Introduction
On June 4th the European Central Bank (ECB) published a significant academic journal titled “Discriminatory Pricing of Over-The-Counter Derivatives” that we recommend as essential summer reading for corporate CFOs and treasury teams. Please see the journal link here, or for those keen to get to the point, please read the rest of this article and the FT.com summary here.
In conclusion, the authors demonstrated that foreign exchange (FX) dealers, including major high street banks and FX brokers, are systematically and consistently overcharging corporate clients who lack currency trading expertise. In some cases, fees are as much as 25 times higher, with certain clients paying 50 basis points on contracts which other companies pay just 2 basis points. See below an example which highlights the impact on total brokerage costs in US Dollars when comparing two trades of equal size with differing spreads (as above).
Why is this happening?
Transaction costs will always vary slightly between clients due to factors such as trade size, type, liquidity, tenor and counterparty creditworthiness. Nonetheless, we frequently observe large price disparity between clients of seemingly similar credit standings entering into similar transactions of equal size. But why?
The journal refers to a concept of “friction”, which essentially describes the conflict of interest between the two opposing parties in an OTC transaction. On the one hand, you have banks and FX brokers whose business, and incentive, is to offer the widest spread the client will accept in an attempt to maximize their profits. On the contrary, corporate clients want to reduce their spreads to minimize input costs (COGS) or the drag on foreign currency earnings.
There are a number of challenges CFOs or Treasurers face when it comes to getting a quote on an FX derivative contract:
- Opaque pricing
- The OTC FX market is opaque, particularly when looking at the pricing of FX derivatives. This opacity makes it easier for FX dealers to disguise additional, hidden spreads, in turn helping them to generate more profit.
- Lack of specialist FX expertise
- CFO’s and treasurers often lack specialist knowledge of what a “fair” price is for any particular trade, making it hard to know when or when not to accept or negotiate.
- Lack of competition
- SMEs, in particular, have fewer relationships with alternative banks and brokers that can provide benchmark pricing and help to increase the competitiveness of FX quotes.
What can be done to avoid paying higher spread costs?
“Measurement is the first step that leads to control and eventually to improvement. If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it.” H. James Harrington
Many SMEs may find that the optimal setup is to continue trading with their relationship bank with an increased focus on monitoring and scrutinizing their execution performance. This can be achieved by engaging an independent supplier of FX transaction cost analysis (TCA). Ongoing FX TCA can create immense value for clients who are looking to have visibility and control over an opaque fee structure and make significant reductions in their execution costs. As per Mr. Harrington’s quote, how can you begin to improve a process that you can’t measure?
At Bondford we are looking to democratize access to FX TCA tools, helping SMEs to achieve more consistent, competitive FX pricing. If a bank or broker knows that their client is engaged with a supplier of FX TCA, they too know they have lost their information advantage. Derivative pricing for their client is no longer opaque and they are incapable of widening spreads without it being noticed. From this position, clients are also better able to enter into meaningful discussions and negotiations, both with their existing counterparts and new ones.
Next Steps?
Are you concerned that you are being overcharged by your bank or broker? Would you like to know how much FX costs you on an annual basis and the potential cost-savings that could be achieved? Contact us today to get a free TCA report. We’d love to hear from you.
