An independent asset manager takes on volatile FX markets

The ever-changing investment environment places considerable demands on asset managers. Clients with long term liabilities – such as pension funds, endowments and insurance companies – have had to diversify their investments more internationally in recent years. That introduces an element of currency risk that tends to increase a portfolio’s volatility without increasing its return.

To address this issue, 7orca Asset Management actively manages its clients’ currency risk, employing a quantitative and risk management-centric investment process. This enables its clients to profit by extensively hedging when a foreign currency depreciates. Customers can take advantage of a currency appreciation by a diminishing hedge ratio.

“FX futures are a reliable and exchange-regulated instrument,” says Holger Bang, head of portfolio management and co-founder of 7orca. “They appeal through a combination of transparent execution, the guaranty of CME Clearing and a standardized process for settlement and clearing.”

Bang uses the case of U.S. dollar risk. The CME Euro FX future is a highly liquid instrument, with an average trading volume of 336,000 contracts per day in Q2 2018, a 66 percent increase over the previous year.

Founding and First Mandate

7orca was founded in 2017 by seven partners with experience in currency risk management. Having worked together for many years, they have a large market network and experience achieving their clients’ investment targets. The firm was granted full permission as an asset manager in November 2017.

It started by managing the active currency overlay of VZB, the pension fund for the Berlin dentists’ association. It now has 12 team members managing ten client strategies with assets under management of €960 million, with a goal to grow that total significantly.

7Orca, located in Hamburg, Germany, currently has €964 million under management

The Choice of Instruments: FX Futures vs FX Forwards

Bang observes that the choice between using FX futures on an exchange or OTC forwards, privately negotiated contracts, depends on the specific circumstances of each client and that both instruments have their advantages.

“For clients who, for example, hold large exposures in EUR/USD and have already set up a clearing broker for trading their equity futures, it makes sense to present hedging via FX futures,” he says. In this scenario the client already has the necessary infrastructure and the FX overlay can almost be implemented on a plug-and-play basis.

In addition, clients can benefit from netting effects on margins if they are already trading futures on the same exchange. For example, positions in equity futures may move in your favor while you are losing on your currency positions. Being on one exchange will lead to a netted margin payment, which can be more efficient paying out gross amounts.

Large professional institutional investors, like pension funds or insurance companies are also mandating specialized asset managers like 7orca to manage their currency exposure though overlay mandates. Mandates are typically high in volume, usually exceeding €100 million and often going up towards €1 billion, adds Bang.

“Our approach is to set up both FX futures and the counterparties for OTC forwards. Consequently, the client achieves maximum market depth, a diversified structure with the greatest possible independence and future security with regard to regulatory challenges and changing market conditions.”

High Liquidity

When asked to assess the liquidity situation of FX futures and OTC forwards using EUR/USD as a reference, Bang estimates that if daily FX trading volumes are approximately $3 trillion, spot and outright trades account for half of that total and EUR/USD represents a quarter of that reduced volume, daily EUR/USD liquidity is somewhere in the region of $375 billion.

“Much of this liquidity is inaccessible as there is no one central platform or bank where you can access the entire daily trading volume, but the figures clearly show the high liquidity of the market,” he continues.

Bang refers to clear differences between the execution of FX futures and OTC forwards, noting that OTC forwards are generally concluded bilaterally between the client and the OTC broker. To ensure best execution, several brokers are asked for their bid-ask price and the client trades at the best price shown.

“FX futures are usually not traded with a specific counterparty, but via the exchange’s central limit order book, which provides access to a wide variety of market participants beyond banks,” he adds. “By trading via the order book, we have the possibility to work the order and potentially trade a considerable share of our volume on average at mid-rate.”

A Greenwich Associates study found that the buyside market participants on whom the sample was based, executed just over one third (35 percent) of their trades on the exchange on average at mid-rate, which tallies with 7orca’s experience.

In the event of restricted liquidity, 7orca obtains liquidity in the OTC market and transfers it to the corresponding future. “This sounds complicated, but it is not,” concludes Bang. “The price is determined off-exchange between 7orca and the liquidity provider. The two parties implement the price by trading a future. We use either exchange for physical or block transactions.”

CME Group has recently launched a tradeable spread, called FX Link, that allows clients to facilitate this transfer by simultaneously trading OTC spot and FX futures.

Bang says adding FX futures to their client toolkit has enhanced the service 7orca provides.

“Together with our clients it enables us to select the best instrument in terms of cost and benefit.”

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