FX markets have been in the news for all the wrong reasons recently with five of the largest banks being fined $3.2 billion for manipulating markets. But how is this possible?
The answer is simple. There was no way to measure the prices for ‘fairness’ thanks to the lack of a reference rate against which to check the bank’s quote.
FX markets, unlike equities, are ‘principal to principal’, meaning that prices that are good for the bank are bad for clients. FX business usually derives from a primary activity, such as buying foreign equities and is a secondary consideration. Family offices are often in a ‘tied’ relationship for their FX, where the bank insists on doing any FX. None of which helps the client to avoid being overcharged.
So how might one hold the bank to account and lower the overall cost of execution? The answer begins with the use of a benchmark. By using a benchmark price that the bank cannot have access to for trading purposes, the client has a yardstick against which to assess the cost of execution. It is a simple matter of subtracting the reference price from the dealt price and calculating the actual cost in pounds and pence. Or dollars and cents.
The bank naturally adjusts its price away from the benchmark to take account of the size of each transaction, the credit appetite they have for the client’s business, and to make a profit. The use of a benchmark means that instead of these ‘discretionary price influences’ being opaque, they become transparent. The client can then hold the bank to account for each aspect of the costs incurred in trading. The effect on trading costs is large, and instantaneous.
The chart shows the spot and forward execution costs for a UK long-only asset manager expressed in US dollars. The addition of the NCFX benchmark has reduced costs from over $12 million a year to around $4 million a year – and the asset manager has not changed a single aspect of his dealing infrastructure!
The costs incurred in transactions are hidden when a benchmark is not used. Hidden costs cannot be managed. Introducing a mid-rate to the trading infrastructure means the client can manage their costs in a number of ways, starting with simple benchmarking of execution and perhaps moving to more sophisticated forms of execution.
The long-term goal is for family offices to recognise that FX exposures are in fact assets, and banks make huge sums of money from those assets because the clients pay the banks to take them away. This is not in the client’s best interest and we believe that the progressive family office should be seeking to manage FX risks much as a bank would. Banks never cross spreads unless they absolutely must and ensure that the value of the FX assets is crystallised on a daily basis – rather than being needlessly given away.
By using a benchmark, and evolving trading platforms to ensure that the latest technology is being used, family offices can easily turn their FX exposures from a cost centre into a cash generative profit centre. That’s how to win the loser’s game in FX.
