LONDON -- The market impact of currency overlay managers has become increasingly important over the past few years as liquidity in foreign exchange markets has shrunk and concentrated among a handful of large investment banks.
And trading in bulk in currency markets does not necessarily ensure the lowest spreads, according to recent research from currency overlay managers Lee Overlay Partners Ltd., Dublin.
Plan sponsors should ask about the market impact of their foreign exchange managers and how this will affect the cost of trading.
"In choosing a currency overlay manager there are five important factors; namely, people, process, performance, market impact and fees," said Adrian Lee, the firm's president and chief investment officer.
Daily volume traded in the foreign exchange markets is enormous, estimated by the Bank for International Settlements to have been $1.97 trillion in 1999; but the launch of the euro and the consolidation in investment banking has meant liquidity is concentrated among a few market makers.
Nigel Rodgers, head of trading for Lee Overlay Partners, which has $900 million in assets under management, estimated that liquidity -- or the amount of currency that can be dealt in the market at a given time without moving the market -- in the euro/U.S. dollar market is between $100 million and $200 million. This compares with liquidity during the mid-1990s, when it was up to $1.4 billion in the deutschmark/U.S. dollar market.
The impact
Market impact, or the effect of a trade on the spread between bid and offer prices, is more significant in the foreign exchange market than in equities or bonds, as currency managers have a relatively limited number of assets with which to trade, said Mr. Rodgers.
His research indicated that large currency transactions could increase the cost of trading and that there is a direct relationship between the size of a trade and its market impact.
Trading costs accelerated with transactions greater than $100 million, which Mr. Rodgers found to be the "threshold of normal liquidity."
The firm found that a $250 million foreign exchange transaction could generate a trading cost of 14.6 basis points, based on a survey of bid-offer spreads on a range of currency pairs quoted by eight of the firm's counterparties. On that basis, a $100 million trade would have a trading cost of 5.5 basis points. It would cost only 2.1 basis points to execute a $50 million foreign currency trade.
Mr. Lee would not name the counterparties but said they were well-known in the foreign exchange markets. He said the quotes for bid-offer spreads were based on periods of low market volatility -- bid-offer spreads and trading costs are likely to increase as volatility rises.
"All deals move the price a bit, but once you get to trade $100 million or more, that becomes a large deal and can test market liquidity," he said.
Mr. Rodgers also calculated the optimal size of assets under management a manager could hold before trades would exceed market liquidity. This was based on the average liquidity in each currency pair, assuming the manager traded each time in amounts of 1% of assets under management.
A manager wanting to trade a range of currencies should not breach $14.4 billion in assets under management, he said.
Market considerations
A manager trading only in the euro/U.S. dollar market could have assets of up to $15 billion, while a firm trading solely in the Australian dollar/U.S. dollar market should be careful not to exceed about $4 billion in assets under management.
But Alex Over, head of marketing for Pareto Partners Ltd., London, which had assets under management of $28.3 billion as of Nov.30, said a manager trading more than $500 million in the market would have sufficient clout to negotiate fairly narrow spreads on transactions.
"Our view is that you should trade with a panel of counterparties" to ensure trading costs do not get out of hand, he said. The firm used a minimum of five and a maximum of 10 counterparties for all its transactions. The fall in the number of traders and the concentration of liquidity among a few banks means it is vital to deal with a range of counterparties.
"You need to carve the transactions up between an adequate number of counterparties, and that number will depend on the size of the deal," he added.
"The bigger the trade, the lower the spread should be. Trading credentials are a serious part of decision making when picking a currency overlay manager," he said.
