Special FX: Taming Foreign Currency Risks Through Automation and Innovation

26th May 2022

There is never a dull day in the treasury profession, especially when volatility is rife in the currency and commodity markets. The flipside of this dynamic environment is the very real threat of financial losses – arising from poor hedging decisions, or outdated practices, policies, and systems. Here, two experts from NatWest share the inside track on how treasurers can better manage FX risks by shaking up legacy processes and old-fashioned thinking, improving data collection through APIs, and embracing automation.

In 2021, there were high-profile, and frankly eye-watering, examples of costly hedging decisions – with some corporates being caught off guard by market movements and geopolitical events, and others pursuing a risky ‘no-hedging’ approach. A large FMCG player, for example, faced a $2.3bn increase in raw material, freight, and FX costs for the fiscal year as a result of its decision not to hedge[1].

Meanwhile, in the first quarter of 2022, treasurers have already experienced some significant challenges in the currency and commodity markets, with the Russian invasion of Ukraine adding complexity. Fabio Madar, Global Head of FX Sales and Structuring, NatWest Markets, explains: “Volatility is certainly high at the moment. But we’ve seen similar choppiness in the currency market during previous crises, so this level of market risk is not new per se.

“Nevertheless, treasurers are also grappling with significant sanctions on Russian entities. In turn, this has led to settlement risk for anything in roubles. This is not normally a huge concern for treasurers as it is typically taken care of by established mechanisms in the market, but suddenly, in February and March 2022, settlement risk became very ‘real’.”

Companies immediately started exiting financial positions with Russian counterparties, explains Madar. “And now, corporates are exiting entire businesses in Russia, and writing off stock bases.” With this kind of activity, there are much bigger concerns than just FX risks – there is nationalisation risk, the risk of licences being removed and capital being seized, for example.

The commodities conundrum

The Ukraine crisis has also contributed to rapidly increasing oil prices, which were already on the rise as a result of inflation, supply chain constraints and the ESG-driven transition to cleaner energy. Price rises naturally lead to increased interest in hedging.

Nick Pedersen, Head of Digital, NatWest Markets, comments: “Certain corporates are starting to demonstrate concerns around commodity risk further down their supply chains, given the magnitude of the energy crisis. This is something that they might not have originally been anticipating, and it inevitably has a knock-on effect in terms of FX.”

Avoiding hedging pitfalls

So, how can treasurers hedge effectively in this tinder-box environment? And is hedging ultimately worth it?

“There is no easy answer here,” admits Madar. “Hedging decisions carry significant risk and can go wrong, especially when markets turn suddenly. Take the example of the impact of Covid-19 lockdowns on the retail industry. Corporates based in the UK that were buying from China for high-street retail operations were buying US dollars and selling sterling as per usual and had hedges in place, which were efficient in ‘normal’ times. When the lockdowns began, however, the retail market collapsed – and some corporates saw huge losses as a result.”

Another area where corporates have been stung recently is in hedging – or rather not hedging – emerging markets. “Even the largest, most sophisticated corporates get this wrong,” says Madar. “One of the biggest tech companies in the world recently missed its projections because it did not hedge emerging markets because its exposure seemed small at ‘just’ 10%. But when 10% of the exposures move down by 30%, that’s a 3% hit.”

Underlying these hedging decisions that have not worked out, says Madar, is a fundamental flaw with exposure data. “Many corporates don’t know their exact exposures – sometimes they confuse the settlement currency with the economic currency. Take the earlier example of the UK corporate purchasing Chinese goods in US dollars. What they see in their system is an exposure in US dollars; in reality that is actually an exposure in renminbi [RMB]. Why? Because the supplier is in China and if the dollar goes down or up, they will change their price because US dollar directly impacts the renminbi.”

Another challenge is the fact that many ERP systems are not actually all that good at capturing FX exposures, especially where companies have different versions of that ERP across various regions. “One European corporate we worked with discovered a billion dollars that they did not even know existed before we started looking at their exposures for them – with the issue being down to their ERP.”

Improved decision-making

What all of this means is that, when looking to hedge, data is the number one concern. Having the right data, in the right place, at the right time is critical when making informed hedging decisions.

According to Pedersen, numerous corporates lack confidence in the exposure data – and therefore are reluctant to automate their FX flows. Certain sectors are, however, more confident in their data. “Take online merchants, for example. They are very confident in their ability to automate because the data they obtain from credit card sales is so rich and easily accessible. As such, this sector is pushing for greater automation and keen to implement it end-to-end.”

In contrast, those in the manufacturing sector are often dealing with unstructured invoice data, which needs to be cleaned and cross-referenced. “In this environment, the data is not trusted, and this creates a roadblock around automation in the eyes of the company.” But there are ways to overcome this impasse.

Box 1: Leaving Excel behind

As an aside, Pedersen notes that many treasurers still use spreadsheets to manage FX exposures. This creates roadblocks in what could be a relatively seamless process, and leaves room for manual errors and delays. As such, for corporates wanting to embrace automation to the full, Pedersen encourages corporates to choose a forward-thinking software vendor and a digitally forward bank that has a good relationship with the vendor. “Relationships are arguably just as important as technology when it comes to FX automation,” he suggests.

APIs and automation

Pedersen continues: “Technology has been extremely effective on the execution side of FX for a long time, and much of this is API led. Now, API services are being made available at the pre- and post-trade points, enabling much richer data capture.”

With enriched data effectively on tap via an API, it is much easier for corporates to better understand their FX exposures – and the true level of risk they are facing, including around transactional FX. “This works across all sectors. So, the manufacturers that I mentioned earlier can leverage an API to plug into their invoice platform, and the bank can then be permissioned to access that data, and make sense of it on behalf of the corporate. This whole process is, of course, highly automated – removing any need for manual intervention.”

Similar API developments are happening on the back of open banking, whereby financial institutions can be permissioned to access account data across multiple banks, enabling an aggregated snapshot of financial positions to be compiled at the touch of a button – with files ‘pulled’ in a standardised format. Again, this is extremely useful in assessing FX risks and making informed decisions. It also requires little effort from the corporate because the bank does the heavy lifting.

While this type of solution is currently being leveraged by certain mid-cap and smaller corporates, Pedersen maintains that, over the coming 12 to 18 months, corporates of all sizes will likely expect their bank, or their technology partner, to display all of their own data back to them.

NatWest already uses APIs to embed the bank’s FX services into the customer’s existing TMS or ERP. This enables seamless transactions and also helps the customer to achieve best execution. Interestingly, APIs and automation can also be leveraged to bring the level of pricing transparency that corporates expect for their main FX risk to transactional FX. “There is no longer a need to split these two elements of FX. At NatWest, we work with a number of innovative partners that can deploy the APIs and automation to enable a single treatment for all FX transactions – regardless of their size,” says Pedersen.

Thinking differently

After sourcing the required data and examining automation options, the next step in improving hedging decisions is to review risk management strategies in line with the hedging policy. “Unfortunately, there are often blind spots in corporate hedging policies, leaving treasurers with limited solutions to call upon,” notes Madar.

Frequently, this leads treasury teams to focus purely on their biggest FX exposures. “This is understandable, but also flawed. Smaller exposures can be extremely risky – as the earlier example of the global technology company demonstrates. Transactional FX might also seem like a small conversion every time an international payment is made, but when these are aggregated, the financial impact can be significant.”

Pedersen agrees, adding that “many treasury functions have an arbitrary cut-off point for what they should investigate and hedge, and what they shouldn’t, based on volume. This cut-off is often largely influenced by the ability for them to capture data. But outdated policies that are too restrictive do not help, either. This narrow approach can lead to price and operational inefficiencies”.

As such, corporates may wish to turn their attention to re-evaluating policies in light of the challenges Covid presented – and the need for greater flexibility in hedging during uncertain times. Treasurers should also re-examine how they prioritise their FX exposures, Madar believes. Rather than simply looking at the volume of exposures, assessing the volatility-adjusted volume will provide “a more accurate picture to base hedging decisions on”.

Another mindset shift Madar sees as necessary for improving hedging decisions is the focus on risk rather than cost. “All too often the cost of a hedging contract is the deciding factor for a corporate – especially now that technology enables such transparency around pricing. And if the cost is deemed ‘too high’, large risks are left unhedged – leaving organisations open to hits.

“What’s more, there are always different avenues to explore in terms of hedging instruments. It’s better to have the conversation with your bank about other, potentially cheaper, hedging instruments than to decide not to hedge – there are innovations happening that could suit your needs in terms of cost and risk.”

ESG and new hedging avenues

One such modernisation is the integration of ESG into the FX space. Pedersen comments: “ESG has rapidly become part of the fabric of banking, and the corporate treasury profession. As such, there is a clear need for sustainable solutions that go beyond the basics of green finance and sustainable deposits – into the world of FX.” NatWest has been an early mover here, with a project between the bank and Drax to implement ESG-linked FX derivatives being a prime example.

Madar describes ESG-linked FX derivatives (which can be anything from forwards to options)  as “essentially, a new way to hedge.” Under the solution, the corporate defines ESG KPIs and if these are not met, then a small penalty must be paid. “This approach is not only beneficial in terms of contributing to the sustainability goals of the wider organisation, but because of the penalty, it helps to focus the mind on ensuring that the correct hedging strategy is being applied.”

Taming the tiger

As 2022, the Year of the Tiger, rumbles on, it is clear that treasurers have much to consider when it comes to better managing their FX risk. There are many creative avenues to explore – from APIs and automation to new mindsets around hedging costs, and the use of ESG-linked FX derivatives.

Of course, there is no one-size-fits-all approach. Pedersen comments: “Every corporate will have different priorities – but treasurers all have the same opportunity right now. Post-Covid, they have a mandate to re-evaluate FX strategies and challenge legacy policies and practices, armed with the potential benefits that could be gleaned from leveraging enriched data thanks to APIs and automation.”

Madar agrees, but cautions that “technology is fantastic, but it is not the be-all and end-all when it comes to FX risk management. People are essential too – collaboration and communication between the corporate and its bank are paramount for successful hedging. All of these ingredients are needed to efficiently and effectively tame FX risk.”  

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