Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Shining a light on FX market opacity
Karl O’Shaughnessy, former hedge fund manager and head of foreign exchange for NAB, has been battling his concerns about FX trading for more than 25 years. He is now advising institutional investors on how to improve their returns.
O’Shaughnessy recently formed SuperClear FX, an advisory business which also offers wholesale clients an implementation ‘product’, which acts as a transparent agency business by dealing independently with traditional FX providers – custodian banks and fund managers. The firm was granted an AFSL last year.
For many in the investment world, FX trading is seen as the last hurdle in the quest for full transparency and maximum efficiency in global investing.
The FX market totals about US$6 trillion a day in trades. It dwarfs all other markets. But 95 per cent of the market, by the number or volume of trades, is inefficiently executed, resulting in billions of dollars in losses to investors; possibly trillions over the course of a year.
Interestingly, O’Shaughnessy does not blame the big global banks which dominate FX activity for the inefficiencies, but, rather, the system itself. He believes that the regulatory trend, particularly in Europe, to put the onus on investors as part of their duty of care, is the correct way to go to improve the system.
“Regulators globally have struggled to get much consistency around FX,” he says. “In the Australian landscape, the duty of care already exists through the trustee responsibilities for super funds. Some class action lawyers are already looking at this space.”
In his final years at NAB, in the early 2000s, O’Shaughnessy was involved with NAB Asset Servicing in the establishment of an FX panel to allow the bank’s big custody clients, including a majority of the biggest industry funds at the time, to access additional competition within the usual bank practices for FX. This fell foul of some internal bank differences of opinion and he left to join Kaiser Trading Group, a currency-trading hedge fund, as chief operating officer. The NAB project languished.
What makes FX unique and adding to its opacity are differences with equities and bond markets such as: there is no central exchange, trades are multi-jurisdictional, liquidity is highly concentrated and many FX transactions are instituted passively under ‘standing orders’. It is no surprise that regulators have struggled.
O’Shaughnessy says in a recent note to clients: “While the bank names have changed, FX market concentration in global FX has remained consistent over the past 30 years with more than 60 per cent of the daily FX volumes funnelled through 10 FX banks. Interestingly, the names that dominate today’s global FX flows are global custodian banks.
“There are valid reasons why global FX markets operate the way they do however in the eyes of regulators globally the balance between the FX banks and the millions of global clients requires tuning.
“Regulators globally have attempted to bring FX market operations into balance and closer to best practice however thus far their attempts have fallen short. It appears the European Securities and Markets Authority (ESMA) is leading the push for greater oversight of FX transactions by mandating client participants in FX markets ensure ‘best execution’ on all their FX transactions. ESMA is placing the onus of ‘duty of care’ upon the buyer of FX services.”
According to a Euromoney survey published in June last year, the top five players in the global FX market, in order, are: Deutsche Bank, UBS, J.P. Morgan, Citibank, and Bank of America.
One of the Australian class action specialists already looking at the FX market is Shine Lawyers. Craig Allsopp, the firm’s practice leader for class actions, said recently that regulators and law firms had both investigated the “manipulation” of FX in the Australian market.
He said: “While nothing has stuck to the big banks so far, it may only be a matter of time. Whether or not they get caught, there is an abundance of evidence suggesting issues with their FX execution.
“In a situation where it is common knowledge that FX transactions could be being manipulated against the interests of clients, trustees requesting FX transactions may arguably have a duty of care to avoid FX execution processes that may result in unnecessary costs to their members.”
O’Shaughnessy’s SuperClear FX has brought together various global standard pieces of trading and analytical systems designed for the market segment as part of his offering. He says the firm can “fully automate” a process to help mitigate the losses due to current inefficiencies.
He is targetting the “95 per cent” of investors at the “passive” part of the FX market for usage and awareness. “You’d be surprised at how many super funds are losing money by not paying enough attention to FX.”
