Private market fund managers “are likely leaving money on the table” because they are not sufficiently shopping around for a foreign exchange (FX) provider, and firms might have more FX exposure at portfolio level than they realise, Javier Llamas, sales manager at Monex Europe, a commercial FX specialist, stated in an interview.

Kangkan Halder: Luxembourg’s FX market has experienced significant growth and undergone notable changes in recent years. Which particular changes have captured your attention the most, and why?

Javier Llamas: A notable difference is the proportion of turnover related to institutional investors. Luxembourg has the largest FX turnover in the EU related to institutional investors in both absolute and relative terms, with institutional investors driving 25% of the volume in Luxembourg, compared to 10% for Germany--the next largest.

What factors contribute to Luxembourg’s FX market being noticeably distinct from that of other EU member states? Do these differences have any discernible impact on institutional clients?

Luxembourg’s regulatory framework, robust services sector and high concentration of experts makes it an attractive jurisdiction for institutional investors to structure their funds through over other EU member states.

Due to the substantial size of the private equity market in Luxembourg, managing currency related risks has to be high on the agenda.

If any part of a fund manager’s investment strategy is to invest outside of the base currency of the fund, at a minimum, investors require them to demonstrate that they have thought about FX strategy and give them the option to manage FX risk over the life of the fund.

Ultimately, FX considerations come down to whether macroeconomic exposure is a factor in the investment decision.

It is paramount in the constantly shifting and challenging global economic conditions we are currently experiencing that managers have a robust FX policy in the place.

With the evolving FX market, Luxembourg undoubtedly faces both opportunities and challenges. In your opinion, what are the main opportunities and challenges that Luxembourg currently encounters?

Due to the increased volatility and macroeconomic uncertainty, investors face a higher risk of value erosion from currency movements than a few years ago. According to the , Luxembourg institutional FX demand (measured by turnover) has increased far quicker than the level of assets under management, more than doubling between 2019 and April 2022, while assets under management grew around 40% over a similar period.

As exchange rates have become more volatile, the importance of FX risk management has grown.

We believe however that Luxembourg financial institutions and industry are likely leaving money on the table because for FX execution there is still a very heavy reliance on the traditional institutions, where business focus on FX activities is low and hence pricing is poor.

We see a huge cost and efficiency opportunity for those institutions who currently tie their FX trading into their traditional banking relationship. On Luxembourg’s annual FX volumes, a saving of just 0.05% on execution costs would be around €45m (of which €11m for institutional investors).

This money would then stay in the pockets of Luxembourg businesses, or in the profits of the investment funds.

Considering the current volatility in money markets, what potential exchange rate risks exist, and how can Luxembourg address them?

If we turn to private equity and asset management, there are four elements to consider regarding exposure to FX risks.

First, would be the initial exposure in the form of a commitment and the subsequent currency element of an investment; second, is the translational value of the underlying investment; third, is the yield generated by the investment; and fourth, is the exit and the distributions that could occur as a result.

There are multiple points where these four exposures may arise depending on which asset class the fund is investing in.

At portfolio level, a firm that is investing in assets outside the base currency of the fund creates a forex exposure for the fund itself from the moment it enters into those investments.

Funds that run share classes in different currencies to the base currency of the fund are also exposed to risk. The exposure is linked to who the underlying investors are, the types of investors, the size of the fund, the strategy and the attitude of the manager.

The Chinese renminbi has been gaining traction as a currency for non-euro and non-dollar transactions, particularly among Chinese exporters. How does this trend fare for Luxembourg and the euro area as a whole?

This phenomenon has taken place over the past two decades, mainly amongst reserve managers, but has recently picked up pace following the war in Ukraine and America’s weaponisation of the USD financial system as a response.

We’re not just seeing Chinese exporters re-basing trade in CNY, but also a lot of Bric nations (Brazil, Russia, India and China) and Middle East exporters looking to diversify out of the dollar, and as a by-product the euro too.

While these developments have largely happened at the periphery and aren’t overturning the global financial system as a result, the political nature of cross-border currency settlements definitely poses a risk to global usage of the euro.

However, we would caution that these trends tend to be very long term, unless they are sped up by geopolitical events as seen in 2020.

Looking ahead, what are your expectations for the future growth and potential bottlenecks in Luxembourg’s FX market?

We anticipate a substantial increase in proactive and dynamic forex management solutions to be implemented on a more widespread basis in the private equity industry as a whole, over the coming years.

We feel that in an era of rising interest rates, the likes of which we haven’t seen for 15 years, along with rising inflation and heightened geopolitical risks, costs are being pushed higher and investors are demanding more from their managers.

Efficient FX risk management enables managers to meet the expectations of investors from a regulatory, prudential capital and reputational perspective. All of this ultimately helps managers protect investors from non-core investment risk, delivers greater capital efficiency and can help protect yields.