FX’s unearned trust

Brett Elvish

By

29/03/2018

Operators in the institutional foreign exchange market have a track record that doesn’t warrant the confidence asset managers show in them, Brett Elvish writes.

OPINION | As a frequent traveller in Asia, I typically take cash with me to convert into local currency at a money changer. I do this because the banks at home hit you with marketing lines such as no commissions, no fees – and then sting you on the exchange rate.

That’s not to say there aren’t challenges using money exchanges in Asia. Travelling in Bali recently, I noticed a number of money changers offering rates that were simply too good to be true – a red flag that you might be getting counterfeit cash. Yet many travellers, full of the holiday spirit (or other spirits!), were likely reeled in.

High fees, ambiguity, marketing tricks and shady practices are, unfortunately, to be expected in this context, but it is not only mugs on holiday who are getting ripped off in the global FX markets – institutional investors often cop a raw deal, too.

Institutional FX activity is complex, opaque, and plagued by asymmetric information favouring the custodians and investment banks on the sell side. The sector is littered with scandals. Globally, fines are running into the billions of dollars across custodian and investment banks, and Australia’s five largest banks have all been slapped with enforceable undertakings relating to FX activities in the last 18 months.

Every asset owner and asset manager has been exposed to these issues, yet few have taken substantive action and have appropriate governance arrangements in place.

Unquantified cost

When it comes to FX matters, the attention of chief investment officers is typically focused on hedging and associated liquidity management. What is not often appreciated is that FX can be the largest asset owner trading activity and for many it would be the largest cost that remains unquantified and unmonitored, despite regulation encouraging otherwise.

Trust in the chosen service provider is typically relied upon. But is that trust well founded, particularly when opposing economic interests are at play and the track record of FX participants is clear?

Custodians are often given great or unlimited discretion in determining FX rates applied to client trades, and they are not held to high standards of transparency. Some big fines have made custodians more cautious, but too many are still not being held to account.

Furthermore, despite custodian rhetoric about straight-through-processing, custodian FX is still plagued by manual activity and associated errors. Small errors on large volumes can be material and easily go undetected – to either party’s detriment.

Blind trust is clearly inappropriate. Interests are not always aligned, and execution convenience may be at the expense of best execution.

Many asset managers (internal or external) are not quantifying their FX costs. This all raises questions about the value of best-execution policies reviewed as part of operational due diligence, and how managers are conforming with their best-execution contractual obligations.

Good practice and Australian prudential standards dictate that material service providers should be independently monitored and evaluated, regularly.

Upon launching the FX Global Code last year, Reserve Bank of Australia deputy governor Guy Debelle said, “The foreign exchange industry has been suffering from a lack of trust.” I would say that many FX participants are being given too much trust, of which many are not worthy.

Ethics is sometimes defined as doing the right thing when no one is watching. Well it is clear that when it comes to FX markets, the right thing, or at least investors’ interests, are not always being well looked after. Fiduciaries are on notice, thus also at fiduciary risk in this regard.

The good news is that there is plenty that can be done to hold FX providers to account. The solution requires quality actionable data, diligence and perseverance.

Brett Elvish is the founder and director of consultancy Financial Viewpoint. 

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