Ensuring the best execution of international FX transactions can be a challenging and sometimes outright impossible task.
However, as fund managers face a number of challenges when it comes to establishing strong and long-lasting relationships with their investors, ensuring best execution can be a great way to build confidence.
Because such relationships are built on trust, understanding the risks involved with trading internationally and articulating potential strategies is key. When it comes to FX risks, costs hidden behind trading overlay strategies can affect the returns of funds if these are not managed properly, and lead to some very unhappy investors if not communicated correctly.
Fund Managers should strive to be as transparent as possible when it comes to risk, without compromising their competitive advantage and ensuring cost control in trading execution.
What is “Best Execution”?
The general understanding of best execution is usually narrowed to achieving best price. The truth is that, when engaging in FX, investors end up facing other risks by controlling the exposures originated by raising and/or deploying capital in foreign currency.
Focusing on the investment space, there are specific liquidity considerations that fund managers need to take into account to ensure successful delivery of FX trading and hedging programs without compromising “best practice”. This requires a broader understanding of the different moving elements that can affect the returns of the fund by identifying KPIs that protect the interest of investors in a holistic way.
Ronan O'Donoghue, Investment Director at Ballybunion Capital “Achieving Best execution is essential to us. International investors that consider investing in our hedged share classes, are always interested to see how we are managing the FX cost and collateral impact on the fund’s performance. Therefore, we are constantly working with our FX counterparties to guarantee cost transparency, better trading facilities and confirm best execution.”
Imagine a fund having two counterparties in their FX panel, and there is a specific counterparty that consistently provides better pricing than the other.
As the manager is driven by best price, the most competitive counterparty earns the majority of FX exposure, which by default increases the counterparty risk and the liquidity at risk of breaching the thresholds of a specific FX line.
Such a scenario exposes private funds to issue capital calls in order to settle or post margin, which violates the main purpose of the committed capital, which is to deploy in the acquisition of assets, and could hurt these relationships for future fundraising rounds.
“Best Execution” should be defined by each fund manager taking into account not only price but also counterparty risk, liquidity, and operational risk.
Ronan O'Donoghue, Managing Director at Ballybunion Capital “We understand that hedging programs could bring hidden risks such as lack of liquidity and high costs if they are not managed properly. Thus, our FX provider played an important role in order for us to achieve the best execution, by reducing fixed costs and keeping competitive collateral terms to avoid any cash drags and stabilize our investor's returns.
Solution
A way to bring balance into the equation and ease the pressure of chasing best price and understanding Best Execution in a holistic way is to pre-define with counterparties Fixed Spread agreements that guarantee fair pricing and cost control amid the broader terms of the FX trading facility.
This can help fund managers focus on adding value by ensuring risk-adjusted returns and avoiding any cash drags that many fund managers fall into by misplacing their FX trading deteriorating fund indicators.
Therefore, it is fair to say that the better liquidity and collateral conditions, it means that counterparties providing these facilities assume higher risk and these drivers are reflected in adding credit as a pricing component in FX and should be predefined in early stages of the relationship.
Investors expect managers to have a comprehensive understanding of industry dealers, agreement types, onboarding procedures and pricing benchmarks that ensure that funds hedge under fair conditions that will work as infrastructure for fund managers to deliver best practice to their investors.
We add value to our clients by negotiating on their behalf the commercial terms of their FX trading facilities, including the agreement of fixed spreads ensuring that on an ongoing basis these are delivered in a reliable and transparent fashion.
Pre-agreed Fixed Spreads provide advantages to fund managers to accurately budget and understand their FX related costs for purposes such as asset level hedging or share class hedging, which can help provide a transparent view to engaged and prospective investors in understanding the drivers that help control the performance of your fund.
Moreover, it is vital to protect the relationships with FX liquidity providers, ensuring a long standing partnership under conditions that help both counterparts avoid scenarios where pricing overcharges can deteriorate the delivery of solutions to investors.
Conclusion
Fund Managers strive to ensure Best Execution to their investors, but it is key to realize that best price can come many times in hidden form of extra cost by ignoring imminent risk surrounding the implementation of FX strategies into your portfolio.
Market standards require managers to have the tools, insights and expertise to build a robust banking infrastructure that will help deliver these strategies optimizing the drivers that initially committed investors to your fund.