Deloitte performed two surveys on FX Hedging market practices back in 2011 and 2015. We recently launched a third version of this survey among 16 of the largest global asset managers and asset servicers having offices in Luxembourg, France, Switzerland, UK or the US. Areas covered included general information, size, product offering, target operating models, systems, detailed processes and control framework.

Since our last survey in 2015, this year’s survey findings shed light on the profound transformation of the hedging overlay services offered by both asset managers and servicers. New major market players have also launched their own currency overlay solutions, further crowding this constantly evolving market. As a result, currency overlay has become more common and accessible to all kinds of investors.

The industry has faced many challenges over the last few years, including regulatory transformation, automation, increase in volatility, a reduction of transaction costs and the opening of new markets and currency types.

Regulatory transformation

In recent years, regulations have targeted a vital aspect of the FX market: transparency for the investor. ESMA’s opinion on Undertakings for the Collective Investment in Transferable Securities (UCITS) share classes, along with the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation and the amended Markets in Financial Instruments Directive (MiFID II), have profoundly impacted the industry.

ESMA’s opinion on UCITS share classes introduced several principles related to currency overlay.

With the “common investment objective”, ESMA clarified the type of hedging that should be applied to UCITS funds by defining the scope of applicable hedging practices at the class level. And, the “non-contagion” principle sets boundaries to mitigate the contagion risk across share classes—for example, ESMA has set some maximum thresholds for the hedge ratio.

The PRIIPs Regulation and MiFID II added further transparency. With its “best execution” disclosure requirement, MiFID II guided the market towards better trade efficiency. With PRIIPs, Hedging transaction costs are now disclosed to investors, allowing the performance impact of these services to be reported.

Over the last 6 years, the average hedging transaction costs have dropped from 12 basis points (bps) per year to 5 bps for a monthly roll G10 currency overlay.

We have observed a strong link between the level of costs and the hedging thresholds disclosed. The drop in costs has enabled asset managers to tighten the hedging thresholds applied, as they could allow more frequent adjustment trades.

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Technical and operational improvements

Another market trend is the growth of process automation, together with the controls and risk monitoring related to hedging.

Asset managers are replacing manual processes with integrated or automated solutions to prepare the trades to instruct on the market. FX hedging providers have developed tools allowing asset managers to monitor and adjust their hedging parameters, including web-based solutions.

In recent years, the number of automated tools assisting different stakeholders to closely monitor hedging has mushroomed. As a result, we observed in the survey that the percentage of respondents monitoring critical hedging KPIs daily has surged from 25% in 2015 to 85% in 2021. These daily controls not only improve the quality of the hedging applied, but also reduce tracking errors of the hedge classes. 

In our 2021 survey, 78% of asset managers received a performance attribution analysis, compared with 42% in 2015. The quality of the reporting has also grown, with respondents considering more types of hedging impacts.

FX hedging processes used

This year’s findings also uncover significant improvements in participants’ hedging procedures compared with 2015’s survey, with technical and operational enhancements reducing tracking errors.

Asset servicers are offering new features to asset managers to reduce different hedging effects. For example, trade splits are offered to reduce the market impact of rollovers, especially on less liquid currency pairs.

The early realization of forwards allows asset managers to reduce the unrealized profit and loss (PnL), which could significantly affect performance if the hedging PnL represents a large portion of the portfolio. Of our 2021 respondents, 67% said they were able to close their hedging positions in anticipation to crystalize the unrealized PnL. Some asset servicers or hedging providers allow asset managers to set up a threshold that will trigger an automatic realization.

New challenges on the horizon

This year’s survey has uncovered some new challenges for our respondents.

Assets managers are increasingly eager to understand and track the various effects on hedged classes, either through a detailed reporting solution or a digital dashboard with interactive features.

Asset servicers and hedging providers have begun offering more frequent reporting to improve the flexibility of their offering. While most currently available solutions only provide performance attribution for standard share class hedging, asset servicers are looking to provide performance attribution for other types of hedged products.

As asset managers broaden the scope of hedging offered, such as portfolio hedging at the class level and benchmark exposure hedging, FX hedging providers are set to develop additional controls over the next few years to monitor the impacts of these new types of hedging.

The different stakeholders involved are looking for integrated hedging tools, such as the computation of hedging adjustments, trading and reporting.

Another challenge faced by asset servicers is the increase of active/discretionary hedging by some clients. While ESMA's opinion on UCITS share classes has prohibited this hedging type for UCITS funds, alternative funds and segregated mandates are seeking more flexible hedging strategies. Such hedging can be passive and rule-based, or active and based on the investment manager’s view of the FX market.