The currency overlay industry is missing out on an important tool that can help reduce the implementation headaches that plan sponsors frequently face when implementing a currency overlay program.
While foreign exchange prime brokerage is becoming increasing popular in the absolute return world, it has been largely bypassed in the currency overlay industry. Why currency overlay practitioners (plan sponsors as well as managers) have yet to embrace FX prime brokerage is somewhat a mystery.
FX prime brokerage has become standard operating procedure for CTA's and leveraged currency managers. For CTA's, adopting prime brokerage was a natural, since the concept is similar to clearing their futures trading through a single FCM. But the concept of clearing interbank FX contracts through a prime broker has not gained traction in currency overlay as a result of several misconceptions:
* Myth 1; FX prime brokers duplicate a service that is performed already by a plan sponsor's custodian. Why do I need a FX prime broker to clear my trades if my custodian can already do that for me?
* Myth 2: Clearing through a single entity will increase my risk as opposed to "spreading it out" across a lot different counterparties.
This demonstrates a lack of understanding as to how the prime brokerage process works. Clearly part of the problem is that the people that are responsible for marketing prime brokerage are not necessarily fully conversant in the issues that pension funds face.
At FX Concepts we first started employing FX prime brokerage back in 1994 having developed the framework with AIG Trading Corp. Prior to adapting this new clearing facility, currency overlay implementation was very time consuming and fraught with all kinds of back office related risks.
Because currency overlay runs under a managed account frame work, each of our clients came with their own set of banking relations. While we tried to establish FX lines with the same banks for all our clients so that we could trade their accounts in a single block, this was not always possible.
As we gained more clients keeping track of which clients had lines with which banks became increasingly complex. So did the process of establishing fx lines at each of the banks. This was a very time consuming and expensive process. Each bank had its own documentation that had to be reviewed by the plan sponsor or its custodian.
Once we were up and running, there was the issue of settlements. Foreign exchange forward contracts that were opened with one bank were frequently closed at another dealer. On settlement day, we then had the responsibility of ensuring that the plan sponsor's custodian delivered the right currency balances to and from the various dealers with whom we had outstanding settlements.
Any slip-up, and the next few days were spent making good on deliveries resolving any resulting interest costs. The unseen credit risk to our clients was if any of their respective counterparties was unable to make a delivery. As a byproduct of the being in the currency overlay business, we were necessarily in the back office business.
In 1994, FX Concepts announced a foreign exchange trading and clearing facility with AIG International that allowed us to greatly improve foreign exchange execution and clearing for our client accounts. This facility also enabled our clients to minimise the credit exposure in the foreign exchange markets by allowing them to house their currency positions at one of the foremost financial institutions in the world.
We now employ prime brokerage for all of our clients (both currency overlay and absolute return) through facilities with both AIG and Deutsche Bank. They benefit our clients in several important ways.
Our clients only have to maintain one trading facility, to review one set of legal documents, to monitor one counterparty credit and have their custodian/back office deal with one institution.
At the same time, we are able to trade on our clients' behalf with 15 to 20 major market-making institutions. Under prime brokerage, FX Concepts is able to trade on behalf of our clients with the prime broker directly and in the name of the prime broker with other institutions - our clients are thereby assured of obtaining the best execution under all market conditions, 24 hours a day.
FX prime brokerage presents a number of important benefits for our clients
* Best execution is greatly enhanced by virtue of having a large number of banking counterparties available at any time. This flexibility increases our ability to alter our execution strategies to obtain the maximum advantage for all our clients under all market conditions.
* Reduction of risk for the majority of our clients will be possible because all client positions will be with the prime broker. For those clients with multiple bank relationships, large currency settlement exposures are almost entirely eliminated since all transactions are settled with one institution on a net basis.
* Transaction processing becomes standardised and automated, leading to clear audit trails and enhanced controls.
* Legal documentation is necessary for only one account.
* It allows the manager to execute all client accounts as a single bloc trade, thereby ensuring identical performance across all accounts.
Furthermore it allows the currency overlay manager to outsource the back office element of his operate and similarly focus on their core competence which is managing currency risk. Ultimately, prime brokerage has allowed us to manage a larger asset base with the same number of people as the efficiency of our operation has improved.
Prime brokerage greatly reduces settlement risk for those currency overlay clients who currently maintain credit lines for foreign exchange trading at more than one financial institution. When the overlay manager liquidates a client position which was initiated with a different bank, the client is responsible for the delivery and settlement of currency balances at value day.
This facility allows our customers to maintain all the benefits of trading with multiple counterparties, namely liquidity and flexibility of execution, while eliminating a potentially enormous exposure in the form of settlement risk. The resulting dollar settlements to or from the prime broker will be small relative to the bulk amounts traded.
As plan sponsors frequently struggle with the complexities surrounding currency overlay, prime brokerage can help to streamline many of the implementation issues. By helping to remove some of the hurdles in enacting a currency overlay and improving manager efficiency, this will help to grow the market.
By Philip Simotas, President, FX Concepts
FX Concepts is one of the early pioneers in currency overlay and FX prime brokerage. Founded in New York in 1981 by John R. Taylor Jr., ex-head of Citibank Corporate Foreign Exchange, FX Concepts' approach employs a disciplined, model-based trading system, overlaid with a discretionary allocation (within strictly confined parameters) to its expert portfolio managers and regular monitoring by an investment committee made up of the firm's top research and portfolio management professionals.
Based in New York City, FX Concepts maintains offices in Paris and Sydney, as well as a trading office in Rochester, NY and a representative in Dubai.