Whose (FX) Money Is It Anyway?

FX costs are the last great unmanaged cost incurred by investors. Despite their significance to investors, they remain largely ignored.  This is because costs are hidden in spread and vary widely.  So we have read with great interest the FX Week exposé of the market practices still common in the Foreign Exchange (FX) markets.

According to the article, post-MiFID2 practises in FX perpetuate the addition of basis points to prices to extract additional value from investors.  Identifying the addition of a basis point here or there is difficult, particularly for asset owners, and especially when the service used to identify this is itself being paid through additions to the price.

These problems of price opacity in FX are of importance to investors because they are part of a routine extraction of value from investors by the banks, brokers and platforms that execute the FX business.  They also mask the conflicts of interest that distort behaviour in ways that make it hard for financial services businesses to pursue the interest of their clients.

Many investors rely on transaction cost analysis (TCA) to manage their FX costs. Yet the practice of embedding the cost of (TCA) within transaction costs actually serves to obscure the true costs of execution because investors are not able to differentiate between sources of costs. They also get to pay for the TCA, without even being asked for their permission. If asset managers do not disclose to clients how they pay for TCA, clients are unwittingly paying for a service that their asset managers ought to bear on their behalf. Asset managers are, after all, paid to manage assets, including the associated transaction costs.

So, what should investors do?

The right starting point is this: client business in FX is attractive to banks because it is almost always profitable.  The bank or broker can always find the price to hedge their own cost before they confirm a price to the client. Though many investors think FX platforms guarantee competitive bids for FX business, all they add is another fee to every deal done.

The next step is to work out where FX costs stem from, estimate what their price ought to be, and then look at ways of minimising those costs.  The reality of FX costs is that the opacity and conflicts of interest mean that they are bound to be high when unmeasured but can be reduced significantly, once they begin to be measured.

What is the cost of doing nothing?

The third step is to ask the right questions of the banks about their charges for FX services. This means obtaining a close understanding of the drivers of FX requirements, and where costs are incurred.  Across the NCFX client base we find the following:

  • The average internationally invested investment portfolio annually executes 8 times its total assets in FX transactions every year.
  • Clients who have not measured their FX costs are paying on average USD 750 per million dollars traded (7.5bps at the FX level, or 28.5bps on the portfolio). Some pay over USD 1,000 per million dollars traded.
  • By measuring FX costs and using those results to negotiate with brokers, costs fall to USD 250 per million (2.5bps) – and often lower – without the need to change their bank, broker or any other arrangement.

As the table below shows, failing to manage FX costs can cost as much as 45 basis points per annum, which amounts to USD 4.5 million per USD 1 billion invested in a fund. Over the 30-year life of a pension fund, that totals USD 135 million in FX fees – or, when scaled up across the pensions industry, roughly 125% of the current pension deficit of the companies in the FTSE-350.

MSCI WORLD Standard USD Return Return at USD 1/MM Cost Return at USD 250/mm Cost Return at USD 500/mm Cost Return at USD 1,000/mm Cost
Total Return % 33.85% 33.21% 32.26% 30.69% 27.61%
Total Lost Value % 0.00% 1.88% 4.69% 9.33% 18.44%
Annualised RoR % 7.45% 7.41% 7.35% 7.24% 7.01%
Annual Cost (BPs) 0.00 4.00 10.53 21.45 44.60

*All data from NCFX and MSCI.  Based on a monthly rollover cost only and no intra-month transactions.  In reality intra-month transactions should be added, further increasing the overall costs.  Data range 02/14 to present.

What’s your number?

These cost figures serve to underline the fact that FX costs are potentially very high.  Nonetheless we hear on a regular basis that ‘FX costs are insignificant’.  We often hear this statement from asset managers and advisers that cannot in fact specify the costs involved in their own portfolios.  So, if you don’t know what your FX costs, it’s time to find out.

What does managing FX costs entail?

Managing costs means achieving more efficient execution. Execution is a complex subject with many different facets, some of which are now unfolding in court. Other facets, such as ‘last-look’ practices – algorithmically choosing whether or not to honour the deal the client has just tried to do –  remain under intense scrutiny by informed parties and are likely to become the subject of litigation.

But asset managers that execute FX business solely for the facilitation of non-base currency denominated business and hedging should not waste too much time on issues affecting those who use FX as a tool for speculation.  All they need to understand is who is paying who in an FX transaction, and how valuable their FX volumes are to their counterparts.

When using an FX platform or ‘aggregator,’ for example, the prudent asset manager must recognise that FX prices are paid by banks and brokers for access to investors (i.e. you). The aggregation service only appears to be free to the investor because the cost is added to the spread made into the platform by the bank.  The fee paid by the investor’s bank to the investor’s price aggregator is NOT disclosed to the investor.

Execution through a custodian, on the other hand, creates a different problem for asset managers. Custodians are known to avoid time-stamping FX deals accurately, in order to “execute” business at a rate more favourable to themselves. This has been the subject of litigation by large investors, especially in the United States.  The custodial policy of insisting that clients should use antiquated benchmarking serves to ensure that clients are pushed into fixing windows that shroud costs to clients whilst maximising profits for the bank.

This advice is not of much practical use. It is difficult for investors to find the lowest cost path to execution as there are many conflicting parties trying to win their FX flow.  The key to solving the problem is to measure objectively and – above all – using a source that is truly independent of the execution chain.  The selected partners in the execution chain can then be assessed against that cost.  If you don’t like what you see, negotiate.

In the end, effective cost management is about more than better execution. Under MiFID II rules it is necessary for banks and brokers to disclose costs. This will only be effective if asset managers are prepared to pay explicitly for benchmarking the prices disclosed to them against a meaningful benchmark. In other words, asset managers must stop pretending that they are acquiring accurate TCA when the cost of it is built into the price they are paying. At NCFX, we routinely encounter clients whose TCA costs are being added to the FX spread they pay. This addition is not always disclosed to the investor. More importantly, these costs are uncapped – the investor pays every single time they trade.

Asset managers like this model, because it means they do not have to pay the costs out of the management fee they are paid to manage the assets of their clients. The cost is instead borne by investors.  This is fine, provided it is agreed with the investors. It follows that investors need to be aware of how they are paying for TCA, and how their asset manager is approaching the subject. Investors must remember that adding a cost to spread reduces investment performance.  One FX “tick” (roughly one basis point USD per million traded in EUR/USD) added to a trade knocks 4 basis points off annual performance.  This explains why custody nowadays costs only 1 ½ to 2 basis points. The custodians are getting paid in another way.

It gets worse. Even where the TCA service is not being added to the spread, it is not uncommon for a TCA provider to be paid directly by a bank, broker or trading platform. This means the TCA service is independent only in the sense that ratings agencies are independent of the investment banks that pay them to rate the securities they underwrite.  The conflict of interest is clear: the TCA provider is working not for the investor but for the bank or broker.

Is there a meaningful benchmark?

Existing 4pm benchmarks cause enormous issues for investors.  That they have been manipulated has been proven in court, but it should also be noted that the legal cases, and subsequent changes to the benchmark calculations have done nothing to stop their exploitation by speculators.  It is quite simple, especially at period ends, to predict how the market will behave as investors push roughly 10% of the daily volume through a five-minute trading window.  Speculators can see and measure the activity in the equity market on the day that investors do equity trades.  Investors requiring FX hedges are then gathered into common fixing points throughout the following day.  Speculators therefore find it easy to buy ahead of activity that will create a rising market in a particular currency, and vice versa for a falling market.  Banks may not be making the money any longer, but it is still being made – and still at the investor’s expense.

A meaningful benchmark would rely instead on live, streaming FX prices from multiple venues. At NCFX, we have developed just such a benchmark and registered it with the European Securities and Markets Authority (ESMA) under the EU Benchmarks Regime 2018.

Importantly, the NCFX is a pure benchmark. We do not make our rates available to trade, but they come directly from the live market, and they are overseen by an independent oversight body.  We have gone to these lengths because data from single sources, be that single platforms or brokers, is inadmissible under the Packaged Retail Investment and Insurance-Based Products Regulation which has set the standard for FX execution and disclosure. 

As clause 17 of Annex VI of the Regulatory Technical Standard of PRIIPs puts it; In calculating the costs associated with foreign exchange, the arrival price must reflect a reasonable estimate of the consolidated price and must not simply be the price available from a single counterparty or foreign exchange platform, even if an agreement exists to undertake all foreign exchange transactions with a single counterparty”.

Indeed, in the MiFID II Q&A of December 2017 (Q8, Page 69) ESMA require that TCA is conducted according to the PRIIPs regulations.

NCFX data is therefore suitable for both MiFID and PRIIPs cost measurement requirements. ESMA has insisted on the “no single platform or counterparty” clause because it recognises that it suits banks or brokers or platforms to use their own data when measuring FX costs. It suits them because the measurement is circular: they are measuring against themselves. This flatters the costs for that bank or platform, masking the fact those costs are imposed on their clients.


FX costs have a material impact on securities transactions, and therefore need to be disclosed and managed.  In seeking to manage FX costs it is tempting for investors to allow the FX industry to conceal the economics behind a barrage of meaningless mitigants, ranging from benchmarking against themselves to the provision of “free” TCA services.

At NCFX, we believe that TCA should be paid for as a service that is external to trading.  We believe that when TCA costs are mixed up with trading then the investor is bound to lose out.  Indeed, NCFX abjures trading altogether, and charges a clear fee for TCA services in order to eliminate any suggestion of a conflict of interest.

FX should be a low cost, low impact aspect of portfolio management, and not a gravy train for the FX business. Without independent, unconflicted approaches to TCA, investors will never know that they are the source of the gravy. Asset managers which fail to demand full disclosure of costs, and use the data to manage FX costs, are failing in their fiduciary duty to their clients.