known him for years and his pipe-fitting skills are adequate. The issue is the mismatch in skills and needs. There are three reasons why an equity specialist is going to struggle with FX TCA:

• Source Data – Not how many sources, but which ones for which currencies.

• FX Market Conventions – Spot focused, forward flawed.

• Domain Expertise – Will the analysis stand up to the scrutiny of your board or other stakeholders?

Source Data
If you’ve never traded a Korean NDF, how do you know what market data sources to pull? The most meaningful contributor to a KRW NDF quote is not going to be the same as the most meaningful contributor to a EURUSD spot trade.

Another important nuance centers around cross-currency trades. Should you store “AUDBRL=” spot rates from Reuters to measure an AUDBRL spot transaction? It probably doesn’t sound that unreasonable, again, unless you’ve actually managed risk in the FX market. If you have, then you know that pulling that quote is not the optimal approach to measure an AUDBRL trade.

FX Market Conventions
In equities, everything is a spot trade. Same value date. In foreign exchange, for many participants, there are more trades for value dates other than spot than there are for spot. To accurately measure currency trading costs, you must account for the forward adjustment, and account for it using FX forward market conventions which are currency-pair specific. In other words, different pairs have different forward conventions, and if you do not know them, you won’t interpret the market data correctly.

Another one of our favorites is, “Calculating the forwards is easy. You can just use interest-rate parity right?” Wrong, and we know a few sell-side salespeople that would love to have you as a client if that’s what you believe.

Domain Expertise
Your board of directors or other stakeholders in your institution may require some education about the currency market in order to put trade cost analysis in the proper context. Check me if I’m wrong here Sandy, but you might want to have some experience trading a market if you’re going to get in front of the board of directors or the Chief Compliance Officer and opine as the expert.

In some ways, it might be easier to call the plumber. He’s already in your address book. But be aware of what the plumber knows, and what he doesn’t know.