Fund managers must prioritise margin-free hedging in FX

Fund managers must prioritise margin-free hedging in FX

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By Max Dobson, Commercial Director at MillTechFX, and Sebastian Wright, Risk Solutions at Investec

Under MiFID II, fund managers that hedge their exposure to foreign exchange (FX) risk frequently have a fiduciary duty to demonstrate FX best execution.

However, they face two major challenges when it comes to achieving best execution. Firstly, they struggle to ensure trades are executed at the best available price, given by the type of trade. They also have difficulty finding a solution that allows them to hedge their FX exposure without the need to post margin, which causes a drag on fund performance.

This has led many fund managers to explore new technology and solutions which provide the best of both worlds – margin-free hedging with transparent best execution.

The best execution challenge for fund managers

There are many factors to take into consideration in the quest for FX best execution, including:

  • Price and cost
  • Speed and likelihood of execution and settlement
  • Size and other factors directly related to the execution of the order

Often price or cost will be considered the highest priority, although for these to be the primary focus, there needs to be an operational robustness in all other components, such as settlement and speed.

Best execution is a fiduciary responsibility and a regulatory requirement for most fund managers, depending on the regulatory classification of the fund and is covered by various market principles and regulation originating from the FCA Conduct of Business Sourcebook and Principles of Businesses, the FX Global Code of Conduct and, most notably, MiFID II. 

Combined, they stipulate that investment firms should:

  • Treat customers fairly
  • Deal with market participants in a consistent and appropriately transparent manner
  • Take all sufficient steps to obtain the best possible result for the client when executing orders 

Aside from regulatory compliance, it also offers benefits such as increasing competition, reducing costs and demonstrating strong governance to internal stakeholders.

Most fund managers tend to open FX facilities to try and get the best price and effectively manage their liquidity. However, working with multiple banks comes with its own challenges – it can place a huge demand on operational and legal resources.

Uncollateralised hedging at the expense of price discovery

Exposure to foreign currencies is becoming more common for fund managers as they expand into new jurisdictions and attract new commitments from overseas investors.

This is on top of increased competition and capital in the alternative markets which is forcing managers to look for investment opportunities further afield.

Fund managers that hedge, using forward contracts for example, must also consider that placing a hedge typically requires margin to be posted against that position as collateral. 

Further, if the initial margin no longer covers the mark-to-market of a hedge, due to movements in the spot rate, the General Partners (GP) may be required to post additional, variation margin. Any capital posted as collateral, sitting dormant in a margin account and not invested, potentially earning higher returns, can cause a drag on fund performance. The FX risk, being mitigated with forward contracts, has been replaced with a potential liquidity risk.

Uncollateralised hedging isn’t just nice to have, the capital it potentially frees up can be redirected into investments, earning a return and boosting performance.

Fund managers can get access to FX facilities that reduce the likelihood of paying initial or variation margin. However, this might limit the number of FX counterparties at their disposal and negatively impact price discovery.

Best of both worlds

We believe that fund managers should look to solutions which combine margin-free FX hedging with multi-bank comparison, end-to-end workflow and transparent pricing.

This simultaneously enables transparent pricing without the cash drag associated with having to fund initial and variation margin calls, thus supporting key aspects of best execution.

These solutions are available now for fund managers to access. The technology is ready, easy to onboard – and in the future, this could be applied to a wider audience. It’s time for fund managers and other players to seize this opportunity and improve efficiency in FX, today.

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