Switzerland, 7th April 2016.
Many UK and US-based investment managers who trade equities look overseas - particularly towards emerging markets – in their search for alpha. However, as those markets generally settle in their home currency rather than US Dollars, fund managers are often left holding a position in a currency that they don’t actually want when making a trade. What they actually want is a position in the stock, it just happens to be denominated in a different currency.
This unwanted currency balance (particularly with the recent increase in emerging markets FX volatility) can lead to additional costs, unwanted risk and inefficient settlement processes involving FX transfers, not to mention awkward question from compliance departments as to why the fund manager is invested in Roubles, for example.
How can this whole process be made cleaner, so that at the end of the trading day, the fund manager holds his account balances in US Dollars and not the foreign currency?
One approach would be to use Depository Receipts or ADRs traded on the home market, so that the position is being traded and settled in US Dollars.
This approach does have its drawbacks however. First of all, ADRs might not be available for the stock in question. Secondly, because they mimic what is happening on the primary exchange, ADRs often provide only shadow liquidity with little real depth, so trade executions can be costly due to wide spreads and thin trading. There can also be a cost implication from increased margin requirements. And some fund managers have mandates that prevent them from investing in ADRs, which can rule them out completely.
So whereas ADRs might make sense in some specific circumstances, in many others they would not.
There is a more elegant approach to solving the problem of unwanted currency balances on overseas trades, which is based around algorithmic trading. The way this works is remarkably simple. All it takes is for the broker to be able to offer a cross-currency execution algorithm.
An example of how this works is as follows. A fund manager wants to take out a position in Gazprom and would like to be able to take advantage of the narrow spreads and depth of order book on the stock’s primary exchange, Moscow Exchange (MoEx). However, he does not want to see any Roubles on his books, he wants everything to be executed, cleared and settled in US Dollars.
Using the cross-currency execution algorithm, the fund manager sends the parent order to the broker, who routes it to MoEx for execution using the chosen algorithmic method (e.g. VWAP; TWAP; Arrival Price; Participation; etc). At the same time that each child order trades on the exchange, the broker automatically performs a USD/RUB FX trade, so that each and every fill is delivered to the fund manager in US Dollars.
Because the fund manager only sees fills coming back in his home currency, it makes the whole process much cleaner from his perspective, as he doesn’t have to worry about holding balances in Roubles or doing any FX trades to convert his position into US Dollars. It’s all done for him in real time.
And this doesn’t just apply to emerging markets. There are many US clients who like to trade Canadian stocks but settle in US Dollars for example, and vice versa.
It is clear that this approach is advantageous to the fund manager for the reasons outlined above, but what’s in it for the broker?
Clearly, offering a service such as this gives the broker a competitive advantage because very few brokers are currently offering this. Brokers can also enhance their margins by taking a spread on the FX component.
The key to all of this is the algorithmic element. It’s a much more simple and streamlined process for the broker to offer FX currency conversion algorithmically in an automated way than it is for them to have resting orders with their FX desk to convert client balances for example.
At the time of writing, currency pairs such as USDJPY have been averaging 30 day volatility of 13%, with more volatile currency pairs such as USDRUB averaging 35%. With most Western central banks heading for negative interest rate policies and with emerging economies struggling from depressed raw commodity prices, this FX volatility is sure to continue.
By automating the FX conversion in real-time the end user benefits from reduced execution volatility whilst the broker can simultaneously offer FX price improvement and improve overall profitability.
Simply put, using algorithms to automatically convert currencies at the point of execution is a win/win situation, for both the client and the broker.