Currency exchange in relationship to trading in different instruments
February 24, 2021. Stefan Willebrand.
Time to address a hot topic regarding currency exchange in relationship to trading of various financial instrument types. There is no right or wrong here and there are many ways to do it, I will simply try to describe a few valid options in this article.
Ultimately it comes down to how the end customer, the investor, would like to interact with their investment activities and most preferences are possible to accommodate, it just comes down to development.
Let’s start with investing in mutual funds. This is the ultimate retail product and designed for ease of use with all the complexities taking place within the fund, that is part of why the fund must charge fees in one way or another to cover its activities.
No matter if the fund units are traded in USD, EUR or SEK the investor has become used to placing their orders in the currency of their own liking. If a German based investor wants to invest EUR 1,000 in a US-based mutual fund they should be able to place an order that details the final investment amount, and any currency exchange is expected to occur automatically.
The fund itself could publish different units for different currencies and then manage the currency exchange internally. Another common practice is for the broker, or the fund network that is used, to conduct a currency exchange, this usually introduces a larger spread between the bid and ask quotes for the currency exchange but on the other hand the amount is usually small. A clearer way to do it would be for the investor to first conduct a currency exchange where the right currency is obtained at the best possible exchange rate and then to use that cash to buy the fund units in the currency that they are traded. This cuts out the middleman from the currency exchange and becomes less costly. This is kind of the same thing as when you go to the ATM machine at the airport to get cash and it asks you if you would like the ATM operator to conduct the currency exchange or if you would like your custody bank to do it. To make that choice you would like to receive a comparison of what rate will the ATM operator give you and what rate will your custody bank give you, but you never get that option.
These two options will result in a difference in how the exchange rate will be reported on the trade note to the investor. In the “lazy option” where the currency is exchanged “automatically” in conjunction with the order the exchange rate could be reported on the same trade note as the trade. In the more cost-efficient option, the currency exchange is a separate event altogether and should have a trade note of its own.
Now let’s look at equities. As opposed to mutual funds, where the fund accepts the actual purchase amount and allocates fund units to the investor, an equity trade involves purchasing a number of shares. The shares are often traded in real time on a stock exchange so it cannot be known exactly at what price the trade will be able to execute. Because of this it is not possible to know exactly how much cash the purchase will consume so the most efficient manner is to first buy the shares and then conduct the currency exchange to cover the resulting deficit.
Enter the concept of “Cross currency buying power” and “Cross currency margin”!
To be able to make a trade the investor must have some sort of asset in their account which could be used for purchasing other assets. In the example above the investor might have deposited EUR 1,000 into the account and wants to buy shares of Apple which will consume USD. If the shares are currently trading at USD 125 per share and the conversion rate between EUR and USD is 1.22. The investor will be able to buy 9 shares of apple, consuming USD 1,125.
If settlement is made two days after the trade (T+2) the conversion from EUR to USD should be made before the settlement date or the account will have a deficit in USD, which by the way could be ok from the perspective of the broker since there are enough EUR available in the account to cover the trade, the buying power is there and the cross-currency margin to settle the trade.
From the perspective of the investor a currency exchange could then be made separately after the purchase is made because at that time it will be known exactly how much USD is needed. With regards to trade notes there will be one trade note for the trade and a separate trade note for the currency exchange, clear as crystal.
How about the other alternative, could the investor be offered to buy shares of Apple by entering an amount in EUR? Sure, the broker would then be able to make some extra money on the spread for offering this service. What would happen in practice in this case is that the broker will get the order to buy EUR 1,000 worth of Apple shares. The broker will first buy the shares without having to put up any cash since settlement will occur in two days. With the execution in hand the broker will perform a currency exchange for the required amount on behalf of the investor at an exchange rate spread.
The full EUR 1,000 will not be used since partial shares is not used here; fractional shares is a whole different topic though. On the trade note for the investor the equity trade will be shown together with the exchange rate that the broker gave to the investor.
Personally, I like decoupling the currency exchange from the trade, as an investor I like to have the choice and the information about the exchange rate so that I can decide upon it and as a broker I like to give full transparency to the investor. Again, no rights or wrongs, just a few different options.
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