FX risk management faces volatility challenge

By:
Paul Golden
Published on:

The sheer volume of risks faced by the FX market is placing pressure on banks to create mitigation strategies to cover a wider range of market challenges, from Brexit to illiquidity.

Brexit, China’s economic slowdown, the continuing emerging markets/commodity crash, this year’s US election, negative central bank interest rates – these are just some of the most important risk factors affecting FX markets.

The problem for banks, suggests Synops chief engineer Paul Stafford, is that at the same time their customers have become more demanding in expecting risk management to limit volatility while liquidity constraints have reduced participants' ability to access the market to react to risk.

"Cash flow hedging techniques work best when extended over long periods, but long-tenor derivatives carry much higher spreads and margin due to bank risk aversion and increased oversight," he says. "Even balance-sheet hedging (with just 30-day tenors) can strain the credit capabilities of FX brokers."

ADS Securities chief dealer Paul Webb agrees that key liquidity providers shrinking their risk appetite at the same time as clients are becoming more sophisticated in their use of tools such as low-latency trading algorithms makes risk management more challenging.

The most notable change in the market so far this year, according to Henry Wilkes, co-founder of Institutional FX Advisory Partners, has been a combination of demanding market sentiment with high volatility caused by swings in stock markets and commodity prices causing headaches for risk managers struggling with real-time mark-to-market valuations and credit lines.

"Reduced liquidity (while less pronounced in the spot market than forwards) is an issue," he explains. "The significant reduction in the number of banks willing or able to take on market and credit risk has resulted in a reduction of core primary liquidity providers concentrated on the major global players surrounded by a plethora of secondary liquidity providers."

This has been seen most acutely in the forwards markets where cost of capital and credit risk are a major factor resulting in clients finding it difficult to hedge their risk at competitive prices, particularly for large exposures.

"We are seeing a trend to move to larger and more comprehensive systems, where technology can be used seamlessly to conduct pre-trade and post-trade analytics to help optimize performance," says Tod Van Name, Bloomberg’s global head of FX and commodity electronic trading.

Vendors have found it difficult to respond as they are incapable of exerting an impact on most of the risks they face, suggests Gary Wright, CEO of BISS Research. "Venues equally have struggles with liquidity and this may be influenced by the quality of collateral available that has a straight line to the OTC clearing and margining requirements."

Wilkes refers to "huge disparities" in the ability of banks to track risk comprehensively, while acknowledging that even the most sophisticated risk models can be caught out by extreme market events. "There is a premier league of major banks that have the resources and risk appetite to build sophisticated risk models and can clearly track risk comprehensively, but there are many others who still struggle with complex structures and markets," he says.

Van Name agrees with Wilkes’s observation that, outside the top-tier banks, most institutions are finding it challenging to get the budgets, staffing or time to build increasingly complex technology solutions. "As markets become increasingly regulated, they are also looking for a partner that can provide seamless access to a variety of regimes across multiple asset classes," he says.

Brad Bailey, an analyst at Celent, offers a relatively upbeat assessment, suggesting that the continued move to electronic trading and the focus on capital usage and credit extension is creating a much more robust infrastructure for a broader and more holistic view on risk.

He says: "Vendors are responding by offering tools for liquidity takers to utilize increasing data streams for better analytics and those who are making resource-constrained buy and sell sides more effective are doing very well."

Stafford suggests that the real issue is not the ability to track risk since treasury management and enterprise resource planning systems can report the mark-to-market for exposures (booked and forecast) and derivatives as well as providing other metrics such as unhedged value at risk.

"It is about what methodology is used to select the tenor and notionals of the hedges themselves – in other words, what strategies are used to manage risk," he says. "A secondary concern is ensuring hedges remain effective and selecting proper accounting rate methodologies to ensure that the strategy produces the expected results."