A Destination for Asset Allocators
ASSET ALLOCATOR SPOTLIGHT
Foreign exchange trading is now more efficient and transparent than ever due to technological advances. However, these advances have been slower to transfer to restricted market currencies where local practices and requirements can hinder efficiency improvements.
By Paul Fyda | July 2022
In recent years, technological advances have made foreign exchange trading more efficient and transparent than ever. The solutions available to automate FX execution and operational workflows in most established markets have grown, with many options that can be customized to fit asset managers' needs. Tools like algorithms can augment execution while FX outsourced solutions can automate tasks, freeing up managers’ trading desks so they can focus on higher value activities and orders.
As a result of this innovation, investors in many foreign currency markets are benefitting from a better operational model with improved workflow that can translate to increased value. However, these advances have been slower to transfer to restricted market currencies. In restricted markets, local practices and requirements can hinder efficiency improvements.
Before an investment manager invests in restricted currencies, they should consider the challenges and the growing number of options available, such as passive dealing via custodian standing instructions, direct dealing and outsourcing. While automated solutions exist for restricted markets, managers may benefit from working with foreign exchange partners who have the experience and expertise to help steer them through the marketplace and optimize their operations. In a restricted market, the most efficient solution may often be full outsourcing with the right partner.
Restricted market currencies offer a myriad of obstacles including limited trading hours, fewer counterparty options, and more importantly, a wide variety of local regulatory requirements that can complicate FX transactions. The most consistent regulation across these markets requires FX transactions to be linked to underlying investments in the local market. And while regulations and policies toward foreign exchange can liberalize over time, it is not a common occurrence. Some countries impose new practices that add further trading complexities, such as India recently changing equity settlement from T+2 to T+1.i While the impact of this new market practice is still being reviewed, it may result in India being a full prefunding market, which could be extremely challenging for foreign investors.
Since it can be difficult to navigate regulations, market practices and relationships, there tend to be fewer FX counterparties that provide comprehensive coverage. Therefore, most foreign exchange in restricted markets is still executed through passive products, like custodian standing instructions. Global custodians have the underlying security details and resources required to satisfy regulatory requirements, and naturally have relationships with local providers that allow them to execute and settle transactions within applicable regulatory guidelines. However, both direct dealing and comprehensive FX outsourced solutions are becoming more common in the most prevalent restricted market currencies.
One of the execution options available to investment managers is direct dealing. If a firm has one global custodian, direct dealing may offer better trading control and execution and may be the best fit for their needs. Nonetheless, direct dealing is not without problems. For example, if a manager has multiple global custodians, direct dealing becomes more complicated and the results can be inconsistent. This is not only related to varying FX rates when dealing with counterparties, but also because FX banks and custodians tend to have different trading requirements when transacting in restricted markets. For example, each FX bank or custodian typically has customized requirements for providing the corresponding security details that are needed at the time of dealing in certain markets. Accommodating these disparate requirements can make the process extremely convoluted for managers when executing across multiple providers.
Somewhat more complex is when a manager trades directly with a third-party FX bank, meaning someone other than their global custodian. In addition to providing the security details required at the time of dealing, each of their global custodians will typically have different requirements for the incoming settlement notifications, the messages that are ultimately used to settle the FX transactions. These rules apply only to restricted markets and are usually related to the underlying account structure or regulations in each specific restricted market. This is one of the most arduous aspects of trading third-party, whether direct or passively, as this process is very difficult to support without a flexible settlement system capable of customizing messages across currencies and providers.
Figuring out how to manage disparate obligations from various custodians can be challenging for managers. When dealing direct, the manager is responsible for providing any underlying security and account details, and in some cases, ensuring tax implications are managed accordingly. In addition to taking on these additional responsibilities, the manager assumes all operational and execution risk. The process around direct dealing has improved significantly over the last decade in terms of transparency and flexibility but can still present challenges. As a result, other execution options have evolved in these markets as managers look for reliability and increased control across their workflow.
A restricted markets fully outsourced solution is another option to consider. These programs manage clients’ FX lifecycles efficiently and transparently, offering support across trade generation, netting, execution and settlement.
In addition to achieving execution quality and consistency across multiple providers, outsourced programs can ease many of the challenges associated with direct dealing. The provider manages specific market regulatory requirements and can instruct the initial settlement message with flexibility across providers and currencies. Outsourced providers also generally have trading relationships with multiple onshore counterparties in restricted markets, which can enable access to better price discovery and market information. While these services are generally passive, managers benefit from a customized, defined execution model based on their operational workflow and needs and can outsource the market regulatory requirements and the settlement process to the outsourced provider.
As has been the case for years with developed markets, fully outsourced FX programs are gaining traction in restricted markets as they address the challenges and provide multiple benefits, including cost savings, better benchmarking, risk management and more transparency in trade execution. As managers’ FX preferences and approaches continue to evolve, the demand for full outsourcing is expected to grow. With a simplified and automated workflow, managers have more time to focus on their core strategies.
Thanks to technological innovation and automation, FX trading has become more efficient than ever. Although restricted markets tend to evolve slowly, the solutions available, such as outsourcing, have been upgraded and refined over the past decade and investment managers should evaluate which model best fits their needs. It is important to choose an FX partner that will offer the service, expertise and technology to optimize their restricted currency strategies.
i https://economictimes.indiatimes.com/markets/stocks/news/t1-settlement-to-kick-off-from-feb-25-what-it-means-for-you-and-market/articleshow/89771842.cms?from=mdr
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