Asset managers, institutional investors, corporates and other buyside firms are being pushed to assume more of the risk and cost involved in foreign exchange (forex) transactions because the banks that have traditionally assumed these costs face trade constraints in the wake of new regulations and changing market dynamics.

Unless they develop the capabilities to manage forex-related risks, buyside firms including private equity and mutual funds, unit trusts, pensions and life insurance firms are likely to bear more costs going forward.

The development stems from two key trends: asset under management (AUM) of funds and institutional investors are booming. More importantly, the level of international business for many funds and corporates are expanding.

In Hong Kong alone, the total AUM of the fund management industry grew 10.5% year-on-year to a record high of HK$17.7 trillion (US$2.3 trillion) as of the end of 2014, according to data from the Securities and Futures Commission (SFC).

Meanwhile, the latest survey on global forex turnover from the Bank of International Settlements indicate that trading in forex markets averaged US$5.3 trillion per day in April 2013, up from US$4.0 trillion in April 2010 and $3.3 trillion in April 2007.

“While there are more foreign exchange risks to manage, the service functions that are available to offset forex risk are becoming more expensive,” says Phil Weisberg, global head of foreign exchange at Thomson Reuters.

Before the global financial crisis, liquidity in the global forex market was robust and underpriced and the banks were willing to assume the execution risks involved in moving huge amounts of foreign exchange through the market.

But that has changed. New regulations following the crisis made it more costly for banks to assume risks. Basel III has raised the capital that banks should hold against their books, while governance and business conduct requirements on lenders have become more restrictive.

“If you put these things together, you get some of the behaviour that we’re seeing in the forex market today, where the markets have been moving more than they used to. So it’s harder to get large trades done. They’re still doable, but in essence the liquidity takers (or the buyside firms) now have to pay more to execute those trades,” Weisberg tells The Asset.

Sharing the risk

In addition, heavy fines imposed by regulators on some banks for alleged market manipulation have put pressure on asset managers to understand the forex execution process better. As it is turning out, some of the mistakes relating to foreign exchange trading were oversight in the processes and procedures involved in the execution of trades.

“There is a transfer of risk taking place from the banking community to the buyside and this is a very big trend that is just beginning,” says Weisberg.

“Up until recently the buyside was waiting for things to return to the way they used to be before the financial crisis. I think now they’re cognizant that things are unlikely to return to the way it used to be so they’re all thinking about investing in expertise and technology in order to navigate this.”

Some of the larger asset managers are taking a more active role in forex trade. Some are finding it more costly to rely on banks than to assume some of the risks on their own.

Recent developments indicate that asset managers and buyside entities have begun developing their risk management capabilities in forex trading by hiring more risk managers and adding staff to their execution desks.

“Things are changing more in favour of developing the skills on the buyside in order to handle some of that execution risk. If the price of doing risk transfer is going up, you will seriously think about whether you need to pay to do that instantaneously or whether you can manage a part of the execution risk yourself and work the order yourself over time as opposed to just moving the risk over to a bank and let them put their capital to work,” Weisberg says.

In terms of cost, depending on the market and the size of the trade, transactions can cost anywhere from about several dollars to US$100 per one million executions.

“It really depends on the market and the sizes that they have to trade, but if transaction costs are going from several dollars a million to US$100 a million, you make a different decision about whether you want to manage the risk yourself. In some of these markets the price you have to pay for instantaneous risk transfer is going up,” Weisberg adds.