FX REPORT: Buyside Looks to TCA to Improve FX Trading

The dust is beginning to settle following a string of lawsuits from pension plans and other institutional investors alleging the sellside mishandled their foreign exchange trades. While the courts are still working out who is to blame in the matter, the buyside is turning its attention to how to address FX trading challenges in the future. More and more, they’re using trade-cost analysis, a tool borrowed from the equity world, to improve FX trading and get better returns for their investors.

What they’re discovering, however, is that TCA for currencies isn’t the same as it is for equities. Firms who offer TCA for foreign exchange transactions need to really understand the FX market. The buyside today is looking not just for firms experienced in transaction-cost analysis, but for experienced TCA firms that are also able to apply their analysis to foreign currencies.

“There’s no question that undertaking transaction-cost analysis for FX takes a person with the expertise and knowledge to understand the risk management principals,” said James McGeehan, co-founder and chief executive officer of FX Transparency, which provides TCA for currency trading. “The market is extraordinarily nuanced.”

With no set exchanges, currency trading takes place in a decentralized, over-the-counter marketplace where no public volume information exists. There’s a “buyer-beware” attitude, as participants are not automatically obliged to provide best execution. In a market with little regulatory oversight, trade-cost analysis can help buysiders have confidence that they’re getting a fair price. The complexities of the marketplace make TCA tricky for FX, but TCA providers, both brokers and independent vendors, are attempting to rise to the challenge.

According to McGeehan, the buyside started demanding TCA for FX in the wake of legal battles over substandard executions. In October 2009, California Attorney General Edmund Brown filed suit on behalf of the California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS) alleging fraudulent pricing of foreign currency trades. That triggered a string of lawsuits against custodian banks by buysiders saying they had gotten terrible execution on their FX trades.

“There was a wide swath of the market that was not prepared for those news headlines,” McGeehan said. The result was that the buyside increasingly wanted TCA for their FX trades. “Some people jumped in right away, but I still believe there’s a large piece of the market that needs this service,” McGeehan said.

One of the early adopters was Franklin Templeton Investments. In January 2010, the global investment manager hired FX Transparency to help improve pricing on currency trades. Over the past three years, Franklin Templeton has gone from a cost of about two basis points to actually receiving a benefit of a basis point when trading. That means that when the firm had to trade currencies in the past as part of managing international portfolios, it had to give up some performance due to the cost of the currency transaction. Now, its FX trading has improved so much it actually adds a tiny amount of alpha. 

Brian Murphy, vice president and director of currency trading at the firm, said a three-basis-point swing might not sound like much, but with a company like Franklin Templeton that has more than $846 billion in assets under management, those savings can add up very quickly.

Even more dramatic are the improvements seen by the custodian banks the firm uses. Murphy said that while Franklin Templeton executes about 90 percent of its FX trades in-house, in 10 percent of cases it does use custodians, such as when it is dealing with restricted markets.

“We believe that trade cost analysis has improved prices and in turn enhanced transparency in the FX markets,” said Murphy. “Our work with third party vendors has demonstrated that TCA has definitely helped.”

Overpaying on FX trades is what originally sparked the lawsuits beginning in 2009. Pension plans alleged custodians had routinely executed their FX trades at the very worst time of the day. That does not happen as much anymore.

FX costs in general have come down in recent years. While there are multiple reasons for that, Murphy said increased use of TCA in the industry has been a big part of those savings. Electronic trading has increased for FX, leading to more price transparency and better ease of execution. The increased electronic trading, especially trading with FX algorithms, has gone hand-in-hand with TCA for FX. In fact, some of the algos for trading currencies have TCA built right into them, Murphy said.

The challenge is finding a TCA provider that is able to apply its model to foreign currencies. When Franklin Templeton first started looking for someone to provide TCA for FX, the firm found that a lot of the vendors offering trade-cost analysis were just plugging foreign exchange into an equity model. Things have gotten better, Murphy said, but TCA for FX is still a work in progress.

“Back in 2009, 2010, it was definitely a hot topic, with these lawsuits,” Murphy said. “It highlighted the need for greater transparency. It’s going to force people into TCA.”

ITG, which is a popular vendor for equities TCA, launched its trade-cost analysis product for FX three years ago. However, the system it originally developed did not really work for clients. Though the company knew a lot about TCA, it discovered it didn’t understand how to translate that knowledge into a product that was tailored to foreign exchange. After getting feedback from clients, the firm made a number of new hires, including Jim Cochrane, a career FX specialist who had most recently been at Thomson Reuters. Cochrane now heads up a revamped TCA product for currency trading that ITG re-launched earlier this year.

According to Cochrane, each client is different, and vendors have to be able to respond to different needs. Sometimes an investment manager might want to be able to chart out a very specific number for TCA, or the manager might want to be able to look at two different charts at once. “Those are my best engagements,” Cochrane said, “when I go in and actually have an in-depth conversation about process improvement.”

One of the ways ITG improved its TCA for foreign exchange was by improving the data the firm was using. Getting appropriate data is vital when dealing with a market that trades about $4 trillion every day in largely unregulated venues all over the world. Plus, prices in FX depend on the customer. A small-time retail investor doesn’t get the same rate as a large, trans-national bank. How can a TCA provider ensure accurate, usable data?

That was the challenge for Judy Maiorca, a director at ITG who helped the firm gain access to data streams both from large banks and from electronic communication networks. With quality information from both banks and ECNs, as well as from brokers and other market makers in the inter-bank market, ITG was able to secure enough data from diverse sources to make the firm feel confident in its numbers.

“We needed to capture enough differentiation within the market to make sure that our picture was the most complete that you could get,” Maiorca said. “Of course, the market data is growing, so we always need to reassess.”   

The need to constantly take stock and reassess is a concern of all FX TCA providers. While things change in equities, too, the shifts in the foreign exchange world since the lawsuits of 2009 and 2010 have been considerable. For one thing, custodian banks have responded to criticism by offering new initiatives and new pricing structures. Each time they have done so, TCA providers have had to adjust.

FX pricing has improved for large institutions, but it can still be costly for small and medium-sized players.

According to Amarjit Sahota, director of FX TCA services at Klarity FX, multi-bank platforms are working well for large retirement systems like CalPERS, but smaller retirement systems typically outsource everything to investment managers, and the smaller managers don’t always have the clout to get the best prices. In most cases, managers are too occupied with returning alpha to worry much about their foreign currency trades. Other managers, though, have dealt with FX head-on, sometimes discovering they can improve alpha by saving money on currency transactions.

The problem for managers can then be convincing their board of trustees to go along. Many agreements that the buyside has with custodian banks call for an extra charge if clients want to trade away from the custodian for their currency transactions. Trustees don’t want to incur those extra charges, even though managers might be convinced they can get better rates elsewhere. How then can someone tell if the better prices on FX transactions are worth the trade-away fees? That’s where TCA comes into play.

“We’ve been in positions where the investment manager has said, ‘Thank you for turning up and educating the board of trustees,'” Sahota said. Managers can feel handcuffed, knowing they are paying too much on FX but not able to trade away from their custodians, he added. Once they have proof from a TCA provider that they can get significantly better prices, the trustees are more amenable to sign off on paying fees and allowing more competitive bidding of transactions, so long as it improves trading results.

After all, one of the advantages of trade-cost analysis has always been that it can provide hard evidence to those skeptical about some aspect of trading. That’s why even some professional currency traders are turning to TCA these days. They might not feel they need it for themselves, but they often need it for their clients.

Jon Fatica, head of analytics at execution management system and TCA provider TradingScreen, said sophisticated firms that try to actively generate alpha from FX are now going to outside providers of TCA, even if they feel confident in their own analysis of trades.

“Even some currency management firms that have been doing their own FX TCA for quite some time are now looking at independent providers, to provide detailed, corroborating FX TCA reports for their clients” Fatica said. “The FX TCA reports for clients say, ‘This is how we manage currencies for you.'”

According to Fatica, the industry is still in the early-adopter period for FX TCA. The buyside was once in that same early-adopter phase for TCA for equities. Now, trade-cost analysis of equity trades is a given for most firms. The same could one day be true for FX as well.