FX scandal's lessons for asset owners

The foreign exchange manipulation scandal involving major global banks demonstrates that at their core, currency conversions are not merely operational processes. They are significant drivers of value that must be carefully managed. Pension boards and investment managers should undertake to ensure their FX spot execution practices are designed to preserve and protect this value.

In May, five major banks agreed to pay $5.6 billion and plead guilty to felony charges brought by the U.S. Department of Justice in connection with FX manipulation. For globally invested asset owners and other institutional investors, this scandal should be a wake-up call to ensure their own currency trades do not fall prey to similar value-destroying schemes.

This scandal is the largest in terms of fines and a string of bad headlines in the FX market over the last decade. Many venerable institutions, including the California Public Employees' Retirement System and the New York City Retirement Systems, have lost millions from bad FX pricing received from custodian banks in recent years.

Unfortunately, our experience suggests common business practices among many asset owners and other institutional investors have not yet evolved to reflect lessons learned from these FX trading violations. But with the ink now dry on the plea agreements emerging from the most recent scandal, the resounding imperative for institutional investors is that they must re-examine their FX practices to avoid predation.

Because common practice among many institutional investors is to have banks convert foreign-denominated cash flows automatically without validating that the conversions are done at market rates, many can end up overpaying substantially. Even those actively involved in executing spot trades might have only a limited sense as to whether they are executing efficiently. In order to assess execution efficiency, some funds have studied their trades against expected outcomes and found compelling evidence that their trades are being systemically mispriced — a fact that the FX manipulation scandal makes increasingly unsurprising.

A study of 300 spot FX trades of one large city pension fund revealed that, over the course of a one-year period, the fund paid the equivalent of more than $2.1 million in hidden fees to its custodian bank. This study examined the fund's historical FX spot transaction prices against a range of expected outcomes. The expected outcomes were based on a normal distribution of transaction prices between each day's high and low prices. However, the actual distribution of outcomes demonstrated a statistically significant skew toward the unfavorable side of the trading range.

One would expect an efficiently executed portfolio to reflect prices on the unfavorable half of the day's trading range approximately 50% of the time. When that is not the case, that deficiency should raise red flags and call for further examination of the trading inconsistent with efficient trading outcomes, implying the result was not random noise but systemically bad pricing. Independent third-party advisory firms with in-house modeling capabilities can enable a fund to assess trading efficiency with high levels of confidence by analyzing as few as 50 spot trades.

Many investment managers will find it necessary to modify their execution practices in order to address pricing deficiencies.

Funds can improve trading efficiency in two simple ways:

Asset owners should ensure that each and every FX spot trade is actively monitored — whether internally or on an outsourced basis — at the time of the trade by those with sufficient skill to assess execution efficiency. The cost of dedicated or semi-dedicated resourcing to monitor such transactions often pales in comparison to the hidden fees paid to banks on unmonitored trades.

Having banks automatically convert foreign cash flows at end-of-day rate fixings was assumed to add transparency to FX spot conversions. A fix is a currency exchange rate set at a particular time each trading day that can be referenced as the market rate. It is calculated based on actual interbank transactions conducted within a one-minute window. But the FX manipulation scandal reminds us that there is no substitute for active monitoring. While regulatory enforcement might mute the temptation for abuse for a time, enforcement action, however substantial, will not fundamentally alter the compensation incentives that tempt individual traders to push boundaries. As a result, asset owners and other institutional investors should take steps to unwind their operational reliance on fixings where practicable, substituting hands-on execution practices, such as asset owners being actively involved in the currency conversion process. Such practices add transparency and thus encourage traders to price trades more fairly.

Measuring the efficiency of historical execution practices and adopting practices that increase the transparency of new trades — such as actively participating in FX spot execution or confirming spot conversion prices on a trade-by-trade basis — are straightforward steps that reflect lessons learned from a decade of bad headlines in the FX spot market.

Peter Ahlin is director of analytics, and Luke Zubrod is director of risk and regulatory advisory services, Chatham Financial Corp. Both are based in Kennett Square, Pa.