Foreign exchange (FX) is one of the most obscure asset classes for ERISA and governmental plans (as well as other institutional investors). The FX Global Code is an important development. The FX Global Code is a set of good practice principles for both buy-side and sell-side participants. It is also voluntary in nature. So, why should plan fiduciaries be aware of it? First, plan fiduciaries that invest in international securities will most likely hedge their exposure to that local currency. So while FX is rarely used as a source of alpha for plans, it is often used defensively. Second, FX is the largest market but probably the least understood. It’s long been obscure, I think. So what are some of the key principles?
(A) a clear understanding of whether a market participant acts as a principal or agent in executing a transaction;
(B) a need to handle orders with fairness and transparency, which includes making clear whether the prices quoted are firm or indicative, time stamping policy, etc.;
(C) pre-hedging as a principal only and in a manner that does not disadvantage the customer;
(D) understanding how reference prices are established;
(E) whether a markup is fair and reasonable (e.g., how much is the spread?); and
(F) having an effective compliance framework governing FX activities, including processes designed to identify and eliminate abusive or manipulative practices, escalation procedures once issues are identified, etc.
Not all of the principles in the Code apply equally to participants, but they do reflect a consensus (for the most part). A plan investment committee may wish to ask its investment managers whether it’s a signatory to the FX Global Code and how they intend to comply with it, and whether those managers will engage dealers on applicable principles.