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Foreign Exchange Could Be Costing The UK Pension Fund Industry as much as £15 Billion Per Annum.
In this article we address some of the key questions and observations that we have
come across whilst talking about Foreign Exchange and how to measure and control
costs in the area.
We don’t need to worry because we don’t have any FX exposure.
When a fund invests in international assets, whether bonds or equities, the
performance of those assets depends not solely on the asset itself but also on the
currency. If the asset increases in value and at the same time the currency
decreases, the overall performance of the asset is diluted. Add to this the fact that
the fund may receive an unfavourable rate when buying and selling the currencies
involved in purchasing international assets, and the performance is further
Additionally, transition management and portfolio rebalancing often include FX
trades and you may not be getting the best rate available.
Why would we receive an unfavourable rate?
Prime brokers, banks and custodians act as principal to your trades so if you buy a
currency, the bank sells it to you; therefore they may not give you the best rate
Why don’t we know about this?
The FX cost lies in the difference between the rate that you paid for the trade and
the market rate, so no-one actually writes a cheque. The fund does not see any
budget impact and the AUM stays the same, so nobody notices. The cost is borne by
the fund as a trading cost. As pension fund executives and trustees have a fiduciary
responsibility, this is something they should look into.
What kind of amounts are we talking about?
Using data from the Mercer Consulting European Asset Allocation Survey from 2012
and extrapolating for the whole of the UK pension industry The AUM surveyed by
Mercer amongst their Defined Benefit clients amounted to a GBP total of
210,587,000,000 (converted back from their EUR figure of 252.2 billion). In the same
survey we find that around half of these assets are non-GBP denominated, and that
the average FX Hedge Ratio for a UK Pension Plan in 2012 is 62.90%. This gives a
hedging position back to Sterling of around GBP 66.23 billion per year, and on a monthly rolling basis (the norm) a total FX volume (counting only one leg of the
swaps) of just under GBP 800 billion.
Extrapolating these numbers for the entire GBP 2 Trillion in UK Pension Funds, we
find a total FX volume of GBP 7.548 Trillion per annum.
Assuming a cost per trade of 20bps, this is a bill for UK Pensioners of around GBP 15
Billion per annum.
It is in our view wrong that Asset Managers are continuing to use FX fixes when they
are really just a tidy accountancy practice that costs pensioners billions of
pounds. The FX issue is very big, and just because it hits the fund and no-one
actually pays a physical cheque, it is almost universally ignored. Fiduciaries need to
grasp the nettle and deal with the issue properly.
We review our custodian regularly with our consultant and this includes FX.
Many funds review their custodian service on a regular basis along with their
consultant and FX is included in this review. Given the example above can your fund
afford to give away this much in unmanaged FX costs in the interim 1 – 3 year
Our Asset Manager executes at a Benchmark Rate such as the WMR 4pm –
surely this means that our execution is being looked after well?
We believe that this benchmarking approach may in fact be one of the largest
hidden costs faced by investors. Fixes were introduced initially to help with
valuation – a 4pm valuation across Equities, Bonds and FX makes a lot of sense for
Banks then began offering a service whereby clients could achieve the exact 4pm
fixing rate for actual transactions, rather than just using the fixing rate as a
reference for valuations. This meant that asset managers could ensure that there
was no difference between transaction rates and valuation rates. This gives a strong
impression of complete efficiency in the FX execution.
This arrangement suits both bank and asset manager, but is potentially very
Banks require fixing orders to be passed to them several hours in advance of the
actual fix – it would be quite impossible to guarantee the 4pm WMR rate in any
other way – meaning that the bank has what is in effect a ‘free option’ on your order
for several hours.
The current scandal surrounding FX fixes is looking into this – but still has a long way
What can we do?
Transaction Cost Analysis for FX is a relatively new service that can provide you with
the information to speak to your FX provider.
- A simple cash cost figure for every FX transaction you make.
- A monthly breakdown of FX costs by currency, by broker and by instrument(i.e. spot, swap, forward etc…) and provides you with a trade by trade analysis.
This enables you to:
- Understand how much FX is costing you, and how much it is subsidising other
services such as Prime Brokerage, Custody or Borrowings.
- Set an objective benchmark to monitor and negotiate a fair deal for your FX
- Ensure that you are compliant from a best-execution standpoint.
Some further facts to consider:
According to the US Treasury Department FX Sales and Trading Revenue has been
the largest source of bank profits over the last 14 years.
We believe that prime brokers, banks and custodians should earn money on their
trading activity, but it should be transparent, measurable and reasonable.
TCA enables you to reduce costs and therefore, improve performance.
For further information on this or any of our products, please contact us:
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