No fair: buy side takes on pricing problem in FX forwards

Interest in TCA is growing as new data sources offer glimpse into murky swaps and forwards market

  • Transaction cost analysis for FX swaps and forwards has proven more difficult than for spot FX. The market is mostly bilateral and prices are affected by client-specific credit risk.
  • More asset managers are attempting TCA for their FX swaps and forwards trades and moving beyond simply asking their dealer to do the analysis for them.   
  • One way to evaluate trades independently is to use WM/Refinitiv forward points, based on multiple banks’ quotes. But market participants say the sample of quotes used is too small. Moreover, only standard tenors are covered.
  • Newer providers steam aggregated price data continuously and cover non-standard or ‘broken’ maturity dates. Xavier Porterfield at New Change FX says its benchmark represents “the credit-neutral, zero-cost clearing rate”.   
  • Effective TCA will become easier if more FX swaps and forwards are traded electronically. CME Group’s EBS is also working to enable firms to poll their liquidity providers electronically and negotiate their forward points once the closing WMR spot rate is fixed.

How do you land a fair price for a contract if little market data is available and if prices are skewed by a myriad of individual credit profiles anyway? Not that long ago, few buy-siders trading foreign exchange swaps and forwards even bothered trying.

But that is changing. Asset managers are increasingly applying transaction cost analysis (TCA) to their FX trades, venturing beyond spot trades where such scrutiny is commonplace.

“As the electronification of FX markets progressed and the buy side’s interest in consuming large datasets grew, it is not surprising to hear FX TCA has been more in focus in recent years,” says Jan Grindrod, global head of FX trading at Invesco. “Buy-side FX participants want to make decisions in a more data-driven manner.”

Along with other factors, this has led to a rise in third-party TCA providers specialising in FX and to established TCA firms beefing up their FX offerings, he notes. The other factors are likely to include new regulation, such as the best execution requirements under the second Markets in Financial Instruments Directive (Mifid II), in force in the European Union and the UK since 2018.

TCA for FX forwards – and, by extension, FX swaps since they involve forwards – is complicated by the predominantly bilateral nature of the market. Any price data that can be put together needs to be broken down into the many tenors used in FX forwards, with some tenors potentially ending up with only a small sample.

Then comes the challenge of extrapolating the going price from the data, because many prices in the market reflect to some extent the creditworthiness of the particular buy-side counterparty involved.

TCA for FX forwards is in its infancy and none of the existing approaches are perfect. But as demand grows, more sophisticated tools and techniques are emerging.

At one end of the scale, many asset managers simply ask their dealer to carry out the analysis by comparing the trade it did with them with its view of the prevailing market price.

Towards the other end, new benchmarks, such as those provided by New Change FX (NCFX), allow buy-side firms to perform their own TCA, even for forwards with non-standard maturity dates.

Another approach, recently implemented by Invesco, is to combine analysis performed by external TCA specialists with its own evaluation, based on proprietary data.

Whichever way asset managers choose to do TCA for FX forwards, they should not delegate it to their dealers, according to Andy Woolmer, chief executive of NCFX, a regulated benchmark administrator. 

“The vast majority have no independent TCA process in place, either relying piecemeal on bank TCA – which is clearly non-compliant [with Mifid II] – or not bothering at all. This is a drag on performance,” he says.

Other market participants add that best execution for FX forwards is particularly important for active users of the instruments as opposed to those who trade them only occasionally or specialise in other asset classes.

Fair pricing is hard to do

FX swaps – which consist of either a spot and a forward trade or two forward trades – make up the largest segment of the FX market. Add to that FX forwards, also known as outright forwards, and the portion of the FX market involving forwards is even bigger.

Average daily volume in FX swaps and forwards combined reached $4.2 trillion in 2019 or nearly two-thirds of the total FX market, according to the latest triennial survey by the Bank for International Settlements.

In one sense, this large share of the world’s biggest market is behind the times. Although electronic trading for FX swaps and forwards is booming, transactions are predominantly arranged via request-for-quote – replicating the steps involved in voice trading – and most of the business is still bilateral, concluded over single-dealer platforms.

This means relatively few prices reach multi-dealer venues where asset managers can compare them or benchmark their own costs against them.

Credit is an important factor where the price given by one bank to a client in a one-month forward is not uniform for all clients
Jay Moore, FX HedgePool

Another reason TCA for FX forwards is a daunting task is the multitude of factors that determine their prices. They include, for instance, two yield curves, the cross-currency basis and often counterparty credit risk.

This risk is priced by banks into so-called forward points, which are the basis points added to or subtracted from the spot rate of a currency pair to work out a given forward rate. Forward points are also known as a forward premium or a forward discount.

Unlike spot FX, which settles within two days, FX forwards’ settlement dates are usually weeks or months into the future. The 2019 BIS survey found that 61% of daily turnover in FX forwards was in maturities of more than seven days and up to three months.

Hugh Whelan, head of EBS Direct trading platforms at CME Group, notes that many asset managers rely on credit from their banks. As buy-side clearing has yet to begin for FX forwards, these dealers run counterparty credit risk.

Each bank’s perception of a client’s creditworthiness feeds into the forward points the bank offers the client. The credit risk can vary not just by client but also by trade as some buy-siders voluntarily post variation margin on certain FX forwards trades.

“Credit is an important factor where the price given by one bank to a client in a one-month forward is not uniform for all clients, making it hard to create a single source of forwards [price] data that’s representative for all,” says Jay Moore, chief executive and founder of FX HedgePool, a matching engine for the mid-market execution of FX swaps.

Whelan echoes that, saying that banks provide each client with “unique” pricing. Similarly, Invesco’s Grindrod says: “There are often differences in pricing between liquidity providers.”

In addition, the forward points offered to a client are affected by the importance of that firm to the bank – larger asset managers, for example, may receive competitive quotes from multiple dealers.

All this undermines any TCA for FX forwards done by a dealer on behalf of a client.

“[TCA] take-up has been good among those few active market users, but they are often not getting the right service due to not challenging the reference data sources, as they should be doing under the Mifid II rules,” says Woolmer at NCFX.

WMR won’t get you far

So, to be effective, TCA should draw on data aggregated from a number of dealers.

For this, fund managers can turn to WM/Refinitiv (WMR) forward points, which are based on multiple banks’ quotes and, if available, interbank bid and offer forward points. These points are calculated every hour to generate a benchmark price for a given point in time.

A buy-side firm can combine the closing WMR forward points, calculated at 4pm UK time, with the WMR spot rate to produce that day’s closing forward rate. The firm can then compare that forward rate with the rate it received from its dealer that day.

However, there are concerns about this practice.

To work out the forward points, Refinitiv takes a snapshot of quoted rates for each tenor on the hour. Since there is comparatively little trading of FX forwards in each tenor and currency pair, the quoted rates can move around a lot and therefore a single hourly snapshot is seen as a poor reflection of the market.

“There are simply a lot more forward prices per currency pair than spot, with each date needing a different price, so sample size is smaller,” says Nathan Vurgest, co-head of trading at Record Currency Management, a $58 billion asset manager.

“Additionally, with each tenor price, factors such as a bank’s balance sheet, regulatory constraints and thereby appetite for forwards can also play a part,” he adds.

Secondly, WMR forward rates are currently produced only for 11 time periods or tenors, all of them standard, such as one month, three months or one year. In practice, the market is awash with contracts with non-standard maturity dates known as broken dates – expiring, for example, in two-and-a-half months rather than in three months.

For instance, NCFX says on its website: “Most dates needed by end-users are broken dates that meet the specific need of the customer; to match a liability or hedge a future cashflow.”

For contracts with broken dates, traders have to interpolate forward points – that is, estimate them based on the points for adjacent tenors, which would be two months and three months in the above example. The process is complicated and vulnerable to errors.  

For these and other reasons, WMR forward points are not widely used, according to Aled Basey, head of FX sales at third-party TCA provider BestX.

“Swaps may well use the WMR mid as a spot reference, but the forward points will generally be priced at market rather than against the official WMR points,” he says.

And relying on the forward points received from banks goes against the push for greater transparency in the FX swaps and forwards market.

“Customers are left with a distinct lack of transparency when attempting to achieve executions in line with these ‘fixes’ to the point where it is an almost random number generator,” says Lydia Solinski, market data product manager at FX vendor 360T.

New kids on the block

A better approach, then, may be to use aggregated data that is streamed continuously and covers broken dates.  

Deutsche Börse-owned 360T is one firm that provides just that – to much praise from traders. Its FX Swaps Data Feed streams anonymised, real-time data from more than 20 dealers, including tier one and big regional banks, which also covers broken dates.

The data comprises FX swap bid/offer spreads and mid-prices in more than 40 currency pairs and 50-plus tenors from overnight to five years. Used together with the firm’s Essential Data Feed for spot FX, the SDF “creates reliable forward pricing”, 360T says on its website.

The SDF is streamed to third-party TCA providers, such as BestX and Virtu, which are used by the buy side.

NCFX has gone one step further. In June, it launched FX forward benchmark curves for broken dates, in addition to its existing benchmark rates for standard tenors. The firm aggregates live quote feeds from wholesale market sources, rather than from market-makers, to publish a real-time market mid-rate.

A mid-rate benchmark is analogous to the risk-free rate used in fixed income
Xavier Porterfield, New Change FX

Xavier Porterfield, head of research at NCFX, says the firm taps electronic communication networks and similar multi-dealer sources for the highest bids and lowest offers in a minimum quote size of 1 million base notional in the relevant currency.

It then works out the mid-point between the bids and offers. In the firm’s view, the bids and offers represent a mark-up the dealer charges a client to account for its costs, including any allowance for credit risk. So the mid-point between bids and offers is the going market rate or, in Porterfield’s words, “the credit-neutral, zero-cost clearing rate”.

“A mid-rate benchmark is analogous to the risk-free rate used in fixed income,” he says.

On its website, NCFX also says that, by undertaking research and working with forwards traders, it has identified “special” maturity dates, such as the end of a year or a quarter or days when a central bank is expected to change interest rates.

“Once those dates are known, NCFX can deliver an accurate benchmark across the entire curve,” the firm states.

Speaking to FX Markets, Woolmer at NCFX notes that banks and asset managers use its benchmark curves when dealing with a broken date or a maturity date coinciding with a specific event.

While such new data sources are useful, Vurgest at Record Currency Management sounds a note of caution about them.

“If you are using it for broken date forward analysis, you have to delve into how they are building their curve, how many points go into it and what the interpolation looks like. When we have been analysing independent TCA and data providers, that is an important question to us,” he says.

Invesco, for its part, uses a TCA provider alongside conducting its own analysis.

The firm sends all of its trades to the TCA provider, which calculates the mid-forward points and compares Invesco’s executions with those points. To analyse trades internally, Invesco collects bid/ask spreads from its banks via requests for quote and works out the average, which it assumes to be the mid-price.

TCA 2.0

As one of the most active traders of FX forwards, Invesco has some advice for buy-side traders of the instruments.

“Evaluating FX forward trades broken down by their spot and forward point components and analysing executions grouped by different measures, such as executing counterparty, currency pair, tenor, size or any combination thereof, should provide the buy-side firm insight into their trade executions and allow them to use this TCA data to influence future executions,” Grindrod says.

“A buy-side trading desk [also] needs to understand what the expected bid/ask should be on both components of the trade given the size of an order and prevailing liquidity conditions,” he adds.

Such thorough TCA will become easier if the FX swaps and forwards market manages to follow its spot counterpart into the modern age.

Solinski at 360T says that as the market makes the transition towards electronically traded swaps, the “feedback loop” into market data will further improve the products on offer. And EBS’s Whelan reveals that work is underway to create an electronic process for firms to poll their liquidity providers via request-for-quote and negotiate their forward points once the WMR 4pm fix for spot FX is known.  

In some cases, though, effective TCA for FX forwards may remain out of reach.

Many large passive fund managers must hedge indexes where the currency conversion is linked to the WMR 4pm fix on the last day of the month. They are too big to wait and do the trades in the spot market then as the market would move against them, so they spread the trading out through the month using FX forwards, which is usually more expensive than buying spot FX.

Moore at FX Hedgepool explains that banks can anticipate this by pre-hedging through the month.

“If they know that they have to price one client at the 4pm fix on a known date, they can prepare for that and build an inventory, which ultimately substitutes spreads for market impact,” he says.

“This is much more complicated to measure in a TCA report.”

Update, October 21, 2021: The second comment from Lydia Solinski of 360T, on electronification in FX swaps, has been expanded.

Editing by Olesya Dmitracova

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