Time to count the cost of currency trading

The OFT study prompted a call for evidence from the Financial Conduct Authority and Department for Work and Pensions to improve transparency in transaction costs.

The aim of all this is to enable better decision-making on the part of pension schemes, employers and investors. 

At the same time, foreign exchange is becoming increasingly important to pension funds, both as an asset class to invest in, and as a hedge against portfolio currency risk.

Trends such as the weakening euro and strengthening dollar are causing schemes to explore how their currency exposures are being managed.

Taken together, these factors mean that pension schemes face the difficult proposition of evaluating the quality of their FX transactions to meet new transparency requirements, keep costs as low as possible and stay competitive.

The discipline of measuring these costs – both explicit and implicit – is known as transaction cost analysis, and has been used by fund managers for years to analyse and manage their trading costs in equity markets.

The inherent difficulty of measuring over-the-counter trading and the various idiosyncrasies of the currency markets have made TCA more difficult in FX.

Moreover, FX has often been outsourced to a third party, or been a secondary or subsidiary trade linked to another asset, creating a workflow that further complicates proper data extraction.  

But times have changed.

The need to assess the transaction costs associated with buying and selling instruments has come into focus as the FCA looks to provide investors with a total transaction cost figure.

TCA on FX trades is likely to become one of the means to achieve that goal for this asset class.

A recent study by ITG showed that if FX trades were consistently executed at poor prices, the annualised cost figure per firm would be $40.8 million.

The main challenge for pension schemes – and one that shouldn’t be taken lightly – will be standardisation and the consolidation of data

Over 30 years, taking into account interest, that can become a significant amount of value lost in transaction costs.

Evaluation of transaction costs associated with buying and selling instruments, given the recent regulatory developments and studies, is therefore a must for a pension scheme looking to save costs.

But as the National Association of Pension Funds recently argued, that in itself is not enough: a more holistic approach is needed.

When trading FX, as in other asset classes, there are other implicit trading costs to benchmark.

Market impact and delay costs, for example, can add significant sums to the total cost of a trade and should be measured so they can be improved upon.

The main challenge for pension schemes though – and one that shouldn’t be taken lightly – will be standardisation and the consolidation of data.

And standardisation needs to go further than reports: it must also apply to the methodology used to calculate these costs.

The industry will need to agree a principle-based approach that will allow for proper data consolidation.

The call for evidence for transaction costs disclosure for pension funds is likely to prompt various initiatives.

The need to measure implicit costs will probably require the use of TCA of some sort. Measuring these costs gives schemes the information they need to ensure that costs are being measured, monitored and managed right throughout the investment chain, meeting the FCA and DWP’s aim of enabling better decision-making.

Through these measurements a scheme can demonstrate the efforts it makes to employers and investors in delivering the best possible value for money.

Yossi Brandes is managing director at ITG Analytics