With increasingly wide yields between developed markets and emerging markets (EMs), investing in EM assets can yield attractive returns. However, when deploying an investment strategy in these markets, global investors must be cognisant of the FX restrictions that may be associated with the underlying currencies.
Failure to heed and understand the implications of these constraints may have significant consequences.
“The real challenge and risk to accessing these currencies is that, if it’s not done properly, it can lead to equity or bond settlement failures,” says Vincent Bonamy, the global head of FX intermediary services at HSBC.
While some EM currencies are freely accessible on par with their G10 counterparts, those to which restrictions are applied are commonly linked to an underlying equity or bond trans-action with the FX leg of a trade merely becoming a by-product of the original transaction.
“There are common restrictions across some of these currencies,” says Bonamy, “but there remain diverse specificities around pre- and post-trade conditions, tax, and cash management implications among these markets – and that can be a real challenge.”
While navigating the myriad local regulations related to certain EM currencies can be a daunting task, optimising the execution of FX transactions on the back of a bond or equity trade requires due consideration of the liquidity conditions in the country in question.
“It’s very important to ensure FX execution happens during periods of optimum local market liquidity because the depth of liquidity, and therefore bid-offer spreads, in EM currencies can vary significantly throughout the trading day,” explains Robert Winmill, head of institutional FX sales for Hong Kong and FX solutions for Asia-Pacific at HSBC.
This can be particularly challenging for US-based investors who wish to access Asian markets that are only open during the local time zone. In this regard, timing is of the essence.
When optimising FX execution in line with local liquidity conditions, investors need to understand that they are absorbing the currency risk into their underlying trade if FX is not transacted simultaneously with the equity or bond trade.
“This is particularly relevant for fixed income investors and passive funds where any delay between executing the bond or the equity trade and the related FX execution can have a significant impact on the economics of a trade and increase tracking error versus a benchmark – particularly during periods of market volatility,” points out Winmill.
At HSBC, we’re fortunate to be both a leading onshore FX liquidity provider and an onshore custodian in many EM currencies
– Robert Winmill, HSBC
Investors also need to clearly understand other factors that can impact their FX transaction costs in EM currencies, he says. These include the FX execution methodology employed, how spreads are applied and whether netting buy and sell trades is permitted. If netting is permitted, investors need to understand the implications because bid/offer spreads can be significant in certain currencies – particularly on larger orders – and paying both sides of that spread can be an expensive proposition.
Here, detailed knowledge of the onshore regulations becomes very important.
Partnering with the right provider
Given the complex nature of navigating the multitude of challenges in executing FX transactions in emerging currencies, many global investors have had the tendency to outsource execution to third-party providers.
But, with the advent of best execution requirements, an increasing number of international investors have been exploring alternative models and have taken a more active approach to funding and hedging their EM currency exposure.
They often seek a partner, such as HSBC, to help them navigate this process.
“HSBC’s real strength and uniqueness,” explains Bonamy, “is that we can give clients access to emerging and frontier market currencies on a global scale. We offer them global access to EMs by leveraging our local presence and expertise, and by simplifying the process as much as we can.”
Ultimately, he says, investors are finding that partnering with a bank that is able to deliver significant onshore liquidity and a deep knowledge of the local landscape is the most effective way to optimise their FX access to EM currencies.
“At HSBC, we’re fortunate to be both a leading onshore FX liquidity provider and an onshore custodian in many EM currencies,” points out Winmill. “That EM expertise has enabled us to develop specific FX access solutions for global investors.”
Globally, the bank’s local teams are well placed to help investors navigate the dynamic nature of FX regulation and are able to adapt FX solutions to optimise opportunities that might arise from evolving regulation.
As such, the recent changes to regulations on accessing onshore currency markets in China and Malaysia are particularly notable.
“It is now common for investors to execute EM FX directly with our local FX desks in the majority of Asian currencies, accessing onshore liquidity and market expertise directly,” concludes Winmill. “We offer investors the abililty to align their FX funding or hedging trades with execution of the related bond or equity to mitigate FX market risk and costs.”