FOR MOST OF this decade, many corporates took it for granted that foreign exchange was a low-volatility product that was easy to hedge. That notion has been shattered. “The moves in the market over the past few months have resulted in many more corporates thinking about and trying to quantify their FX risks,” says Rashid Hoosenally, global head of FX structuring at Deutsche Bank.
The rise in FX market volatility has served as a rude reminder to corporates with currency exposure of the wisdom of prudently managing FX risk. Companies in Brazil, South Korea, Poland and Mexico have seriously mismanaged FX exposures and reported huge losses as a result. This was either through their own incompetence or, more worryingly, because they were ill-advised on hedging by banks.
Hoosenally says: “Many of the problems [corporate losses] we’ve seen have not resulted from the fact that the instruments they’ve used were necessarily inappropriate, it’s that the quantification of their risk has turned out to be inaccurate. In some cases that has created a mismatch between the underlying exposure and the hedges.”
Hoosenally argues that corporates have been hit by an increase in FX market volatility coinciding with a severe economic turndown. “The actual underlying exposures are subject to variation because of the unpredictability of sales and counterparty risk – there’s much less predictability in the underlying FX risk,” he says. “And then there’s much more volatility in the actual FX itself. The two of those combined have occasionally resulted in problems.”
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“Six months ago, 85% of our business was done on FXall, but as the spreads increased, we’re better off calling up one of our banks” Stefan Nobel, SKF |
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The buy side is not homogenous. Corporates differ, so banks have to adapt their services. “There’s no such thing as a common corporate, they all have different requirements. But there is one common theme and that is that they all require what could be simplistically described as access to good prices,” says Clive Banks, head of corporate derivatives and FX at BNP Paribas. “That encompasses several things, including spreads, access to liquidity and provision of credit. When clients have to do something – when they need to hedge – they need banks which can provide all of these things.” European-based corporates consulted by Euromoney suggest Hoosenally’s and Banks’s views are accurate. It also seems that corporates have extremely realistic expectations about what the sell-side can deliver. According to Stefan Nobel, chief dealer of FX and interest rates at bearings manufacturer SKF, the level of service has been quite consistent. “The banks have been active in trying to help us out,” he says. “Maybe they are pushing it a bit more. I think the banks like our business.” SKF is active in more than 130 countries and transacts about $100 billion of FX a year, so it is not surprising that Nobel should be well looked after. But his comments are similar to those of the treasurer of a privately owned Italian company that transacts about $2 billion of FX each year. “The level of service has been the same. The problem is not really from the banks, but from the market itself,” he says. “Prices have widened and sometimes disappeared, especially around expiries in some currencies, such as Ukraine hryvnia and Russian rouble. It’s sometimes been difficult to get quotes from any banks, but I don’t think that’s a problem of specific FX desks.”
According to Nobel, companies have become more reliant on trading electronically, and prefer multi-bank to single-bank platforms. “We mainly use FXall,” he says. “Six months ago, around 85% of our business was done on FXall, but as the spreads in the market have increased – for example, if we want to trade a big amount of EUR/SEK or EUR/NOK – I think we’re better off calling up one of our banks and asking them to do the amount.”
The banks might like to see corporate business flowing to them on their own portals but the corporates have different ideas. And it is not just about control and compliance. “We haven’t decided to use bank platforms. We think they [platforms] should be bank independent,” says Nobel, adding that SKF did use one single bank offering a few years ago. “All our banks want to give us good information – it [a single-bank offering] didn’t really help us to make any money. It makes sense for us to spread trades around five banks – we get more information back that way.”
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“I’ve taken it for granted that we would trade electronically and process trades automatically. But it’s a different market now” Hans van den Bosch, Unilever |
Another impact of the back-to-basics approach of picking up the telephone to trade is on straight-through-processing rates. “We are very cost conscious,” says Hans van den Bosch, global head of treasury operations at Unilever. “We have always been very focused on electronic dealing to make sure we have a high level of straight-through-processing and that we spend as little time as possible on human intervention in processing, especially for smaller tickets. Historically, we reached a level where around 90% of our transactions were done electronically. Now, it is different because of the markets. Banks have reduced the size they will auto-quote in. I’ve taken it for granted that we would trade electronically and process trades automatically. But it’s a different market now, so I can’t assume that any more. “I need to review how to do things,” says van den Bosch. “I need to readjust. Whether we are paying the right price is not clear. But it is like a pendulum and it needs to recalibrate. Perhaps we have been too much STP-focused and efficiency seeking and now we must look at things from a different angle.”
Not necessarily more vanilla
For the moment, there appears to be more use of less-complex instruments. “There has been a move back towards more simple, vanilla products,” says BNP Paribas’ Banks. “That’s not to say that we’re not providing more complex, structured solutions, but there has been a greater use of products such as swaps and outrights.”
This has come at a time when the wisdom of using options to hedge FX risk has never been greater. “There’s arguably a need for more optionality in hedging, but this is at a time when many are moving towards using more vanilla products,” says Deutsche’s Hoosenally. “Derivatives are what you make of them. We’re very focused in trying to show clients that far from being weapons of mass destruction, properly designed derivative strategies are far less risky and offer far superior risk control than, say, forward strategies. The majority of the work we’ve done in structuring and engaging with our clients is around encouraging them to put much more flexibility into their hedging programmes than they have done historically. That can be a slow process to do and clients have to justify why such strategies at the moment look expensive. They are expensive for a simple reason: they are valuable. The challenge is to get an appropriate flexible strategy that is affordable and has the right accounting treatment.”
Hoosenally says corporates have not closed the door on more complex products. “They are listening. This is not about today or tomorrow, it’s about the entire hedging policy of companies. It is not about individual trades. It’s really at a strategic and policy level that this has to be addressed. I would love to see corporate treasurers and CFOs agree policies with their boards that allow them to use more option strategies into their hedging mix, because while it may appear to impact their hedging rates negatively at the outset, over time it will greatly reduce mismatches and negative surprises.”
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“There’s no such thing as a common corporate, but they all require access to good prices” Clive Banks, BNP Paribas |
BNP Paribas’ Banks says that corporates are not as unwilling to use options as is sometimes reported. “The level of expertise at the corporates has definitely risen,” he says. “I recently had a chat with a CFO and he talked at length about what he expected and what he wanted from some target redemption forwards his treasury had put on.” However, although the negative impact of accounting standards such as FAS133 and IAS39 on corporate hedging is often played down, treasurers do have to consider them. “We especially use options, because we want the maximum flexibility in our FX management,” says the Italian corporate treasurer. “We have a very specific FX risk management policy, but we’re not so worried about the balance sheet impact of international accounting standards. That doesn’t mean we don’t care about them, but it means we won’t compromise hedging as a result of IAS requirements.”
Hoosenally argues that the economic wisdom of using options should be considered more important than compliance with accounting standards. “I feel that it is important to get the economics of the hedge right,” he says. “Of course, it’s appropriate to get the accounting treatment as close to the economics as possible. But if it was a choice, I’d get the economics right and then explain that to shareholders.”
Many corporates, though, are more likely to err on the side of conservatism. “We rarely use any types of option structures,” says SKF’s Nobel. “We do sometimes use risk-reversal structures. When we hedge we tend to trade in maturities of between three and 12 months in our main risk, which is the US dollar. Even risk reversals can be difficult to use, though, because of hedge accounting.”
Unilever’s van den Bosch says that he has no need to use options. “Our risk management is relatively simple in the instruments we use – they are very plain vanilla, such as FX spot, forwards and non-deliverable forwards. We don’t use any options for our normal hedging programmes,” he says. “In my view there are two main reasons to use options – when there’s uncertainty about the underlying cashflow and positions you have. For Unilever that is not really applicable, as we can forecast our positions with a relatively high degree of confidence. The second element is that you use options to protect the downside, but we have a risk system in place where we decide wherever to actively hedge or not.”
In contrast, Cédric Cornec, head of front office of Alstom’s corporate treasury, says he is happy to use options, which account for about 20% of his hedges. However, while he is generally satisfied with the service he receives, the nature of Alstom’s hedging has led to other issues. “Looking at recent developments, spreads have got wider and we’re cautious about that. But we’re also extremely cautious about our counterparty risk. Our position cycle is very long. Typically our hedges have maturities of three or four years, but we sometimes go out even further to 10 years. The spreads on these have widened even further and do impact on our costs.”
Banks lack innovation
Cornec says there is little differentiation in what he is offered by his banks. “I don’t think the banks are that innovative. They all tend to offer pretty similar products and solutions. Typically, they’ll try to get us to agree break clauses, say after one year, or collateral agreements, but we’re not really interested.”
Credit has become an issue and it is possible that it will lead corporates to consider making greater use of options, rather than the underlying market risk. Van den Bosch says: “Globally we use over 20 banks, but 95% of the business is concentrated with around 10 or so. We use certain banks for specific currencies when our core banks might not be able to offer us the service we want. The basic thing about credit is still the same. We’ve always emphasized relationship banking. We don’t look for the best deal on a single-transaction basis. We have what we call our golden circle. It has 10 group-one banks and they all participate in a standby, committed facility to Unilever. In return we give them preferential access to our business. In principle, that has not changed, even in this current crisis.”
The control of credit by the banks has frequently been cited as a reason why they did not want the market to move towards a single, centralized location that made use of a central counterparty. It remains to be seen if things have changed to a degree where a CCP will be embraced, but if it frees up trading and funding lines it will be taken far more seriously than in the past.
“One of the things we’ll see this year is that intensity of coverage will be driven as much by the extent to which counterparty risks increase,” says Jim O’Neill, co-head of risk solutions group, EMEA, at Barclays Capital. “Because of the increases in volatility and scarcity of liquidity both within the banking system and for corporate clients, counterparty risk has become a very hot topic.”
O’Neill points out that while vanilla products such as forwards and swaps may be easy to account for, they can be credit intensive. “The use of strategies where clients are net buyers of optionality can be more credit efficient,” he says. “Clearly the more exotic the structure becomes, the credit profile can increase. But as a general rule, option strategies can create credit efficiencies for both the client and the bank.”
He adds: “When the market is less volatile, clients tend to do less because although hedging costs are low, they don’t see there’s a great deal of risk. The market dislocation in 2008 did however encourage some clients to enter the market to hedge on a more active basis. Restructuring activity is also running at increased levels.”
Reality bites
There seems to be a sense of reality about why banks have at times widened their spreads. O’Neill says: “I think that the reality has hit the street that capital and liquidity were mispriced and undervalued. Clients and banks have become acutely aware that liquidity is a scarce commodity. Given that some bank counterparties have fallen away from active market-making, some of the resulting illiquidity has been reflected in greater hedge costs.”
Unilever’s van den Bosch says: “We’ve seen a widening of spreads. There’s a higher level of risk. I think we maybe got too used to trading in a world where things appeared risk-free. This crisis has shown that is not true and risk has been reassessed. The markets are not always as stable as we might have liked to think.” But have the banks been fair in their pricing? “That’s difficult to say,” he says. “Volatility is clearly much higher, but it is not possible to judge at this stage if the prices we are seeing are a fair reflection of that.”
Alstom’s Cornec agrees. “It’s too early to say [about the fairness of pricing] and I think if the banks had done their jobs properly before, spreads wouldn’t be so wide now,” he says. “The job of a banker is to take some risk and extend credit to their clients. I think it’s regrettable that at the moment they have to be so concerned with reducing both of those. If I ranked the banks now out of 10 I’d give them six. Before, they were eight. In the past, not all of them were listening to what we wanted, but they are doing that much more now. They switched their attention from corporates to financial institutions, but now they’re interested in what we’re doing again and that’s a good evolution.”
That’s good news for banks. Zar Amrolia, global head of FX at Deutsche Bank, says: “Risk premia in the global economy are not going to diminish in the short term. So currency risk will remain significant for the foreseeable future. Most CFOs will have to measure and manage this. We’ve seen a change in attitudes over the past three to four months and now I think that will lead to a huge change in behaviour over the next three to four months. We are now being approached by clients we have not worked with previously.”
