London (HedgeNordic) – Regulators have long advocated for an unbundling of foreign exchange services. New technological advances enable an open architecture approach to selecting FX providers and counterparties. “Practicalities on the post trade side were an obstacle in the past, but thanks to the proliferation of things like cloud computing, APIs and common standards on margining and credit risk, it is now possible to match all settlements within one vertical. Systems and protocols such as CLS, FIX and Swift were created to standardize processes and democratize access to markets,” says Conor Daly, FX Solutions Strats and EMEA head of eFX sales at Goldman Sachs. There should now be a level playing field for everyone, even if some deliberate or unintended barriers to fair and equal competition do remain.

The inertia, factor long-standing relationships and, occasionally, restrictive contracts might lead some asset managers to view the default option as bundling currency hedging with other services from providers such as administrators, custodians, depositaries, or prime brokers, which may also be balance sheet lenders. Yet a tender process, such as an RFP/RFI exercise may identify a dedicated currency provider as more competitive. This can be in terms of anything across pricing, best execution, operational efficiency or reporting requirements. A currency specialist can dovetail with existing service providers: “we provide seamless post-trade connectivity with third party custodians, prime brokers and portfolio management systems,” says Daly.

Smaller and newer funds might be particularly keen to lighten their operational burden, and be anxious to reduce the chances of any operational mishaps around FX hedging, which can be an existential threat for a neophyte manager. “Disjointed FX workflows caused by having too many counterparties, platforms and agreements can be a challenge for smaller teams. Some clients lack the technology or IP for managing currency risk efficiently,” says Hugh O’Dea, Vice President of FX Sales at Goldman Sachs, who covers FX in the Nordics and other regions.

The Goldman Sachs Passive Currency Overlay (PCO) offering has hundreds of clients covering a broad spectrum in terms of AUM size and fund structure complexity. In the Nordic region, clients include many featured by HedgeNordic, including some of the largest household names and newer firms starting with little assets, who may also be using Goldman’s leading equity financing resource. The unit is taking a constructive view on the longer-term growth prospects of some start-ups: “we work with them from day one to provide content, technology and expertise that helps them to scale up,” says Daly.

PCO focuses on portfolio currency hedging, share class hedging and FX cash management, and reduces the operational workload inside asset managers. PCO aims to ease operational burdens and risks for COOs, Treasurers, Portfolio Managers and Heads of Operations and middle office managers, whilst also improving governance structures.

The three most common criteria for selecting FX providers are pricing, best execution and operational efficiencies but their relative weighting can vary between clients. “Some earlier stage funds require a lot more support with engineering, operations and regulatory items. STP is a priority for many,” says Daly.

AUTOMATION, ELECTRONIFICATION AND APIS

There is a lot of scope to automate undesirable aspects of currency risk management, such as data keying and handling or trade bookings. However, risk management will often retain an important human touch. “Electronification of FX markets hasn’t meant fewer humans: on the contrary, it’s meant more humans, serving more clients, doing more valuable things with their time,” points out Daly, who has been active in electronic FX for 13 years.

For execution, the blend between algorithmic and higher touch execution will vary partly with the currencies traded. Goldman’s Systematic Market Making (SMM) unit helps the firm to deliver a hybrid risk management approach. “Currencies with better pre-trade price transparency and active, central limit order books are easier to deliver higher levels of systematic market making to,” says Daly.

The open architecture is powered by technological advances, that are in a sense plumbing and wiring: “APIs reduce friction to collaboration,” says Daly. FIX protocol APIs are widely used for execution, portfolio management and post-trade processes. Meanwhile, restful APIs can also help to access data services such as market data for back-testing. The entire client onboarding process can also be expedited through APIs, which are embedded in client portals or websites and share data in real time.

MARGINING, STRATEGIES AND OPTIONS

Approaches to currency hedging will vary with criteria including the investment strategy, types of collateral and leverage. Generally, cash and top grade government bonds are acceptable collateral.

Margin is negotiated on a client by client basis, informed by timely data on NAV and exposures. “We look to incorporate our clients’ requirements regarding credit terms wherever possible,” says Daly. This can be a moving target with SAC-CR and regulatory changes underway. “Where illiquid strategies, such as private equity or private debt and real estate, have less cash and liquid assets on hand, GS has a number of alternative solutions to traditional spot and forward FX hedging programmes to assist clients,” adds Daly.

MARKET COVERAGE

Goldman Sachs turns over tens of billions of dollars of notional per day and can source liquidity through interbank markets. Currency market coverage is wide and includes an extensive franchise in emerging market currencies, including NDFs, and Goldman takes pride in maintaining access through turbulent markets.

INTERNALISING AND NETTING

Goldman Sachs FX overlay platform assist clients to achieve execution cost reduction through netting (whereby both sides of a transaction could be crossed at or near the mid, thus avoiding part or all of the bid/offer spread). This can be achieved within the same fund and across portfolios, where the rate benefit is distributed in a volume weighted manner to treat all funds fairly and ensure correct reporting and downstream settlements. “Clients of GS particularly like this netting capability, where they operate look through hedging across their portfolio and share-class hedging needs,” according to Hugh O’Dea.

In addition to this, Goldman Sachs, as an FX flow house, is focused on internalization, and minimizing the market impact of trades. “Risk intermediation is one of our most important functions as a partner to our clients,” according to Daly.

COUNTERPARTY EXPOSURES AND RELATIONSHIPS

PCO clients have counterparty exposure to Goldman Sachs acting as principal, directly and/or via clearers or prime brokers – and the systems can coordinate amongst multiple clearers and PBs. “PCO takes the raw exposures, regardless of where they sit, nets them down to the smallest possible delta, hedges and then manages the cashflows back to prime brokers and custodians,” says Daly.

Beyond spot FX, this requires an ISDA and CSA with Goldman Sachs. “In recent years, standardization of documents and streamlining of processes have made the onboarding process less onerous and less daunting than 5 years ago,” according to O’Dea.

CURRENCY CHARGING BUSINESS MODELS

Clients pay for PCO via trade execution on the platform. In contrast, Daly has observed some other currency providers charging a variety of fees including management fees, administration installation costs, and other execution costs that can be difficult to benchmark. “We have also seen per transaction booking fees, which do not make sense in a world of scalable straight through processing,” he argues.

The most egregious practices observed have probably been opaque currency reporting without any time stamp, which could make it difficult or impossible to ascertain if best execution has been obtained – and could thus be the most expensive “hidden fee.”

BENCHMARKS AND TCA

Best execution is a nuanced and multi-dimensional concept where price is only one among many criteria. “PCO has quantitatively demonstrated best execution versus a variety of benchmarks, such as WM Fixing, BFIX and Siren FX. The choice of benchmark is partly determined by fund valuation points,” says Daly.

Various third party TCA providers can be used. Many are already on the menu and connected to GS and clients are also able to select different providers.

REBALANCING THRESHOLDS AND HEDGE RATIOS

Costs are partly influenced by trading frequency, which in turn depends on rebalancing thresholds and hedge ratios. Clients can weigh up the benefits of more accurate currency hedging against the extra transaction costs it entails; GS PCO provides back-testing analytics to support clients with their decisions in this regard.

Rebalancing thresholds have generally been between 0.50% and 5%. “In 2022, with increased levels of FX volatility, clients have been reviewing them more often and gauging them against peer group practices,” says O’Dea. Where hedge ratios are not fixed, in effect a variable hedge ratio is an active wager and a form of active currency overlay and managers do have discretion to express these views.

This article features in HedgeNordic’s “Powering Hedge Funds” publication.