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Custodians Enjoy a Privileged Position
Users of foreign exchange services are coming to recognise the benefits inherent in a more holistic approach to assessing value.
Debate around the vexed topic of institutional cross-border equity transactions often neglects the foreign exchange trades which by necessity must, more often than not, be effected at the same time. Although the advent of the euro has brought clear advantages, the role played in the international investment business by the movement of cash between different currencies to ensure settlement or income repatriation should not and cannot be underestimated.
Custodians enjoy a privileged position; indeed, their proximity to the cash and security settlement accounts is the envy of many of those traditional foreign exchange market participants who go out of their way to condemn custodians' forex execution offerings for their lack of price competitiveness. The increased sophistication in recent years of those web-based dealing systems focusing on foreign exchange execution has only fuelled this discussion.
However, this obsession with execution alone fails to acknowledge the broader 'value' afforded by custodians whose activities extend well beyond that particular sphere of activity.
A holistic approach is expected to become ever more important as pension funds and their managers begin to scrutinise in greater detail all elements of transaction costs across entire portfolios. The equity trading side of the business has already recognised this. Managers have discovered that realising value for money is not simply about securing the best price at a given point on a specific deal; rather it relates to the entire value chain for the entire portfolio.
There are three ways in which a broader, more intelligent approach to foreign exchange services creates significant value to fund sponsors and pension plans.
1. Overall costs are reduced by leveraging the consolidation of the value chain and through the integration of trade, FX and cash flow management.
2. Integrating these flows allows for consolidation through 'intelligent netting', which in turn reduces accounting, cash and reconciliation activity.
3. A superior reporting capability allows enhanced portfolio analysis and hence delivers significantly more than could be provided by an integrator of all three flows.
By focusing purely on price at a specific point in time, the value of the advice and judgment applied to activity across the entire portfolio is ignored. The ability to triangulate requests for FX with the underlying security settlement, (both to assess the likelihood of settlement and to ensure that the subsequent movement of cash is undertaken efficiently, and costs are optimised) must be incorporated into any calculation of value. Filtering rules, data extraction and settlement; none of this is carried out at the FX execution houses or by the much touted execution platforms, yet all these functions are performed at RBC within current trading mandates. The cost and risk associated with splitting the underlying equity trade and completion of the associated foreign exchange transaction must be factored into overall costs.
As for 'intelligent netting', far too little attention has been paid to the needs of the underlying fund clients who are the real beneficiaries of this concept. While there are over 100 currencies, as a rule only the US dollar and the Euro, together with the Japanese yen and British pound, play a significant role in holdings. In the case of a pension fund utilising multiple managers, it is therefore nigh on inevitable that on any given day some of those managers will be selling a currency that others amongst those managers are buying; furthermore, many of those managers will be buying or selling a particular currency in varied, often small, amounts.
Each of those trades, if completed, has a cost in terms of both trading and settlement. If small amounts can be aggregated, better rates can be achieved and fewer costs incurred in relation to those cash movements. Where amounts can be netted, all external costs disappear. Our experience suggests the savings thus derived vastly overshadow those made by going the 'better price' route with competing market makers who focus on the deal rather than the total portfolio benefit.
Aggregation and netting savings require automated capture and sophisticated analysis of trade data coupled with an FX workflows engine that verifies the transactions and determines how to optimize savings within a particular client mandate. Custodians are also better placed than managers using an intermediary execution system to offer straight-through processing at the 'back-end' of a trade.
Using the data it holds concerning the activities of all managers, a custodian can also provide detailed analysis of the effect of currency exposures direct to the fund. Even if the fund is not using a currency overlay strategy to support its investment objectives, understanding these exposures and their impact on overall performance is key to the exercise of appropriate fiduciary responsibility. Again, the ability to develop and offer this kind of information cannot be replicated by an institution who does not have the information for the reason why the FX trade was required in the first place.
If fund managers and their sponsors are seduced by the apparent attraction of commodity FX execution platforms as the sole criteria for evaluating value they will likely be the losers. There is undoubted mileage in not having to trade at all; a result of intelligent netting; and linking FX requirements to security settlement and an enriched reporting data set (security holding, FX trade, cash movement). Price on an FX trade only constitutes a small part of the overall value equation.
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