A new study by New Change FX (NCFX) studies the cost outcomes of using the London 4pm WM Fix and while it is important to note that the company also offers a benchmarking of transactions service, the study indicates that the cost of trading at 4pm far outweighs the benefits on a 15/1 ratio.
To provide what it terms “ a fresh look at the issue”, NCFX has created a new measure of FX cost; the Unit Cost of Volatility (UCV) which it says provides a clear view of costs irrespective of prevailing volatility conditions. “The results when we look at the Fix through this lens are startling,” the firm claims.
The paper looks at EUR/USD, Cable and EUR/GBP and references the “common defence” of the London 4 pm Fix, that FX effects are a random walk, and indeed it confirms that in its analysis which shows that there 43 days out of 65 in which it cost more to trade in Cable at the 4pm Fix than Noon (39 days for EUR/USD and 34 for EUR/GBP). NCFX states, however, that deeper analysis, using the UCV indicates that while indeed the top-level effect may be a random walk, there is a significant skew; “the benefits are small, and the costs are large.”
The analysis compares the UCV of trading at 4pm and Noon London and NCFX says the idea of UCV comes from standard market impact theory – i.e. the general rule of thumb in trading that it should cost one day’s volatility to trade one day’s volume because risk exposure increases as a function of time. “If it takes a day to clear a trade, the risk exposure of the trade is one day’s volatility,” the analysis explains. “Because of the way volatility is calculated, the relationship of volatility to time is consistent over scale. The risk to clear a trade over five minutes is equal to five minutes volatility. UCV expresses transaction costs as a ratio of cost over volatility. Specifically, if we know the amount that is being traded, we can quantify the inventory risk in USD terms.”
Given the well-documented spike in volatility at the 4pm Fix, NCFX says the UCV for trading at the Fix should be lower than, or certainly not significantly greater than, trading at other times of the day, because the higher volatility should decrease the ratio of cost to risk. “This is not the case,” the analysis states. “The UCV of trading at the fix is higher. Defenders of the fix can get away (almost) with saying that about 50% of the time it is advantageous to trade at the Fix, but the difference between the costs and benefits of using the fix are massively skewed against users of the Fix.”
The paper studied the cost benefit outcome of trading at the Fix during the first quarter of 2020 (it should be noted that this will include the March quarter end where a pre-hedging programme in Cable caused significant pre-window market impact) and calculated the five-minute USD cost of volatility at the Fix and the five-minute USD cost of volatility at midday. Orders for the Fix must generally be submitted at least 15 minutes before 4 pm, therefore the analysis measured price action as the absolute change in price at 15 minutes prior to midday and 4 pm. It then arrives at USD values by taking the average daily volumes of global FX turnover and adjusting these for the volume at the Fix (it assumes net participation of approximately 3% of daily volume traded at the Fix). “Greater participation rates do not change the UCV,” NCFX says. “Nor do they change the quantum of difference between costs and benefits, they just make the USD numbers bigger.”
The analysis indicates, NCFX says, that for every time participants are one dollar better off for having used the fix, they are 15 dollars worse off when the Fix goes against them. Breaking that down by currency pair, the analysis finds that the negative skew is 25-times in Cable (including the aforementioned price action in March), 9.7-times in EUR/GBP and 13-times in EUR/USD.
“If the odds of a benefit or cost from using the Fix are 50:50 (they were worse during the sample), then these are the probabilities of ruin,” the analysis states, adding that the consequences of this are that trades are completed as required and the index price may even have been achieved in the process, but Fix participants will have fewer assets than if they had traded at some other time of day.
“If FX is simply driven by liquidity needs; i.e. if it is unimportant from a return perspective, then a serious effort should be made to ensure that FX is not actively damaging the portfolio,” NCFX argues. “It is important to bear in mind that the UCV methodology should by rights have shown the Fix to be at least no worse than at other times of the day. It is massively worse.
“Participants of the 4pm Fix need to abandon any pretence that participating in the Fix meets best execution requirements,” it adds. “Participation bears significant and systematic costs.”