How can a bank assure its clients that a service it offers is smarter, faster and cheaper than that of its competitors?
Most banks can offer assurances on the quality of FX trades but the real need is for external validation
The simple answer is that it can’t. It might conceivably put together a detailed report that gathers data from all of its competitors and proves it is best, but the mere fact that the report is issued by the bank tends to undermine its credibility. What banks and their clients really need is an independent arbiter that can compare the options and deliver informed, unbiased analysis.
Currency managers have long sought this kind of service, known as transaction cost analysis (TCA), to prove to their clients that they are executing foreign exchange transactions on their behalf as well as possible. But while several offerings have sprung up, not all buyside firms have found a platform that meets their requirements.
James Wood-Collins, chief executive of Record Currency Management, said: “We have a regulatory obligation to deliver best execution and it’s a big part of what our clients expect from us, so we are willing to spend money on this. We have looked closely at the universe of TCA providers and tested a few systems, but we haven’t yet found one we have been satisfied with.”
Demand for such reassurance may be considerable. The industry has been rattled in recent years by the banks’ rigging of foreign exchange benchmarks and many asset owners now want to see evidence that their orders are being transacted fairly, transparently and at the best available price.
The revision of the European Union Markets in Financial Instruments Directive will also require market participants to demonstrate best execution, so TCA looks set to become a crucial part of the market fabric as firms will need technology that can generate credible, impartial transaction reports.
Lee Sanders, head of FX and money markets execution at Axa Investment Managers, said: “Internally we are putting ourselves under much greater pressure to evidence best execution in FX and fixed income, to the extent that every trader has to be able to justify the execution of every trade. TCA is one of the ways that can be achieved and it gives a very transparent audit trail to explain why a particular counterparty was chosen.”
While a number of banks, including JP Morgan and Morgan Stanley, have developed sophisticated TCA tools, there is growing recognition across the market that external evaluation of trades is more valuable. Axa IM uses reports from two providers, and it tops this up with its own internal analysis.
Sanders said: “We have had conversations with some banks about TCA in the past but we have always felt we needed the assessment of our trading to be truly independent. We currently take a combination of independent reports and we use the trade data we collect to challenge our traders and our counterparties over how trades were executed, which in turn improves our transaction costs.”
But while TCA has become a fairly industrialised process in equity markets, it has been much more challenging in FX. Part of the problem is that the forex market trades largely off-exchange – deals are executed through a wide array of trading platforms, bank-owned algorithms and internalisation engines that banks use to match buyers and sellers.
With no central exchange issuing a best bid and offer that could be used as a benchmark, Wood-Collins has not yet found a TCA provider that has sufficiently deep coverage of the full range of currencies, products and trading strategies on which Record requires analysis.
Wood-Collins said: “An independent provider will only ever be able to benchmark against a sample of the market, but the higher the market coverage and the more banks contributing data, the better. Additionally, the nature of our business means we would like TCA that goes well beyond the spot market into other products, in particular forwards, and has a broad coverage of currencies, including the less liquid pairs.”
Demand for strong, independent TCA is not confined to the buyside. Banks, too, stand to benefit from robust analysis if it gives their execution an accurate rating against that of competitors. JP Morgan, for example, offers post-trade TCA against various benchmarks at the transaction and portfolio level, but acknowledges that independent analysis would be more credible for all parties in proving the value of its execution services.
Richard James, head of currencies and emerging markets execution services at JP Morgan, said: “The challenge is that there are currently no independent providers getting the right level of market data to compile valuable transaction cost reports. An independent provider would need to be receiving our data as well as data from all the other banks because we want clients to be able to independently assess our performance relative to that of our competitors.”
TCA providers are not blind to the challenge of sourcing reliable data. As far back as 2010, US agency broker ITG partnered institutional FX trading platform FXall to develop a TCA offering for FX, but following client feedback, subsequent iterations of the product sought to incorporate a broader range of data. It now aggregates data from nearly 20 sources and has signed up around 50 clients in recent years.
Jim Cochrane, FX senior product manager at ITG, said: “The most important feedback we received from clients is that one input, whether from FXall or any other trading platform, was not enough to capture the whole market. We now have access to a wider source of data than the banks themselves.”
As providers such as ITG acquire more clients, each submitting its own trade data to be analysed, that data becomes a source of value in itself if it can be aggregated to create a meaningful benchmark of activity in particular currencies.
But buyside firms need to be assured that if their data is to be used for this purpose, it will be stripped of any confidential information first and used only at an aggregated level to inform TCA. Wood-Collins believes there needs to be contractual assurance that data will remain confidential, but has not so far been satisfied that providers fully recognise the sensitivity of data submission.
Wood-Collins said: “We recognise that TCA providers can use customer data to improve the quality of their analysis and we are willing to have our data pooled as long as it is stripped of any client identifiers, but we need to be absolutely sure that the data can’t ever be used for any other purpose.”