The search for clarity: exploring new frontiers in FX TCA

By John Galanek, COO, FX Transparency

Today, nascent demand for that same type of TCA is bubbling up in foreign-exchange markets. In fact, that need for transparency into FX costs is starting to spread to thousands of FX trading firms, especially those that claim to offer world-class trade execution.

Of course, recent currency-trading litigation brought against custodial banks has sparked investor demand for more data on FX dealing costs. However, even with high-profile lawsuits and the corresponding link between the benefits of equities and FX TCA, there are several barriers to widespread adoption of TCA in the highly fragmented FX market.

Barriers to FX TCA adoption

For starters, FX execution quality isn't on top of many investors' list of considerations when weighing what will make their investment a success. Typically, their concerns focus on whether they bought the right stock, and did they buy it near its low price. (The conventional wisdom is that if an investor leaves 50 basis points on the table for poor FX execution, it is not material because they are trying to make 50 percent on the stock trade).

That flying-blind strategy on the investors' part, however, has created one big beneficiary: the banks. Since the Office of the Comptroller of the Currency (a division of the US Treasury) began tracking the data 13 years ago, FX trading has been the most lucrative part of bank trading revenue in the United States. In their role, the banks act as principal to OTC currency trades, not as an agent as they often do in equities; therefore, their economic incentive is to give investors the worst possible rate that they will accept, because the bank has the other side of the trade (when the investor becomes long a currency, the bank becomes short the same currency).

In other words, many banks are in no hurry to change the FX status quo.

In addition, most buy-side firms do not have timestamps that represent execution time on their currency trades. Timestamps make it much easier to utilize the existing equity TCA methodologies and evaluate the execution quality of a single trade. But even in the absence of timestamps, if investors are trading 5 basis points away from the mid-market rate on most of their trades, there is no way to hide that fact with a good sample of trades.
Next, the disjointed nature of the FX market itself is, perhaps, its own worst enemy: There is no volume data that represents the entire OTC market. FX liquidity is fragmented across tens of OTC trading platforms and direct trades between counterparties (see Figures 1 and 2 below). This makes a typical equity VWAP analysis a difficult starting point for FX TCA.

Additionally, every participant's tradable volume in an OTC market is a function of credit - who has extended you credit, and to whom you have extended credit. Each market participant (both buy-side and sell-side) has different liquidity available to them. Therefore, even if each electronic platform were to publish volume data for trades ex-post (which most currently do not), those volumes would not be representative of both Firm A's and Firm B's liquidity. This is different from the exchange-traded equity world where credit inconsistencies do not exist. In equities, all participants face the exchange from a credit perspective, and all have equal access to liquidity.

Lastly, accounting for the costs of the FX forward adjustment is arguably more important than debates about VWAP proxies for the spot price, since it is much less transparent. Most buy-side FX trades are not executed exactly for the spot date, but for some other value date. Painstaking efforts must be taken to store accurate day counts and FX swap points for any currencies that will be part of TCA (and using simple interest rate differentials does not account for the basis risk between the pairs and is hence a fundamentally flawed approach).

What's driving FX TCA adoption?

There are market forces and structural forces that are leading increasing numbers of FX trading firms (on both the buy-side and sell-side) to analyze FX trading costs.

On the buy-side, history tells us that large mark-ups on custodial bank FX trades have been a vexing problem for investors for decades. What has put FX TCA on the radar screen of both the asset managers and plan sponsors has been recent litigation between the State of California pension funds and State Street Bank.

Buy-side firms are also struggling to provide support to their best execution practices in currency space, where most have historically not performed TCA on a regular basis largely because FX has been given a free pass from hurdles defined by MiFID and Reg NMS.

Figure 1

The regulatory environment for all OTC trading is increasing globally, leaving less wiggle room for currency execution quality.

On the sell-side, the strategy is simple: Banks are looking to FX TCA as a way to win market share by demonstrating that their market-making capabilities and electronic-trading platforms offer superior execution for the buy-side.

Risky business

Mark Twain once famously said: "What gets into trouble is not what we don't know; it's what we know for sure that just ain't so." Mr. Twain's comment captures the challenges facing investors that transact in the OTC FX market, many of whom have believed the currency market is always liquid and best execution is a given, but have never bothered to actually measure it.

Those firms that choose to ignore FX TCA probably won't suffer too much in the short term. But in the long term, investment managers run the risk of being asleep at the wheel, if and when a client or stakeholder of theirs investigates currency trading costs before their manager does.

For sure, FX TCA is a larger concern for the buy-side investors than it is for sell-side firms.

Figure 2

Buy-side firms today must ensure that they are analyzing and addressing the needs of their various customer constituencies, such as clients and key stakeholders. This base ranges from clients of hedge funds and asset managers, to pensioners and state attorney general offices for public plan sponsors, to the board of directors and employees at a private pension.

The overriding concern is that one of these core stakeholder groups will address FX costs before their investment manager does, which will make the manager look like it hasn't been doing basic best-execution due diligence. That, in turn, can lead to losing a valued client, especially if the results are poor.

What are the benefits?

Again, we can look to history to predict how transparency in the FX markets will benefit clients and institutions, while at the same time providing a significant and new competitive differentiator for both buy-side and sell-side firms.

A large, sweeping benefit for all buy-side participants will be a reduction in overall FX trading costs as TCA becomes ubiquitous. This is, of course, exactly what happened in the equity market 25 years ago when TCA went mainstream. There is no good reason to think that the same outcome won't repeat itself in the FX market. For asset investors, measuring costs can lead to a process to reduce them, which in turn leads to better performance numbers. After all, how can you actually reduce trading costs if you don't bother to measure them in the first place? Extra levels of due diligence can also give asset managers an advantage when competing for new business.

Good enough for FX TCA

Since the OTC currency market is so fragmented, the methodologies and tools for getting that critical look at transaction costs are still being perfected. But as many others have put it before: Let us not allow the quest for "perfection" be the enemy of "good enough."

In this instance, it can be reasoned, some FX TCA is much better than no FX TCA at all. The lack of market-wide volume data can be overcome by assuming a constant order flow rate, for example. This is not a perfect situation, but this assumption can provide very meaningful analysis. It is also important to recognize that FX TCA is not an "apples to apples" comparison unless derivatives are compared to derivatives, swaps are compared to swaps, and spot trades are compared to spot trades. You get the picture.

Some FX TCA providers now have enough data to offer a meaningful peer benchmark. For instance, it would be useful to know that your firm's cost is 0.3 basis points to trade spot and forward EURUSD; but it's even more empowering to know that the median for other buy-side firms is 1.2 bps and, by comparison, your firm is better than 87 percent of the others in the TCA provider's peer universe.

Cautious optimism

Just because there are nascent solutions entering the marketplace doesn't mean that all participants are willing to accept them with open arms.

First movers in the space include leading-edge market-makers who are embracing FX TCA to prove to their clients just how good they are at what they do. Many FX platforms now provide FX TCA as part of their execution service. And leading banks that push the volume model as opposed to the hard-markup model are anxious for third-party FX TCA providers to show just how good their pricing really is.

However, the biggest hurdle to making FX TCA as robust as equity TCA is a lack of transparency surrounding execution time on the part of custodial banks. Hedge funds and sophisticated asset managers don't have this problem; but anyone who invests in emerging market securities does.

The custodial banks have the FX data, of course, but they don't want the world to know how much they are making by acting as principal on forex trades. Therefore, investors won't be able to ascertain timestamps from the banks until one of the banks decides to truly partner with their clients. Then, the other banks will have to follow along-or risk losing the faith and trust of their clients.

The road ahead

There is no doubt that demand for FX TCA has started to increase. The lawsuit filed by the State of California pension funds will likely end up being a catalyst for those investors who are seeking greater transparency in currency trading costs.

Still some managers are reluctant to engage in FX TCA because they are concerned the outcome may not be flattering. But as Abraham Lincoln once said, "You cannot escape the responsibility of tomorrow by evading it today."

The fact that equity TCA has become so prevalent serves only to bolster that assertion. There are, however, a few more things that will help FX TCA to become as widespread and robust. First, buy-side firms need to modernize their order management systems to make them capable of tracking timestamps: Order creation time, arrival at the trading desk time, and order completion time are common in equities and can make FX TCA more comprehensive.

As better data with timestamps becomes the standard input to FX TCA, this will support the development of pre-trade cost analysis models (both empirical models and theoretical models). An estimate of trading costs ex-ante will be extremely valuable for traders who need to decide between executing at 4 pm EST and taking on price risk by waiting for the Singapore open.

Investors today do not have to stand for their custodians' refusal to provide execution timestamps. The investors are the clients, and they wield more power than they think. This outdated practice has to-and will-change. It just makes too much sense not to.