Fine-tuning Corporate FX Management
With higher interest rates and global geopolitical tensions, corporate treasurers must ensure that their approach to FX risk management is suitably robust for this challenging environment.
The past few years have seen a fascinating evolution in the processes corporates employ to manage FX. Since the onset of Covid at the beginning of 2020, a series of events have added significant complications to the market. The pandemic triggered a colossal shock of volatility, and subsequent geopolitical events have sparked other market challenges in different areas of the world and across specific currency pairs. And while central banks pushed up interest rates to try to tame inflation, this significantly impacted the cost of hedging.
Andy Gage, Senior Vice President, FX Solutions, Kyriba, reflects: “What many clients are struggling with is hedging programmes built before Covid and in a zero-to-low-interest-rate environment. Now they’re having to think if they should be doing this process differently.”
While many central banks have been remarkably co-ordinated regarding their monetary policy to this point, any future policy divergence or other unexpected data or events may introduce uncertainty into the markets, which can have a knock-on impact on FX. The recent snap French election is a testament to that.
Lisa Dukes, Co-Founder, Dukes & King, explains: “Heightened uncertainty has affected corporates by adding a layer of unpredictability to their financial planning and risk management strategies.”
This has necessitated more dynamic and responsive FX management practices to mitigate potential adverse impacts on the company’s profitability and financial stability. “Treasurers must be even more vigilant, being ready to adapt to rapid currency fluctuations, ensuring they can protect the company’s margins and maintain competitive pricing,” Dukes adds.
Given the geopolitical systemic risk, the macro backdrop does not suggest that FX volatility will soon return to the pre-Covid lows. This should be a critical concern for treasurers, as FX volatility can significantly impact their organisations’ finances.
Eric Huttman, CEO, MillTechFX, highlights: “We ran a survey last year that showed around 70% of UK corporates experienced an impact on their bottom line due to currency volatility.”
Aim for continuous challenge and review
The first item to consider when appraising a treasury’s approach to mitigating FX risk is a review of the currency management policy to ensure it is fit for the contemporary environment. Treasury FX policies must strike a balance between flexibility and consistency. While consistency across all markets provides a standardised approach, tailoring policies to specific markets and currencies is often necessary to address specific risks and opportunities.
Dukes affirms: “By utilising best practices – such as the FX Global Code – to underpin the policy, a robust, standardised framework can be achieved enabling corporates to stand ready, from a position of strength, to flex as the market or currency demands.”
Established by a working group sponsored by the Bank for International Settlements (BIS), the FX Global Code provides guidelines to ensure that all market participants can operate confidently and effectively, maintaining high integrity, transparency, and professionalism standards. The Global Foreign Exchange Committee, which includes central banks and private sector entities, reviews and updates the Code every three years to keep it relevant. This year, the Code is under review, with updates expected later.
Similarly, for treasurers, an effective hedging approach should include continuous challenge and review, as this is necessary for policies to stay aligned with market dynamics, changing exposures, and company strategy.
“A regular review cycle is critical to ensure that policies remain relevant and effective, and treasurers should be prepared to adjust policies to reflect current business needs, growth aspirations, and market conditions,” Dukes notes.
From a transactional FX perspective, the policy should consider that cross-currency payments will always be needed. Certain unpredictable events might not be included in the hedging policy, and even activities that might be thought of as routine may not be covered.
Alex Wong, Head of Product Management for Corporates, Global Payments Services, Bank of America (BofA), elaborates: “Treasurers should think about dividend payments and OpEx [operating expenses] requirements, for example.”
Around the payments piece, there is a need for efficiency and convenience. Some transactions may be relatively small and therefore slip below a formal FX policy. However, including these payments in the policy should still be considered.
“Payments that might fall below the threshold for FX risk management are normally those for suppliers or customers,” notes Wong. “But in those scenarios, a treasury could still make savings, improve payments efficiency, and help trading relationships.”
Be a sophisticate
Treasurers at the cutting edge are recognising that markets have changed over the past few years – after the raft of black swan events – and are adapting to the new normal. This manifests through upskilling or seeking expert support to adopt sophisticated hedging techniques to manage FX risk more effectively. One way this sophistication manifests is by using options and forward contracts.
Dukes outlines: “By incorporating both options and forward contracts, treasurers can secure worst-case protection while also targeting better rates for future trades. Utilising derivatives, including options, in this way and focusing on creating value across the portfolio to manage risks more holistically, means treasury teams can be prepared for whatever the market throws up next.”
A further differentiator for sophisticated treasurers is how they manage forward curve exposure. With longer-dated exposures, thinking about the components of that exposure is critical. “This may involve looking at solutions to hedge interest rate differentials, capturing value from favourable forward curves, and derisking future hedging against uncertainties including potential central bank divergence,” Dukes notes.
Credit risk management is another area where treasurers can differentiate. Using derivatives to limit or cap credit line exposure ensures that the ability to hedge remains intact, even when market conditions shift unfavourably for the existing portfolio positions. “No one wants to deliver the message that you have been stopped out on hedging when it is more attractive to extend the hedge,” cautions Dukes.
For treasurers who do not hedge or follow a rigid percentage-based hedging approach, it is vital to remain flexible and responsive to market changes. A fixed strategy might lock in losses, which ultimately increases the risk to the business or prevent the treasury from securing opportunities to de-risk. A more dynamic approach can better align with evolving market conditions.
Treasurers keen to take a more risk-based approach to their FX management and use that to drive a hedging programme must first align internally with the company’s auditors and executives. Once this has been achieved, the hedging programme can be fine-tuned by applying it to the company’s historical FX data.
Kyriba’s Gage emphasises: “Regression testing helps ensure that the new approach is going to perform by comparing it with how the scenario actually played out. That’s a vital foundation. Once everything has been approved and the approach has been tested, it is crucial to codify this in the hedging policy.”
Immediately prior to implementation, it is important to ensure there are clear metrics that treasurers can report to management. These metrics should show the programme’s successes to all involved and help them understand any issues that arise.
“If there are deviations outside of expectations, treasury must have proper reporting in place to explain those metrics,” emphasises Gage. “They need to be able to do that in a way that calms any stakeholders who are uncomfortable with the process or don’t understand FX.”
Any exception outside of the policy framework should be clearly explained, along with what mitigation steps the treasury will take to return to acceptable levels.
One tactic for organically minimising FX exposures that has been popular with treasurers for many years is netting. This is where the exposure in one currency is offset by exposures in the same or a different currency elsewhere in the business.
Wong reveals: “We’ve seen an increased uptake of FX netting solutions by clients in recent years, particularly in healthcare, global industrials, tech, media, and telecom.”
This has been partly led by this continuing trend of treasury centralisation and IHBS [in-house banks]. These companies are utilising multicurrency notional pools. Netting complements this method of liquidity management and satisfies the need for just-in-time funding.
On the development side, netting efficiency has improved, particularly when integrating with ERP systems.
“The gathering of the accounts payable and the accounts receivable information is better facilitated,” BofA’s Wong points out. “The dispute process has also sped up because many netting systems now include dispute management.”
Bhupen Velani, Head of Global Transactional Foreign Exchange Trading, BofA, provides some context around the efficiency scale the right netting programme could deliver for corporate treasury.
“We ran netting analysis for a client recently, showing them what impact implementing multicurrency netting through our solution might have,” Velani recalls. “On average, they would have seen a 75% reduction in FX notional traded, close to a 90% reduction in transaction settlements, and more than 97% fewer FX trades they would have to complete. For a treasurer, that’s music to their ears.”
These compelling numbers highlight that netting can be a valuable tool when offsetting exposures of the same type and tenor. However, this does not mean netting is a panacea for all FX risks.
Dukes warns: “When there are differences such as exposure type, accounting treatment, tenor or profile of underlying exposures, netting should be approached with caution to avoid unexpected and unwanted volatility.”
Finding the counterparty sweet spot
Following the banking turmoil in spring 2023 involving the collapse of Silicon Valley Bank and Signature Bank and the takeover of Credit Suisse by UBS, albeit due to different factors, corporate FX counterparties have been under great scrutiny. Treasurers are now checking that they have enough diversification of their counterparty base.
MillTech FX’s Huttman outlines: “If we ask our client universe, ‘Are you looking to diversify your FX counterparty base?’ the vast majority of them, around 80%, say, ‘Yes’. The question then is how to apply that desire with the realistic constraints that exist.”
The most significant constraints come from banks wanting to provide more than a small element of a single service to their corporate clients. For a medium-sized company looking to set up 20 different trading lines purely for FX, in reality, they’re trading one-twentieth with each bank. Several banks might not even accept them as a client in that scenario. This leaves treasurers looking at how to access many underlying banks in the most operationally efficient way possible. The challenge is not to inadvertently add operational risks while trying to solve counterparty risk.
“We recommend treasurers should have at least three FX counterparties,” Huttman reveals. “But then, once the counterparties are in place, managing the split between them requires thought.”
For example, a corporate might have lines with three banks, but for best execution reasons, they have all their exposure with one. The treasurer may assume they are safe because they think they have the other lines. However, if they have yet to use those lines, there is a question as to whether they still have them due to their inactivity.
“At the other end of the spectrum, does the treasurer split their exposures evenly across the three banks at the expense of best execution?” Huttman asks. “That’s also not ideal. Corporates need something in between that can give them that flexibility.”
Another consideration for treasurers with their FX counterparties is that not all banks price the same. Treasurers must thoroughly analyse the transaction costing, as this could be a critical differentiator between potential counterparties.
Gage notes: “Bankers will often ask corporates if there is a way that they can achieve more volume with them. Treasurers are arming themselves with excellent analytics within their treasury systems, so they can reply that they are open to that conversation, but they have to examine their prices. That’s where transparency is key.”
Tech support to the rescue
Transaction price analysis is one example of technology revolutionising treasurers’ approaches to FX. Tech is enhancing both efficiency and risk management.
Dukes elaborates: “Automated trading platforms, advanced analytics, and algorithmic trading tools help treasurers to execute trades more efficiently and at better prices. Technology also facilitates real-time monitoring of FX exposures, automated hedging strategies, and improved reporting capabilities.”
The desire to automate manual processes is keenly felt by treasurers who want to drive efficiencies and reduce risk across all their processes, including FX. There are several drivers of this desire.
Huttman reflects: “The top three comments that we hear most frequently as reasons to eliminate manual processes is to reduce costs, including execution costs, eliminate silos, and reduce the operational risk.”
Companies are striving to get rid of the concept of gridlock, which is a function of silos caused by different people using different processes and different systems.
Gage enthuses: “Corporates are looking to have robust, straightforward systems that are very well connected, which break down the silos to provide a much more fluid and dynamic set of capabilities. That’s as applicable in FX as it is for the rest of treasury planning.”
It should be no surprise that, as with overall treasury digitisation, APIs are playing an essential role in helping to facilitate the movement of data in FX processes.
“APIs provide information from banks for liquidity and risk management purposes and also pull data out of the ERP system internally,” Gage adds. “They are making treasury the central nervous system of the business, and one that’s well connected with internal and external resources for a gamut of treasury and risk management processes.”
However, while technology enhances productivity, treasurers must maintain a deep understanding of the underlying processes and risks.
Dukes advises: “The focus of technology should be on improving the quality and speed of data, efficiency of execution, and supporting infrastructure to free up more time to consider the risk in the context of all other information available.”
Protecting against FX headwinds
The first step to achieving best practice for FX management is for treasurers to define the challenge they wish to overcome. Once that is established, the next step is quantifying the company’s FX risks. Are some risks so small that the effort to solve them would not be worth the time and resources? That question will vary from company to company. When those questions have been answered, treasury can begin to formalise its FX risk management approach.
Huttman highlights: “When the issue has been defined, and the risks quantified, treasurers can then build a policy, execute it, make sure to measure it well, track the right elements, and then revise it as necessary. All of that can be wrapped in a technology layer to achieve it in the least manual way possible.”
While there is no one-size-fits-all for best practice FX risk management, BofA’s Velani outlines common themes among all leading treasury approaches.
“It is all about data and automation,” he points out. “Having the right data in your hands promptly helps make better-informed decisions. Then having automation from front to back, including FX booking automation, operational and reconciliation efficiency, and tying it all into the ERP or TMS.”
A combination of strategic foresight, flexibility, and technological integration underpinned by a policy governance foundation puts treasurers in the best possible position to protect their organisations from FX headwinds.
Dukes suggests: “It’s important that treasurers regularly review and challenge FX policies, ensuring they remain aligned with current market conditions, company strategies, and integrate the FX Global Code as a policy requisite.”
Diversifying the mix of hedging instruments used is another positive way to mitigate risk. Treasurers can achieve this by combining options, forwards, and bespoke solutions to manage different aspects of FX risk that are suitable for the exposures being managed. At the same time, there can also be a focus on value creation.
“Use derivatives not just to secure a P&L rate but to create a corridor of P&L certainty and unlock value,” urges Dukes, who notes that building and maintaining strong relationships with banking counterparts can help achieve smooth execution and better pricing.
She concludes: “By adopting these practices, treasurers can better navigate the complexities of FX management and contribute to their organisations’ overall financial health and strategic objectives.
