Three Key Reasons Why FX Currency Management is Driving Front Office Outsourcing

The COVID-19 pandemic has intensified the challenges faced by asset managers and asset owners to manage and mitigate the impact of currency volatility in their global investment portfolios. COVID-19 presented a perfect storm of challenges. On the one hand rising volatility triggered unprecedented shifts in net asset values (NAVs). At the same time, pressures to focus on core alpha activities meant currency hedging activities were sometimes set aside for those lacking automated solutions. This brought to the forefront the question of, should FX currency management be kept in-house, or outsourced? In this article, Northern Trust’s head of Currency Management, Andy Lemon, discusses three key reasons why an outsourced programme should be considered.

Even before COVID-19, asset managers and asset owners were increasingly looking to outsource currency management as part of their front office rationalisation. Aside from cost pressures, chief operating officers and chief investment officers had been challenged to meet the pressures of rising regulatory requirements and technology resiliency. This latest front office outsourcing trend followed the previous distinct cycles of back and middle-office outsourcing.

The COVID-19 pandemic has exacerbated these challenges. What was once regarded as a non-core function has been shown to have the potential to significantly impact overall portfolio values if not set up effectively– testing business resiliency plans. The following considerations illustrate the potential advantages of an outsourced currency management programme.

During the pandemic, transaction volumes ballooned due to increased market volatility causing substantial changes in NAV valuations. Some asset managers hit a capacity spike and were unable to cope due to their reliance on manual processes – leaving portfolios exposed to the rapidly changing currency fluctuations. Even in normal trading conditions, an overreliance on manual processes provides a heightened risk of trade and calculation errors and can detract from alpha generating activities. This has been an incentive for  many managers who were challenged to seek outsourcing specialists who are able to handle a large volume of transaction with automated systems. Meanwhile others with little exposure to global currency fluctuations or managers who have already heavily invested in technology may still retain these as they can justify the ongoing investment in internal resources and technology to operate and may still be content to keep an in-house operation.

For firms looking to outsource, they should consider an outsourcing provider which can offer a customised parameter set execution model. This means hedging activity can be automatically set in response to established market triggers, removing the burden of responding to dynamic market events – from minor fluctuations to large- scale unanticipated global events such as COVID-19, or a global market shock.

Under this arrangement, the provider’s system makes decisions based on market information, so it’s not discretionary. However, it can be viewed as a passive/active solution. It is passive as the asset manager or asset owner doesn’t have to keep asking for changes. The activeness reflects execution being based on customised, pre-determined guidelines agreed with the asset manager or asset owner. So, if their FX rate moves from 1 to 1.10, that triggers a different hedge ratio and the provider will execute based on those terms. The third-party provider is the active partner, but from the client’s perspective it’s more hands off. As it’s based on an agreed logic the set execution model removes the investment decision burden from the client while giving them the flexibility to change the parameters.

An outsourced provider may also be able to offer greater access to scalable technology such as machine learning models designed to enable greater oversight of thousands of daily data points that can help manage risk throughout the currency management lifecycle.

The timing of trades is also key to resiliency and optimum performance outcomes. For example, an asset owner based in Australia may be executing deals in the US, which could result in a delay between the valuation point of the fund and when the execution happens. The time lag exposes the asset owner to risk and may impact performance.

This risk can be mitigated by using a 24/7 provider which can execute closer to the fund’s valuation point. Having an effective currency hedging programme can minimise the FX spot’s impact on the portfolio’s non-base currencies – it’s not just about operational efficiencies but also optimising performance returns.

Asset managers and asset owners need to demonstrate enhanced oversight and governance of the impact of FX movements across their portfolios to meet regulatory, investor and board expectations. This means being able to track adherence to target hedge ratios view unrealized P&L and understand performance divergence.

Having an outsourced provider does not discharge asset managers or asset owners from their regulatory / governance obligations. However, it may provide the detailed transactional data to make it easier for them to fulfil these obligations but without the operational risk. Part of this is providing detailed reporting by directly interacting with a client’s systems through a variety of communication channels. These can include traditional routes such as excel or CSV files via email or direct connectivity via application interfaces such as APIs, Secure File Transfer Protocols, or online tools. Some providers, for example, may offer digital visualisation tools to enable their clients to view their performance analytics via interactive dashboards directly from their desktops.  Asset managers or asset owners can drill in and  gain comfort for the various reporting layers within their organisation, be that operations management, CIO, or risk management. This enables them to regularly assess their performance and adjust their hedge ratios or other hedging parameters as well as utilise to explain divergence to investors. However, on the other hand oversight and governance factors may also lead some asset owners and asset managers to prefer to keep all aspects of their FX requirements including their FX currency management programme in-house to have full control. While asset owners and asset managers have responsibility for their oversight requirements, it doesn’t have to be an operational burden.

A number of asset owners adopt a multi-manager approach to their FX currency management. This may cause potential performance analysis issues due to receiving multiple reports in different formats. Outsourcing to a specialist provider enables asset owners to receive a single report that provides a total portfolio view to make it easier to oversee as well as the ability to work with a dedicated provider to enhance the overall performance.

Consolidating to one external provider also enables asset owners to benefit from potential cost savings.  An asset owner may have as many as 80 managers performing currency management functions. Some may prefer to keep a panel of providers to benchmark against and gain a variety of approaches. However, this means a significant number of different FX currency hedges which may take opposing market positions. By consolidating with a specialist provider, netting benefits can be realised by consolidating currency transactions.  It may also assist in reducing the resourcing pressure to benchmark currency portfolio performance due to the single view. Delegating currency management to a specialist provider rather than the fund manager may also potentially lower fees by removing a non-core asset manager activity.

From an asset manager’s viewpoint outsourcing also has cost benefits.  For very large managers with extremely high  FX currency transactions, the large volume of trades may provide the potential to net off positions, ultimately saving in transaction costs.  But for other managers building a whole system workflow around transactional FX when it can be outsourced may not be justified. Running your own currency management operations entails staffing, system, regulatory reporting and legal expenses. While it is feasible to set up an automated solution in-house, it can  involve a large  capital spend, not only the initial capital costs , but also ongoing the maintenance costs. Having an in-house operation may also divert traders’ focus from key alpha generating activities.

An effective currency management program is key to managing and mitigating against portfolio currency risk for both asset managers and asset owners.  While COVID-19 has heightened the focus on outsourcing the currency management desk, the pressures driving outsourcing will continue as we embrace a ‘new normal’. While some asset managers and asset owners may elect to retain this function in-house, recent market events have shone the light on what has sometimes been regarded as an ancillary activity by demonstrating the importance of customised automated solutions able to deal with market shocks and fluctuations 24/7. They have also highlighted the need to have a transparent view of the currency management portfolio to meet governance and risk oversight requirements and make  evidence based  decisions to  adjust the program’s parameters to optimize performance. Moreover, an outsourced arrangement can help reduce costs across the spectrum of fees, staffing and technology investment. In conclusion, a decision to outsource to a  currency manager may help fund managers and asset owners achieve operational resiliency, reduce risk and enhance performance while reducing costs.

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