-       Martin Luther King Jr., 1963

It is almost unfathomable to label the current climate of finance in the political and currency trading spheres anything other than a time of challenge and controversy. Both Wall Street and Congress are easy punching bags for all citizens given recent events. In foreign exchange, much scrutiny has been placed over disclosures of trading practices and currency execution costs for international investors. The venom directed at each constituency is easy to justify, but it is worth looking under the covers a bit to see if it is rational. As guiding principles, I will use three outlined by David Walker in a recent interview: Truth, Leadership & Solutions.

For those not familiar with David Walker, he served as the seventh Comptroller General of the United States and head of the U.S. Government Accountability Office (GAO) for almost ten years (1998-2008).   Currently, he is the Founder and CEO of the non-partisan, Comeback America Initiative (CAI).  At CAI he is providing a large dose of reality to the American public, businesses and politicians, promoting fiscal responsibility and solutions in an attempt to improve the US’ fiscal position in this time of challenge and controversy.

Starting with the politicians, I, like most Americans, find it brutally painful to listen to the daily banter. Each side feels the need to blame the other for all that is wrong with our economy.  In the end, the polarization makes most feel both parties are out of touch with reality.

• Truth: We have to recognize that the economy is a compilation of policy decisions from many Presidents & Congresses, present and past. Let’s not forget the congressional imperative to aggressively promote home ownership to all.   This DC led mission helped fuel the sub-prime mortgage market and housing bubble.  Our economy became about producing more homes than the rate of the population while exporting manufacturing jobs overseas. Obama absolutely inherited a mess, but three and a half years in, he owns it too.

• Leadership:  Not much to speak of here.  Unless Obama or Romney’s respective camps have a come to Jesus moment and place the nation’s best interests above their own quest for the Oval office.   Both parties must avoid pandering to their polarized constituencies.  This is unlikely, and thus we will be devoid of leadership in the near term.

• Solutions:  Mr. Walker provides good fiscal direction here.  Self-imposed spending austerity is necessary mixed with proper tax / entitlement reform.  Growth strategies promoting domestic manufacturing, infrastructure repair and expansion of domestic energy sources.  And if we are being honest with ourselves, more tax revenue is required in the short term to fund a down payment on our debt burden.  Sometimes the truth hurts.  Financial markets would recognize a credible plan to right the fiscal ship, and would likely continue to purchase US debt.  European style “kick the can down the road” solutions would not placate the bond vigilantes on the subject of US debt post the presidential election.

The controversy in foreign exchange markets surrounds currency execution services offered to institutional investors by custodians as “free” while the trades were being handled at the day’s worst rates and beyond.   There is no excuse for this quality of execution.  However, a myopic focus on the allegedly pitiful FX execution practices of global custodians misses a large swath of the market.

• Truth: The credit, liquidity, and settlement services offered by OTC foreign exchange banks, custodians and dealers deserve compensation. The question is how much. In the current era of increasing market volatility and waning risk appetite by traditional liquidity providers, currency bid / ask spreads are perversely narrowing.  High frequency trading operations have more than filled the activity decline of the major dealers. Additionally, the proliferation of liquidity aggregation programs has helped bridge the decentralized market structure of FX. Transaction cost analysis (TCA) results show the majority of actively negotiated trades that we measure receive competitive rates.  That said, there are wide variances in execution skill between investors and many international investors today do not know their currency execution costs.

• Leadership:  In response to the execution quality controversy, many buy-side firms have demonstrated leadership.  Asset owners are engaging investment managers on currency execution processes and methods.  Many are requiring independent FX TCA be performed on international mandates as part of the RFP process.  Many investment managers in turn have closely scrutinized liquidity outlets and operational functions to address the heightened concerns.  Rigorous internal and external analyses of their trading data have been essential components of their leadership.   Banks, dealers and custodians have responded positively by improving transparency of trading data.  As a result, improved trading products are providing greater choice and control to buy-side investors.

• Solutions:   A one-size fits all approach is not rational.  Each investor has to ask themselves several questions when reviewing execution options: What liquidity venues are best? Will trades be executed via e-commerce? Will an agency solution be used?  What is the asset mandate and benchmark?  What currencies will be traded (deliverable / restricted)? What volumes are anticipated?  Using FX TCA, a cost-benefit analysis can be performed to see if any additional costs will be justified by execution improvement. Irrespective of the FX execution method, the only way for international investors to satisfy stakeholders (trustees, clients, and regulators) is to undertake independent cost measurement. Foreign exchange trade cost analysis should be a process with high integrity for source data and comparative universe statistics.  Direct currency expertise and knowledge of conventions is essential for accurate analysis.  Then meaningful interpretation of the results can occur to support investment returns. Crucially, transaction cost analysis providers must be objective. They should not offer brokerage or liquidity services.  These offerings create a clear conflict of interest to the goal of objectivity.

The words of Dr. King in 1963 truly illustrate the current climate of challenge and controversy.  Daily headlines are littered with financial scandal juxtaposed with examples of extreme political polarization.  International investors are faced with heightened scrutiny on their currency trading practices while the European debt crisis looms.  On top of it all, heightened uncertainty is creating volatility.  Currency execution and political challenges must face the harsh truth, show resolve with strong leadership and create innovative solutions.  Only through this difficult process will the United States and international investors emerge well positioned for the future.

The unique thing about FX is that they will also have to apply the tax to corporate hedgers, ultimately penalizing multinational corporations for mitigating currency risk.

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Although this is a big move in percentage terms, we think it will have little impact on currency transaction costs to most buy-side participants. If you think about it in basis point terms, on a $1 million trade, the current per ticket fee is about 1/100th of a basis point, so even if the fee doubled, it wouldn’t have a meaningful effect on bid/ask spreads in our opinion.

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