Transaction Cost Management

Practical Corporate FX Risk Management Series, Part 7

This article is part seven of an eight-part series on FX risk management.

Author: Gavin O'Donoghue | Partner & Vice President, Technology

In this section, we look at transaction cost management (TCM) for FX transactions. Often referred to as TCA (transaction cost analysis), at AtlasFX we prefer to use the term “management,” meaning that the analysis creates actionable outcomes to reduce the cost of FX trading.

So, what is TCM?

TCM is the process that informs the corporation of the exact transaction cost of each FX trade executed with counterparty banks. This amount can be analyzed by currency pair, FX product, trade period, and time of execution.

Why is TCM important to corporate treasurers?

1. Tracking over/under-compensated banks

Corporations often need bank credit in the form of loans or revolver facilities to back up commercial paper (CP) programs. Rating agencies ensure that a corporation has access to sufficient credit before assigning a rating to CP programs.

Banks have to assign capital to the credit facilities, which is a cost. They often look to be compensated by the corporation via other streams such as debt issuance, interest rate swaps, transaction banking, or FX. The corporate treasurer needs to track how much each bank is awarded to ensure that the banks providing more credit are rewarded with a proportionate amount of revenue.

2. Identifying fraud

Tracking the profitability on FX trades ensures that the company traders are not dealing away from market prices and awarding business to counterparties in return for financial return or non-financial offerings such as tickets to concerts, sports events, fine dining, etc.

3. Improving execution

Having a comprehensive TCM process in place allows the corporate treasury team to identify patterns in FX trading that can lead to reducing costs. It helps answer questions such as:

• Are trades executed at illiquid times?
• Are trade ticket sizes too big?
• Are too few counterparties being asked to quote?
• Which currency pairs are most profitable for banks?
• Which counterparties are most competitive in each currency pair?
• Which FX products are most profitable for banks?

How do banks make money on FX?

The object here is not to bash banks; they provide FX liquidity and reduce risk. However, it is important for corporate treasurers to understand how banks profit from FX trades.?

In our last article, we covered execution and set out some guidelines to maximize price transparency and minimize the opportunity for banks to make excess profit margins (beyond what is necessary for taking on the risk). Remember, the FX market operates in a principal vs principal environment; i.e., what is good for one side of the trade is bad for the other.

"We get the best FX prices."

This statement is often incorrect. Breaking down the profitability on an FX trade into different buckets:

• Spread: This is the bid-offer spread on the price shown to the trader at the time of execution.
• Skew: Even if the corporate FX trader asks for a two-sided price, the bank's pricing algorithm will have a fair idea of whether the corporation is a buyer or seller and will 'skew' the price in that direction.

Information leakage: The time delay (even a few seconds) between the 'arrival time' of the request for quote (RFQ) and the 'execution time' of the trade provides counterparties with an opportunity to act upon the information within the RFQ. The result can lead to the market price moving away from the corporation before the executable quote is delivered. Flash Boys by Michael Lewis covers the importance of milliseconds in the execution of trades (his example is equity trades).

How does TCM work?

Most large corporations execute their FX trades over multi-bank FX platforms (FXall, 360T, and Bloomberg are the most popular). Regular (could be as frequent as daily) data extracts of executed trades provide the information needed to perform TCM. The report from the execution platform (this is an automated load in AtlasFX) contains detailed trade information including both the 'arrival time stamp' and the 'execution time stamp'.

Key calculations in TCM

• Arrival time to execution time: Calculates the gain/loss on the trade between the mid-market price at the arrival time compared to the mid-market price at the execution time.
• Execution rate vs. mid-market rate: The gain/loss between the rate provided by the bank and the mid-market rate at the execution time (split between spot and forward rates).

Where do the mid-market rates come from?

AtlasFX partners with Virtu to source independent mid-market FX rates. The process is fully automated from end to end. AtlasFX sources the trades from the execution platform and then matches the mid-market rates from Virtu at both the arrival and execution times to calculate the gain/loss on each trade.

TCM reporting

AtlasFX offers an interactive BI tool to report TCM. The data reporting is automatically updated each month. In addition, automated reporting can be sent to the treasury team at the end of each trading day.

Sample TCM reports

Explore the other articles in this series

• Part 1: Balance Sheet Exposure Basics
• Part 2: Accounting Rate Approaches
• Part 3: Balance Sheet Hedging Cadence
• Part 4: Month End Rate Process
• Part 5: Daily Rate Process
• Part 6: Hedge Execution
• Part 8: Balance Sheet Reporting and Analytics

Want to dive deeper into FX risk management? Explore the resources on our website.?

Ready to transform your FX risk management workflow? Request a demo of AtlasFX.?