FX hedging during market downturn

4 May 2020 - The current market downturn further strengthens the need for managers to focus on their core investment business and reduce operational risk by outsourcing non-core functions to trusted service providers. Among these functions that may be readily outsourced is the foreign exchange (FX) hedging of share classes.

The primary goal of a currency hedged share class is to replicate the base currency returns of a fund to foreign currency share classes without the uncertainty of exchange rate variations; data accuracy, permanent access to the FX market and timeliness are paramount.

Operating a share class hedging program is a specialised activity

Share class hedging involves both operational and financial risk and is complex to maintain. It is a specialised activity to which any error or omission has a cost. Determining how a hedging program should be set up and run is therefore an important strategic decision. Operationally, it involves four components:

  • Periodic calculation of FX trades to be executed: FX trade calculation requires both a timely access to capital activity and NAV information and full accuracy in trade determination.
  • Execution of the FX trades into the market: Managing a fund and securing a trade isn’t as simple as just getting the best price on the market. You must have strong and stable relationships with the FX counterparties, to give you the price and the size that you need when needed, implying to have numerous competitive options readily available. 
  • Daily FX collateral management: Managing margin returns on a daily basis can be a cumbersome process, particularly where collateral management against FX hedging is concerned.
  • FX reporting, including regulatory reporting where necessary: While there is no centralized body governing the FX market, trading is regulated by several bodies across different jurisdictions. With the introductions of EMIR and Mifid II, amongst others, funds of mid-large sizes have to dedicate increasing time and resources on regulatory reporting.

In-house vs. delegated share class hedging

For most fund managers, the question of share class hedging is not if, but how. The temptation to retain the function in house may be preferable if there is already a dedicated FX team in place with access to integrated information systems and FX relationships that offer competitive and continuous access to the market.  However, for many this is not the case and a delegated arrangement can offer a better alternative to trying to build an in-house capability.

Delegating to a trusted partner not only reduces the need for managers to invest in the people and systems necessary to execute a share class hedging programme, it also allows the manager to “in-source” its access to the FX market and generally ensure better pricing and continuity of execution. Not only does this provide managers with a high quality service that supports international expansion, it also improves both operational and cost efficiency, meaning that managers can be freed up to focus on what they do best – generating alpha.

Citco FX Services

The Citco Group Limited and its affiliates has successfully serviced its FX clients since 2005 through Citco Financial Products (UK) Limited (“CFP”), a credit and FX services specialist subsidiary with a dedicated team of seasoned professionals across Europe and the US. The team today services in excess of 50 share class hedging programs for FX calculation and over 50 fund managers for FX execution.

The CFP team manages all aspects of share class hedging, always tailoring its services to client needs from FX calculation, execution and collateral management to reporting.

  • FX calculation mandates leverage on in-house information systems and proprietary tools to offer a complete outsourcing of FX trades determination and efficient risk reduction via a full integration into the our FX ecosystem.
  • FX execution mandates are performed with a unique set-up: FX clients face one of the Citco Banks, which in turn faces multiple market FX counterparties. As a result, FX pricing is optimised to achieve best possible execution and is fully transparent to the Client, as quarterly benchmarked by an independent cost optimization consultant.
  • FX collateral management is fully delegated: margining determinations and cash flow operations are processed daily by the CFP team on behalf of its FX clients.
  • CFP’s FX team can provide its clients with all financial and regulatory (including EMIR) reports in relation to calculation, execution and collateralisation of FX trades, in standard and/or bespoke formats.
  • Full integration of CFP’s FX services into our administration environment further ensures investors an optimal level of transparency of the fund’s FX operations and execution standards.

By Nicolas Queme, Head of Credit and FX Solutions, Citco Financial Products (UK) Limited.