What Can Usain Bolt Teach Us About FX Transaction Cost Analysis?

“The measurement of dealing costs is an interesting topic but not of great relevance to our firm’s activities in FX.”

This is an actual quote from a well-known currency overlay manager. A surprising statement from someone who acts as fiduciary don’t you think? One’s interpretation might be that this overlay manager believes his firm is sophisticated enough to forego quantifying the implicit commissions they dole out to the street via currency trades. This kind of hubris leads to a relevant quote from the great American author, Mark Twain…

“What gets us into trouble is not what we don’t know. It’s what we know for sure that just ain’t so.”

It is plausible his firm possesses great execution skills, their talent might be world class. Let’s call them the Usain Bolt of FX execution. For those unfamiliar with Mr. Bolt, he is a Jamaican sprinter and holds the title of the world’s fastest human being. How did Usain Bolt obtain this legendary title?

Did Mr. Bolt call a press conference and tell all he was the fastest ever, and thus running the 100-meter race was not relevant to him? Or did he go to the 2009 World Championships, compete, and let the results speak for themselves. Usain opted for the latter where he posted a time of 9.58 seconds in the 100 meters, which crushed his previous record from the 2008 Olympics.

FX execution quality is not world class sprinting, but in both areas, you need an unbiased measurement tool. Sprinters have the clock and investors have TCA for currency execution.

The Top Four Reasons NOT to Engage in FX Transaction Cost Analysis:

“FX Trading Is Free… Right?”

Any bank service that is free in perpetuity should be the first warning sign to an investor. There is no explicit commission fee to trade OTC FX, as market making banks and custodians are happy to let you play in their casino gratis. Why? On average banks trade at the mid-market rate, and hence earn the difference between that rate, and the rate they charge your fund.

Make no mistake, the last thing your custodial bank wants you to know is how much they made executing your currency trades last month. You don’t believe every custodian in the world conveniently forgot to timestamp all of your FX trades for the past two decades do you? Those days are over as new analytical methods facilitate FX trading cost calculations even in the absence of timestamps.

“The Regulators Have My Back…”

Regulatory oversight for institutional OTC currency trading does not exist. Once your assets under management rise above $10 million you are considered an institution with enough sophistication to police currency execution without a regulator (the CFTC and NFA govern FX below $10 million AUM)

Over 90% of foreign exchange occur in the Over-the-Counter (OTC) market. This off-exchange market creates a “wild west” atmosphere with essentially no rules.

In fact, the only rule that does exist today explicitly grants US banks the right to charge 300 basis points above the prevailing interbank rate on every currency trade to private pensions that fall under ERISA law. This is the ironically titled “Pension Protection Act of 2006.” As a point of reference, the interbank market trades under three basis points bid-ask spread for most currencies.

Reg NMS and best execution do not apply at this time either. These laws apply to “securities,” and today OTC foreign exchange is not considered a security.

So there are no regulations governing institutional currency trading, except one that allows the banks to charge private pensioners 300 basis points above the prevailing FX rate.

“My Custodian Is Acting As Fiduciary to Achieve Best Execution in FX”

Sorry to be the one to break it to you, but double-check your custody agreement. The custodian is typically acting as principal, not agent with regard to your currency trades. That means they have the other side of your trade, and completely oppose you economically. All the competition in the world between banks cannot change this structural flaw. To maximize trading revenue, the custodian’s economic incentive is to give the investor the worst possible rate that they will accept.

“My External Managers Monitor Currency Trading Costs For Me”

For many plan sponsors, outsourcing international equity and bond portfolios to external managers is a smart move. Pensions get deep domain expertise and a track record of success for a pre-defined fee.

Not all international managers are created equal when it comes to currency execution. Some money managers handle the FX process as well as the hedge funds that treat currency as an asset class. The reality today is that these managers are generally the exception, not the rule. To find out how well your managers are performing on your behalf, simply ask them for last quarter’s FX TCA report.

The large gap in currency execution quality between asset managers can happen for many reasons. First, currency execution is viewed as an administrative function and delegated to staff with little market experience at asset management firms who do not treat currency as an asset class. Second, some managers outsource FX trading entirely to your custodian so they do not have to incur the expense of staffing a currency-trading desk. Empirical trade data shows this is the most expensive method of execution available.