Currency volatility poses an increasing risk for institutional investors with significant global assets. Fluctuations in foreign exchange rates among currencies can impact investment returns, adding turbulence and uncertainty to portfolios – as well as constant noise. To address this threat, asset managers and owners know that a vigorous, daily currency management system – armed with a highly focused hedging program – is a vital element to manage risk and enhance returns within their core investment strategy.
Effective currency management and hedging is an increasingly complex and costly burden, adding to portfolio processes and additional non-core risks for sophisticated investors with growing global exposures. As a result, more firms are moving to automated outsourced solutions that can perform this duty far more proficiently and cost-effectively. But others are still struggling with a bias to keep it internal – saddling them with greater workflow burdens, currency volatility and risk of losses from ineffective hedging with each passing quarter.
Currency management is growing
more complex and time-consuming
For several reasons – including diversification and long-term sector opportunities – institutional investors are expanding their global exposures, which naturally multiplies the number of currencies and governmental jurisdictions they interact with. At the same time, the critical currency hedging programs they need to protect their investments – which use FX forward contracts or other methods (often in combination) to lessen the negative impact of currency fluctuations on returns – are facing greater scrutiny and regulatory control from governance bodies across the world, making these programs increasingly more complex to manage and maintain.
The combination is making currency management more complicated, difficult, and time-consuming for teams to tackle effectively, straining abilities and stealing effort from other critical functions that are core to the investor’s mission and purpose.
“These increases in international currency exposures are adding risk to the investment performance and increasing the operational burden and cost to maintain their portfolios,” says Andy Lemon, Head of Currency Management for Northern Trust. “Rather than focusing on alpha-generating activities, institutional investors are spending more time and resources focused on responding to the evolving complexities and added risks from their currency exposures. Many see this as uncorrelated risk on the desk, with only downside operational risk implications and potential opportunity loss by not focusing on enhancing returns.”
A need that’s outgrown the trading desk
Traditionally, foreign exchange hedging and other needs in daily currency management have been front-office tasks that were handled by an employee (or two) that supported the trading desk. “Most institutional investors don't have a currency management desk,” says Lemon. “They have a trading desk, and it may be supported by an operational team – and currency management is a function that someone on this team performs in addition to alpha generation.”
This common model can lead to some undue burdens in light of more modern solutions. The first is opportunity loss, as the team is losing a member to a daily chore that is – albeit complicated and vital – wholly transactional. “The CIO or COO needs to ask, is this time-consuming transactional task best suited for this team and use of talent, or would the trading desk and firm benefit from outsourcing this function to a specialist provider who is able to handle current and future volumes on scale?,” says Lemon.
The second risk is that the model can lead to undue errors. The employee that handles currency management typically develops idiosyncratic work processes that – even at large firms with ample resources – often involve spreadsheets.
The third risk is that if that employee leaves, the firm’s competency to manage its currency walks out the door with them. “Management teams will frequently tell us, the person who built the currency spreadsheet left a year ago, and no one knows how to update the macros,” Lemon reveals. It may be hard to believe that such basic issues can stymie operations at large, sophisticated firms, but it’s an occurrence many are all too familiar with.
If keeping currency management in-house increases the risk of opportunity loss, costly errors, and an integral daily capability exiting at any time, why aren’t all investment firms facing these problems outsourcing it to service providers with specialized, cutting-edge technology?
An old taboo: Keep front-office activities on site
“Historically, we've seen back office and middle office activities being outsourced, from a cost perspective, but the front office wasn't really touched,” Lemon explains. Given the headaches institutional investors are dealing with as they expand their portfolio holdings in global markets, however – plus the upheaval from the COVID-19 pandemic that’s fueling ongoing volatility in global currencies – the operational burdens have now finally become heavier than many asset managers and owners want to bear.
“As a trend, we're seeing more institutional investors asking, how can we outsource our foreign currency management while retaining control and oversight?,” Lemon notes, adding that the movement to virtual work caused by the pandemic has also likely helped make this front-office activity feel more viable to move off site.
Fortunately, these investors have powerful, cost-effective options to outsource their currency management needs while significantly improving data accuracy, efficiency, oversight, hedging control and performance, risk management, transparency, reporting ease, and regulatory due diligence. But not all outsourced solutions deliver these benefits.
An automated, customizable solution with a holistic portfolio view offers a valuable solution
Before turning their currency management over to a service provider, Lemon suggests that institutional investors ensure their solution has certain essential attributes: advanced automation, ample flexibility for customization and scalability, and a near-real time view of the entire currency management portfolio. Here’s a closer look at these key elements:
All core data – from a transfer agency, custodian, the middle office, accounting, or wherever it originates – should flow into the platform digitally. If any part of the solution requires manual operations, such as inputting information (like almost every in-house currency management system, not coincidentally), it’s not adding the necessary value.
Automation doesn’t just prevent errors; it brings critical speed. “For example, the system should be automated to calculate the hedges based on your parameters and detect anything unusual immediately, so you can act on it quickly,” says Lemon. For example, AI technology and machine learning can be deployed to analyze every data element to flag anomalies instantly and inform decisions for immediate action.
Flexible, scalable, customized model
The solution should seamlessly evolve and add capacity as rapidly as your needs change. Using AI-infused automation in technology specifically designed for currency management allows highly customized solutions that meet different requirements for different clients, says Lemon. “It can identify unusual activity that if not detected early could cause downstream issues with incorrect FX deals being booked, so timing is critical,” he says.
Institutional investors may want to utilize a dynamic hedging model and adjust the hedge ratio from 100% to 70% based on market triggers, Lemon explains. Or only hedge the portion of a large holding that’s in Turkish lira. Or use proxy hedging to gain correlated exposure to restricted currencies in Brazil, Chile, Taiwan, or Indonesia without the need for NDF execution. An optimized dynamic hedging model can automate each of these functions, and countless others, to create an intricately customized solution for each client, Lemon says.
Near real-time view of entire currency portfolio and share class divergence
Data visualization tools can provide a comprehensive, near real-time view of their currency portfolios, with interactive interrogation features that allow users to drill down to highly specific needs, says Lemon. “They allow you to be proactive and quickly determine the cause of any problems, so you can pivot as needed,” he says.
For example, if the dashboard shows a blip in hedging performance, an optimum platform allows you to answer most critical questions within seconds. What is causing this delta? Is my hedge offsetting the spot risk I have on the exposure? Is my hedge ratio too low causing performance slippage? Having a holistic data-visualization platform that clearly displays your currency status allows you to solve such issues with the speed necessary to protect your assets, Lemon adds, while systems without this feature may be of little more help than the spreadsheets previously used.
Free talent to add more value
As more institutional investors determine that their in-house currency management process requires too much time, effort, and attentional resources to be viable – and technology upgrades would prove too costly – Lemon expects that these factors may increase the pace of the current transition to outsourcing. “Given the clear advantages, I see outsourced currency management becoming the norm in the near future,” says Lemon. Implementing advanced solutions that meet the criteria outlined above may help to reduce operational costs and Lemon notes that this can then allow management teams to shift resources to core investment activities, generating more value for investors.
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