Pension funds are learning that currency costs need to be managed through analysing their transaction costs (TCA). In some cases they’ve been taken for a ride, writes Gerry O’Kane. Investment and Pensions Europe (IPE): 1 Nov 2012
The world of currency strategy has recently had to welcome a new set of players – those offering greater certainty in pricing performance with their transaction cost analysis (TCA) toolkits.
Equity managers would find this ludicrous. This technology-backed concept has been around for 20 years for them. Pricing performance had been largely overlooked in the currency operations of pensions until about three years ago. But regulatory, legal and performance pressures are bringing new clients seeking answers. The solutions on offer are growing from pre-trade impact analytics to post-trade monitoring.
“I’d say there’s treble the interest in TCA now than 18 months ago,” says James McGeehan, the CEO at FX Transparency, a US company building its business in Europe. “There’s a growing understanding that currency is a risk that needs to be managed and it can be a drag on investment returns.”
Litigation opens pension managers’ eyes
Starting in 2009, a number of high-profile litigation cases in the US – aimed at State Street and Bank of New York Mellon in particular – put the issue of FX trading costs on trustees’ minds and illustrated just how opaque the $4trn-a-day market truly is. Not only were pensions unclear about how their FX trades affected the markets when deals were placed – they also had no idea of how much it cost.
In Europe there have been no such scandals but the industry is loth to talk about whether such sharp practices went on. “In Europe, managers are more trusting and there’s an attitude of ‘let’s work together’ to sort a problem, while in the US the first option is to sue you,” as one insider puts it.
But as Ben Gunnee, director of EMEA at Mercer Sentinel, which now offers TCA services, points out, consultants and pension schemes have been pressuring custodians into ever lower fees and forcing them to seek returns wherever they can. Currency spreads were an easy answer. “On the other hand, in one case recently we saw a fund paying about €1m in unnecessary fees,” reveals Gunnee.
Of course as double-digit equity returns have disappeared those few basis points of performance have become more important. “There have been other organic pressures making them look at transaction costs, with one way of enhancing total returns being cost reductions – and there TCA can help,” says Paul Buckley, global head of product for AES for FX and US head of eFX sales at Credit Suisse.
While asset managers often have currency TCA capabilities, less than 50% provided this service to UK institutional clients on a regular basis, according to a survey last year from the Investment Management Association. It is rarely part of a pension fund’s beauty parade.
What’s more, the currency side of the deal was traditionally executed by pension funds’ custodians and few realised that custodians’ fiduciary responsibilities stopped at FX pricing.
Industry repeatedly warned
And yet the industry has been repeatedly warned. Russell Investments published a report in 2004 – ‘It’s time for more choice in FX’ – and repeated the study again in 2008-09 on the cost of FX transactions. Both showed that when taking the average pricing of a currency pair throughout a day, prices were heavily skewed toward favouring the custodians’ spread and providing the worst price for the client.
According to Russell, the average shortfall between the midpoint daily price on bond offer spreads was nine basis points, far higher than the 1-3 basis points considered the industry average for developed market currencies.
“There’s no doubt the CalPERS news [the State of California sued State Street in 2009] got European pensions thinking about TCA, and they’re learning that you can’t manage currency risk until you measure it,” says Peter Eggleston, head of quantitative solutions at Morgan Stanley, which in the past year has launched both post and pre-trade anayltics services. “I don’t think Europe has been complacent but in the past few years everyone has a long list of priorities and TCA has just been further down the list.”
The larger Dutch and Nordic pension funds have been well ahead of the game in understanding the dynamics of their currency deals, with some larger UK pensions joining them. Overall the European industry had not bothered to look at the intricacies of FX transactions.
Eggleston notes that TCA had often been stymied with pension managers believing the value of true cost analysis without certain data sets, like time-stamped data, was limited. The decentralised nature of FX, with aggregate pricing data from a number of FX liquidity pools including spot FX, forwards and swaps, created a complexity impossible to overcome they thought.
But that is changing. “I’d say four years ago no broker could spell TCA, now everyone is touting a solution,” warns Buckley. For him and colleague Nick Greenland, global head of client advisory, the importance of good data and continued investment to build systems to analyse currency transactions is critical in bringing its true value to managers.
“I’d say four years ago no broker could spell TCA, now everyone is touting a solution”
“It’s too simplistic to say TCA is there only to show how much you paid for a trade, it can help in showing the costs to the pension of the sort of deal flows they’ve had – remembering that not all deals are equal – and attain best possible execution,” says Greenland.
Before pension managers even get that far, they’ve been learning some harsh truths. Shockingly, execution time-stamping has been almost absent from currency trades and the FX market does not fall under the Markets in Financial Instruments Directive (MiFID) remit of best execution. “It’s been difficult for pensions to measure their currency costs without time-stamping and while that’s changing, it’s a very slow process,” observes Gunnee.
Time of trade does not equal execution
Worse than that, exactly what is time-stamped varies. “Even when there is some form of time-stamping it’s not always congruent with the time of trade execution,” warns McGeehan. In other words, you might time-stamp a currency pair deal at lunchtime, but execution might take place at 4pm.
Being able to measure pure costs has seen parties agreeing spread limitations on common currency pairs.
The services sold by Morgan Stanley and Credit Suisse go beyond merely keeping an eye on trade costs of the executing party.
TCA today is also about the market impact of a trade, what time of day to execute and which pairs have what characteristics. Research by Morgan Stanley showed that the effects of delayed execution of up to 36 hours in an international equity portfolio, taking into account all currencies in the MSCI World index, could be as high as 500 basis points on an annualised basis.
As Greenland points out, a broker’s experience could tell them not to sell Mexican pesos until New York opens, but being able to model this, along with other market-moving factors, allows funds to assess pre-trade the most beneficial way to enter the market.
In this, TCA is moving beyond simple pricing and alerting pension funds to other bottom-line possibilities. A pre-trade analysis of a currency pair trade can examine how aggregating trades into a single deal might benefit the pension from the cost reduction of netting, or whether the size of the trade might move market prices against you.
“All firms are looking to reduce market impact and reducing costs to an appropriate level and TCA is part and parcel of their trading technique,” says Greenland.
Pensions are embracing the technology in different ways. While custodians scramble to retain business by offering some form of TCA, banks are luring business by offering the most sophisticated solutions they can and as an adjunct to their currency-trading arms. Third parties are also pushing their products as a way of checking the performance of custodians, banks and asset managers.
Both Gunnee and McGeehan agree that as a good TCA system is introduced there are immediate benefits. “If you’ve not undertaken such an exercise before, you can get big improvements very quickly,” says Gunnee.
“You might call it the low-hanging fruit but if you don’t keep monitoring this fluid market you can easily lose improvements in both pricing and performance,” agrees McGeehan.
Pension funds are gradually learning that when they are able to benchmark the cost of their trade execution using the best tools the industry offers and which strategies work most effectively under a range of market conditions, there are returns to be had.