The FX market is the largest financial market in the world, with a daily trading volume of $7.5 trillion. A significant proportion of this volume comes from fund managers, but despite their high exposure, they often suffer from a lack of transparency, especially when it comes to pricing.

MillTechFX’s own research found that 73% of UK fund managers believe there is a lack of transparency in the FX market, with cost calculation (33%) being the biggest challenge they face when dealing in FX. As a result, many fund managers find it challenging to get a clear view of their FX execution and hedging costs.

So, what’s the reason behind this lack of transparency? As fund managers review their FX set up heading into 2024, here are some of the top hidden costs that they should be aware of when it comes to FX:

1. FX Execution Costs

Execution costs are often the first thing fund managers will reference when speaking about FX costs. Think of a bank as a currency wholesaler, who will then discount away from their wholesale rate to incorporate a profit margin or ‘spread’ when they quote their clients.

In theory, this cost should be easier to monitor and manage than all the other costs in this list. However, in practice, and even to this day, many fund managers cannot say explicitly what they are being charged.

One of the best ways for a fund manager to understand their current execution costs is by carrying out regular Transaction Cost Analysis (TCA) via an independent specialist. TCA is to FX execution what an audit is to annual accounts – third party analysis ensures that your FX counterparties are not ‘marking their own homework’.

2. Forward points

Forward points arise in certain FX risk management products such as forward contracts or FX swaps and are a universal market cost that is largely influenced by the interest rate differential between two currency jurisdictions.

Forward points can be negative or positive, and may be to the hedgers’ favour or detriment, depending on which currencies are being bought or sold.

The tenor of a hedge can be altered to take advantage of a non-linear forward curve in certain circumstances such as when the trade expiry date doesn’t need to match a pre-defined exit date.

Any spread that is incorporated into a forward rate, or the far-leg of a swap, can be monitored using TCA, in much the same way as other over the counter (OTC) FX products. 

3. The Cost of Cash Drag

For fund managers that hedge FX risk using products such as swaps, forwards or non-deliverable forwards, they may have experienced the cash drag associated with placing margin. 

When placing a hedge, a bank may request cash collateral (initial margin) to be held as security until the hedge matures and is settled. 

If a fund’s investible capital is held back for initial margin, then deployed capital must work even harder to hit the target internal rate of return (IRR).

It’s almost impossible to know, with any degree of certainty, where FX markets will move, meaning a fund manager won’t be able to forecast how placing margin will impact a fund’s investment returns.

For this reason, fund managers tend to seek out uncollateralised hedging facilities with each of their FX counterparties with a view to freeing up investible capital. 

4. Credit Valuation Adjustment (CVA)

CVA is an adjustment in the FX rate by a bank to account for the possibility of client default. CVA is not zero when FX hedges are collateralised, but it is heavily negated when compared to uncollateralised hedging.

CVA will vary from bank to bank, for different clients and might be influenced by prevailing market conditions. This means when a fund manager is executing a longer-dated trade that induces CVA, they can’t know exactly what their hedging costs will be in advance. 

In order to maintain FX transparency and cost control, fund managers could explore using shorter trade tenors (e.g. 6-months or less) that don’t incur CVA.

5. Historic Rate Rollovers (HRR)

HRRs have been around for a while but get a mixed reception from different global regulators and are not generally considered best practice.

Standard practice is for any mark-to-market (MTM) gain or loss to be crystallised at each roll date and for the fund manager to receive or instruct a cashflow accordingly.

Instead, with HRRs, the single FX counterparty that holds the current hedge incorporates any potential MTM loss into the new hedge rate and the hedge ‘roll’ is performed ‘off-market’. It’s the FX equivalent of kicking the can down the road.

HRRs should be considered more of a lending product than an FX product, because any accrued MTM losses are subject to a lending rate being applied to them before the new, off-market hedge rate is decided. 

Fund managers should pay particular attention to the discretionary nature of continued access to HRRs every time a hedge is rolled forward, because it relies entirely on the credit appetite of the FX counterparty.

HRRs are at their most valuable to a fund manager when they carry a significant MTM loss in the hedge rate, which is conversely when the FX counterparty’s credit appetite will come under most pressure.

6. Operational Overheads

In our view, the least transparent and most challenging FX cost to quantify is the ‘opportunity cost’ of the time and operations associated implementing and managing day-to-day FX functions. Here are just some of the potential operational costs:

• Onboarding a new FX counterparty
• Managing the lifecycle of FX transactions
• Manual processes and human error
• IT systems and integration
• Counterparty monitoring

Out with the old, in with the new

With the management of currency risk moving up the fund manager priority list, we believe fund managers should review alternatives to the single bank-based approach to get a clear view of their execution costs. Instead, fund managers should consider looking for technology-driven solutions that enable them to compare the market, streamline their operational workflow and get the best possible deal when it comes to FX.