The impact of T+1 on the foreign exchange (FX) market will largely depend on how asset managers and owners handle their FX in the compressed settlement environment. Those trading their own FX may need to improve upstream trade-related processes, ensuring that they generate the exact amounts of FX in advance of applicable cutoffs. Alternatively, managers may look to utilize a custodian-outsourced FX Standing Instruction model that generally requires fewer process changes to accommodate the shorter settlement window.
Regardless of the FX model, a significant portion of FX transactions already settle on T+1 or even T+0. In many ways, it will be “business as usual” for the execution of FX transactions when the compressed T+1 framework becomes a reality in North America next May. That said, the shortened framework creates an added layer of complexity in matching equity trades and generating FX to fund the trades.
Relying on Upstream Trade Activities
The efficient processing of FX transactions to fund cross-border trades relies on activities in the upstream securities trade process. Effective front-office technology will help ensure trades are booked efficiently, instructions are communicated in a timely manner and settlement of the FX transaction occurs as expected.
Custodians have a natural advantage when it comes to mitigating the T+1 effect on FX. Their strength is underpinned by proximity to the underlying security trade and dynamic connectivity between the custody and FX execution processes. The custodian’s ability to execute and settle FX trades directly within the account on the back of the FX trade is a powerful value proposition.
Related: Don't Delay - T+1 Settlement is Imminent
Considerations for Asset Managers
Asset managers that deal with multiple underlying clients, brokers, custodians and other managers may face FX challenges in the new settlement regime. The need to coordinate security trades with these different parties can make it difficult to provide a finalized amount of foreign currency in advance of the applicable cutoff.
One option that has recently been gaining momentum is for managers to outsource supporting functions such as post-trade operations—commonly referred to as the “middle office”—to a third-party specialist with the technology, subject matter experts and scale to automate and manage costs over the longer term. Improving and consolidating the pre-trade Order Management Systems and post-trade middle-office functions can have a positive effect on both the underlying security trade and the subsequent FX trade.
On top of this, managers are increasingly looking to outsource the FX requirements associated with their global investment portfolios. Integration between a middle office provider and an automated FX execution platform helps to ensure that security trade information is exchanged, and FX trades are executed, in an accurate and timely fashion.
Considerations for Asset Owners
T+1 is also serving as the impetus for asset owners to examine their FX processes with a view to improving execution efficiency and, as a potential added benefit, the performance of their funds.
As asset managers look to consolidate their middle office and other support functions, the benefits of consolidated FX execution with a single, custodian-agnostic counterparty are worthy of consideration by asset owners. This enables the transfer of FX risk to an external specialist, reducing costs through scale and trade netting across multiple investment managers and custodians. In addition to helping owners better understand their overall risk profile, FX consolidation facilitates consolidated reporting and consistent Service Level Agreements through a single process and point of contact.
While centralized FX execution is important from an efficiency perspective, it also delivers an improved picture of the true cost of FX execution. Agreeing on a contractual spread for automated FX execution with a centralized provider allows for greater transparency into the total FX costs. Once quantified, these costs can provide owners with a more accurate view of investment fund performance.
Add-on Solutions for Managers and Owners
There are various “add-on” solutions for asset managers and owners to consider as they enhance their FX processes in preparation for T+1. For example, the use of FX Standing Instructions, as mentioned previously, enables automated execution of operational FX on a 24/5 basis. Standing Instructions are custodian-agnostic, including the ability to integrate dynamically with custody or centralized middle office trade management functions. Additionally, conditional order routing sets parameters to facilitate timely FX settlement and can be customized to ensure all currencies meet applicable cutoffs.
The Importance of Acting Now
It is essential for asset managers to review their existing trade execution and settlement processes in preparation for the compressed T+1 regime. And asset owners have access to a variety of options designed to improve FX management and meet the requirements of a shortened settlement window. For both stakeholders, the changes are likely to require increased automation, outsourcing to third-party specialists, the adoption of new services or a combination of these alternatives.
In any case, managers and owners alike must move quickly to enhance their operating models, as the T+1 clock is ticking and May 2024 is fast approaching. The risk of not making the necessary system and process changes will have significant adverse effects on stakeholders’ ability to operate effectively in a post-T+1 environment.
This article was originally published to RBC Our Insights on November 20, 2023.