In the realm of securities trading and settlement, there have generally been two models for managing FX. The in-house transactional model sees the investment manager separating FX transactions to decouple them from the wider securities settlement chain. The alternative is to leave FX transactions as an integral part of the securities settlement process – the custodian mandate model. However, with fund managers looking to reduce infrastructure and costs as their margins erode in the face of heightened competitive and operational pressures, the mandate option of outsourcing FX settlement to a custodian in order to benefit from a more integrated settlement solution is now looking increasingly attractive.
The transactional model, where the institution segregates and decouples the FX execution from the settlement process, makes a number of assumptions: that the heightened risks of segregating FX from the settlement value chain is understood and effectively managed and mitigated; that all buyers have access to all the information they need to ascertain timing and frequency of FX execution to ensure matching of trades and value dates, that buyers have effective systems and staff competency to manage the accuracy, completeness, and performance of FX.
This model requires the institution to prove the level of performance it achieves, as well as reporting on management and demonstrating efficient governance. The requirement to keep up with increasingly complex and diverse markets, trading volatility, governance demands and the need for performance is obviously placing additional administrative and reporting burdens upon institutions.
By contrast, under the mandate model FX administration is outsourced to the securities services provider and the institution only assumes responsibility for management oversight of FX performance. The provider will deliver governance reporting to support the client or fund manager to demonstrate performance in all the functions required to capture, manage, execute and manage risk in settlement related FX.
While both the in-house, transactional model and the mandate model have their respective strengths and weaknesses, determining which is the best option for a particular fund manager or client is a more complex undertaking than merely making a straight comparison based on costs or benchmarking criteria. Clients and/or funds should consider each model’s ability to meet their needs in terms of transparency, consistency, quality, governance and risk management
The settlement of securities related FX encompasses a broad range of functions, and it is important fund sponsors are clear on the true costs of managing these components, which can be organised within four broad categories.
The first of these can be described as trade capture and validation tasks. This encompasses the capture and validation of all the securities trades over the course of the trading day in order to extract accurate FX requirements for trading; ensuring that over or under trading of FX is avoided; filtering currencies into the correct currency pairs for effective base currency and cash management, the correct matching of value dates to ensure accurate settlement and timing to settle cross border securities; and meeting cut-offs for currency cash movements to ensure securities settlement.
Emerging markets
Where emerging markets are part of the equation, additional factors must be taken into account – namely, the input and validation of security details to comply with special regulations, compliance with tax regulations at the country/security level, the need for additional SWIFT/fax messaging to ensure pre-advice to the country agent of security details or proof of the cash funding when required.
The second category covers the calculation of and execution of FX requirements. Once all the trades are validated, functions performed include, the aggregation of trades where appropriate, and the execution of FX with relevant counterparties to settle trades, obtaining competitive and/or benchmark FX rates; confirmation of execution and cash settlement instructions; advising third parties of activity if required (e.g. third party fund administrator/fund accountant); and liquidity management through value date matching.
Then there are the credit and risk management functions. These functions include: the management of FX trading limits; the management of counterparty risk when trading FX with market suppliers; the management of FX exposure and positions including ensuring trading is against the correct base currencies for each fund and finally cash reconciliations.
A key element of FX risk management is the controls and processes required to avoid potentially costly errors such as overtrading (buying/selling wrong amount); dealing on the wrong side or for the wrong value date; buying/selling the wrong currency or amount; inaccurate liquidity forecasting; and the risk of inaccurate settlement.
The fourth factor is operational and governance reporting. These functions encompass the correct allocation of FX transactions back to the linked underlying security trade for appropriate fund valuations, the reporting on trades and FX transactions, and provision of governance reporting to prove execution and performance of FX management.
Fund sponsors need to factor in a range of costs over and above the rate FX is transacted at. There are numerous operational and management costs associated with all the above mentioned, as well as the overhead required to execute these functions such as execution and support staff costs, subscription costs to rate feeds. Firms also need to invest in risk monitoring infrastructure and trading transactional costs, such as inward/outward payment fees or SWIFT messaging.
There are significant costs inherent in managing FX settlement above and beyond merely the FX rate/market cost. The decision to outsource will ultimately come down to individual choice: either the client or the fund manager will feel that FX settlement is linked to and more cost effectively integrated with securities settlement process or not.
By integrating FX settlement with securities settlement, there are several benefits that accrue to clients not available under the transactional model. Both operational and performance-related risk will be reduced, along with infrastructure and management overhead. Operational risk is offloaded to your provider. Because FX and securities settlement are different sides of the same coin, you are also reducing the risk of a FX transaction not settling or not matching up on value date. Any change in securities settlement is naturally taken care of by the custodian, so you avoid overtrading FX.
Fred Francis is vice president, securities finance and global products for RBC Global Services, Institutional & Investor Services.
