Henry Vaughan

A common assumption amongst finance and treasury professionals is that, by adding new foreign exchange (FX) counterparties, one increases competition, and by increasing competition, one gets access to better FX pricing. This initiative will provide a company with the opportunity to diversify their counterparty risk and access further credit for forward purchasing. However, the answer as to whether this process helps corporates to achieve better FX pricing is not “black and white”. Here are a few factors to consider: 

Is your bidding process optimal? 

SME’s typically do not have access to multi-bank FX dealing platforms (e.g. 360T, FXAll, FXGO). These systems give their users quotes from all their available counterparties in real-time, enabling them to select the best price at a click of a button. 

Without such systems, CFOs and Treasurers face the onerous task of benchmarking quotes from several Banks and brokers via multiple channels (online, phone, e-mail). Not only is this process inefficient, but the time-lag created by waiting to receive all these quotations means that companies are incapable of comparing their counterparty’s pricing on a level playing field. This is because the mid-market exchange rate, the benchmark used for comparing pricing, is never static, fluctuating on a second-by-second basis. 

The end result is this; yes the CFO or Treasurer will select the best quote offered to them during the bidding process, however, that quote may not be the best quote that was available to them at the exact time they decided to execute the trade. 

In this example, the company requested quotes from 5 different counterparties at 17:36. In the 4 minute window thereafter, quotes were received in c.30-second intervals. From the start to finish of the bidding process, the GBPUSD exchange rate moved in a c.15 pip range which is not uncommon, even in such a short timeframe. 

Whilst the CFO or Treasurer would argue that they obtained the most competitive exchange rate offered to them (HSBC – 1.2365), they cannot argue, with certainty, that they dealt at the most competitive exchange rate available to them at the time of execution. This is because the basis point cost for transactions varies between their counterparts (1bp to 10bp). If quotes were benchmarked in real-time at 17:39:30, Western Union would have won the deal, not HSBC, resulting in the company achieving a rate of 1.2373 vs 1.2365, an $8,000 cost-saving. 

So, let me ask you a few questions. Has this client benefited from having five, competiting counterparties? Does this type of bidding process consistently reward counterparties that offer the tightest basis point spreads? If not, what is the incentive to offer competitive pricing? 

Reduced wallet share and the impact on spread cost

Whilst currency brokers are solely reliant on FX flow for revenue, Banks are not. From their perspective, they will look more holistically at revenue generation across all auxiliary services offered to clients and adapt pricing in each service accordingly to meet their targets. If, for example, a corporate decides to stop placing FX deals with their relationship bank in favour of an FX broker, that bank will lose revenue. To make up for that lost revenue, the bank is likely to adapt the pricing of certain auxiliary services to account for that loss, for example, by increasing interest rates on their debt or overdraft facility, or increasing basis point spreads in their interest rate hedging. Yes, adding a new FX broker may result in access to more competitive pricing on FX transactions, but CFO’s and Treasurers need to be mindful of the consequences of placing significant amounts of business outside of their relationship banks. 

Conclusion

In this article, we explain that adding multiple FX counterparties does not necessarily equate to improved FX pricing. Although it seems logical that, through a competitive bidding process, firms would adjust their pricing lower to win more business, they may be unwilling to do so. Firstly, if their client’s FX volumes are low, or reduced due to them distributing their flow amongst several firms, it may become uncommercial to offer highly competitive pricing. Secondly, if the bidding process the client has in place often rewards counterparts for offering less competitive pricing, then motivation to adapt pricing lower will be reduced. Client’s cannot control how markets will move during a bidding process, nor can they guarentee that they will recieve all their quotes in real-time. They can, however, have influence and control over the number of FX counterparts they deal with, and the pricing those firms offer them. The latter can be achieved by using FX TCA tools to consistently monitor the competitiveness of their counterparties pricing, using the analysis to continually review and re-negotiate terms. If their pricing is consistently competitive amongst all their counterparts, client’s can at least guarentee that they have obtained the most competitive quote at the point of execution. As corporates grow, they can then start to refine their bidding process to make it more fair, utilizing systems such as 360T or alternative multi-bank FX dealing platforms.

If you would like to understand how our team can help with your execution process, get in touch with us today on +442037438358. We’d be delighted to help.

The question above is frequently asked by treasury professionals who are responsible for protecting their company’s revenues and profits from adverse fluctuations in exchange rates.

Broadly speaking, the goal of a professional FX risk management strategy is to ensure that a company has downside protection in the event that currency markets move against them. When assessing whether a company has implemented “the best” FX hedging strategy, it is worth reviewing the following checklist: 

• Is the performance measurable?

  • It is impossible to say whether an FX hedging strategy is effective without it being measured against key performance indicators (KPIs). These could include the level of risk reduction achieved, overall cost and expected liquidity impact from margin requirements.
  • The best FX hedging strategies can demonstrate effectiveness against predetermined KPIs, in all market conditions.

• Does it balance hedging policy objectives and constraints?

  • When undertaking FX hedging a Treasurer has the ability to set multiple parameters including hedge tenor, hedge ratio and the derivative instrument used.
  • There is no perfect combination that will work for every company. The best FX hedging strategy should optimize the expected outcome based on each company’s individual circumstance and predetermined, measurable KPIs.

• Is it repeatable? 

  • A strategic hedging policy and process should be defined and implemented beforehand to create a framework that can deliver consistent results, regardless of future currency market moves
  • Whilst a hedging strategy can include some element of opportunism and take tactical input based on market conditions, this should be done within a consistent, repeatable framework.  
  • Implementing speculative hedging activity based on daily newsflow or sharp market moves is just that, pure speculation. 

• Does it incur additional risk?

  • Treasurers and finance teams should ensure risks are not being repackaged through derivatives to appear elsewhere further down the line.  
  • There are plenty of examples where derivative solutions sold by transactional FX providers (banks and brokers) result in a client incurring significant unexpected losses (see link).  
  • Remember that if a specific product seems too good to be true, it probably is! 

A final point to make clear is that no-one can consistently and reliably predict the future direction of currency markets. FX hedge funds and other aggressive trading firms like Goldman Sachs often lose large sums of money attempting to profit from this type of speculative activity. It comes as no surprise, therefore, that predictions from FX analysts at Banks and FX brokerage firms often turn out to be wildly incorrect. As a Corporate Treasurer or CFO, why take the risk of making a speculative decision on the timing of your hedges based on an emotional bias or attachment to a “favorable” rate? Getting the timing wrong could well have greater negative consequences than the upside from a correct prediction.

Measurable, repeatable reduction in risk due to successful currency hedging will benefit all stakeholders and increase the chances of long term business success. Adhering to the principles above should enable every business to implement the best possible FX hedging strategy for their unique set of circumstances.  

If you feel like your strategy needs improvement, or you’d simply like greater visibility into its performance, get in touch with our team today on 02037438358. We’d be delighted to assist you. 

Introduction

Since early last year, I have spoken to a large number of Finance Directors (FDs) and Treasurers who, at least at the outset of our discussions, have mistaken Bondford to be a foreign exchange (FX) brokerage. I can completely understand why they might think this, as the meaning of the word ‘independent’ is not always intuitive when it comes to FX service providers. Furthermore:

1. The majority of sales calls FD’s and Treasurers receive regarding FX services are from FX brokers (e.g. MoneyCorp, Western Union, and AFEX). It is unlikely that an SME has ever been approached by an independent currency hedging adviser, as they typically focus their attention on larger corporates and institutions. In turn, FD’s and Treasurers may understandably assume that any company approaching them to offer “currency hedging advice” or related services must be another FX broker looking for transactional flow. 
2. There may be some confusion between the term “independent adviser” and “independent business”. Independent businesses are classified as being private, not publically owned. An independent adviser is something that, in this context, has an entirely different meaning. We’ll explain this in more detail below, but in short, a brokerage can be an independent business, however, they cannot offer “independent” hedging advice. 

This article attempts to explain the difference between FX brokers and independent currency hedging advisers. We’ll discuss why we feel that it is important to seek independent advice regarding your currency hedging, and we’ll conclude on some next steps for those considering engaging an independent consultant. 

What is an FX broker? 

An FX broker acts as an intermediary between their clients and a panel of Tier 1 banks, leveraging their purchasing power and lower operational costs to help clients, particularly SMEs, gain access to wholesale, competitive exchange rates which are typically reserved for larger corporations. 

In addition to offering currency exchange services, FX Brokers have the ability to offer flexible credit facilities for forward purchasing, international payment services, and currency hedging advice. These auxiliary services are often used as a means to differentiate themselves from other FX brokers and to justify higher commissions. Some brokerages may even market themselves as “currency risk strategists”, but ultimately their revenue is generated by converting currency, providing credit facilities and making international payments. 

Brokers are paid through a transactional “spread”. This spread is calculated based on the difference between where they buy from their panel of banks to where they sell to their clients. Costs are highly opaque and difficult to measure without FX TCA tools (see blog on this topic here). This business model creates a conflict of interest between the client and broker, as the latter is directly incentivized to:

1. Maximize commission or spreads on FX transactions
2. Promote hedging products or strategies that are highly profitable to them, but do not necessarily address the needs of their clients

As the brokerage market becomes ever more saturated and competitive, these firms are seeing margins in their straightforward spot and forward FX business being squeezed. As such, cases involving the mis-selling of foreign exchange hedging products are frequently evident and clients are susceptible to poor practice, due to the incentives outlined in points 1 and 2 above.  

For an example of this, please see this case-study on Newstar Garments who were mis-sold target accrual redemption forwards (TARFs) by their FX brokers, causing $5 million in losses.  

What is an independent currency hedging adviser?

An independent currency hedging adviser provides expert, impartial guidance to its clients when they are assessing and selecting FX hedging products and related risk strategies. 

Acting as a fiduciary, the adviser’s role is to ensure that clients are well educated on ‘all’ hedging products and solutions that are available to them, and the potential impact each decision may have on their business. In particular, they help to protect clients from being mis-sold unsuitable hedging products or strategies by their Bank(s) or FX broker(s) that:

1. Are unnecessarily costly
2. Are unsuitable or overly complex
3. Will not help them to accurately achieve their commercial and/or risk objectives. 

Independent currency hedging advisors act as a true extension to their client’s finance function and are specialists in managing exchange rate risk. Using their extensive product and strategy expertise, in tandem with their independent positioning, they are best positioned to offer clients highly effective, robust hedging solutions that will accomplish their unique objectives at minimal cost.

Independent advisers are paid in consulting fees which are clear and transparent. To maintain their impartiality, zero revenues are generated from FX brokerage, either directly or indirectly. Clients of independent advisers are therefore not required to “move business away” from their relationship bank(s) which can often result in higher auxiliary service costs. Their business model ensures complete alignment of interest between the client and adviser. 

Why corporates should seek ‘independent’ currency hedging advice?

Here is a summary of why a corporate may choose to engage an independent hedging adviser: 

1. Independent hedging strategy expertise
   • By combining risk management expertise with their independent positioning, advisers provide their clients with confidence that their hedging strategy has been comprehensively and impartially considered against all alternatives and the selection made is the optimal choice to ensure they achieve their commercial and/or risk objectives 
2. Lower FX trading costs 
   • By utilising independent advisory tools and market expertise, clients are better positioned to scrutinise and negotiate the pricing offered to them via their Bank(s) and/or FX broker(s) 
3. Reduced counterparty risk 
   • By receiving independent guidance on which counterparties are more creditworthy to trade with, clients can minimize the risk of default on hedging contracts
4. Reduced workload and operational risk
   • Service enables clients to focus on their core business and have experienced consultants do the “heavy lifting”
5. Improved performance visibility 
   • Clients have better visibility into the performance of their hedging strategy as an advisor can provide measurement tools

Next steps

Have you questioned the suitability of FX hedging products or strategies sold to you by your Bank(s) and/or FX brokers? Would you be interested in gaining an independent perspective on the effectiveness of your currency hedging strategy? Would you like to know how much FX costs you on an annual basis and the potential cost-savings that could be achieved?

Contact us today to get a free TCA report or schedule a free introductory call with one of our experienced strategy consultants. We’d love to hear from you.

Introduction

On June 4th the European Central Bank (ECB) published a significant academic journal titled “Discriminatory Pricing of Over-The-Counter Derivatives” that we recommend as essential summer reading for corporate CFOs and treasury teams. Please see the journal link here, or for those keen to get to the point, please read the rest of this article and the FT.com summary here. 

In conclusion, the authors demonstrated that foreign exchange (FX) dealers, including major high street banks and FX brokers, are systematically and consistently overcharging corporate clients who lack currency trading expertise. In some cases, fees are as much as 25 times higher, with certain clients paying 50 basis points on contracts which other companies pay just 2 basis points. See below an example which highlights the impact on total brokerage costs in US Dollars when comparing two trades of equal size with differing spreads (as above).

Why is this happening?

Transaction costs will always vary slightly between clients due to factors such as trade size, type, liquidity, tenor and counterparty creditworthiness. Nonetheless, we frequently observe large price disparity between clients of seemingly similar credit standings entering into similar transactions of equal size. But why?

The journal refers to a concept of “friction”, which essentially describes the conflict of interest between the two opposing parties in an OTC transaction. On the one hand, you have banks and FX brokers whose business, and incentive, is to offer the widest spread the client will accept in an attempt to maximize their profits. On the contrary, corporate clients want to reduce their spreads to minimize input costs (COGS) or the drag on foreign currency earnings. 

There are a number of challenges CFOs or Treasurers face when it comes to getting a quote on an FX derivative contract: 

1. Opaque pricing
   • The OTC FX market is opaque, particularly when looking at the pricing of FX derivatives. This opacity makes it easier for FX dealers to disguise additional, hidden spreads, in turn helping them to generate more profit. 
2. Lack of specialist FX expertise
   • CFO’s and treasurers often lack specialist knowledge of what a “fair” price is for any particular trade, making it hard to know when or when not to accept or negotiate. 
3. Lack of competition
   • SMEs, in particular, have fewer relationships with alternative banks and brokers that can provide benchmark pricing and help to increase the competitiveness of FX quotes.

What can be done to avoid paying higher spread costs?

“Measurement is the first step that leads to control and eventually to improvement. If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it.” H. James Harrington

Many SMEs may find that the optimal setup is to continue trading with their relationship bank with an increased focus on monitoring and scrutinizing their execution performance. This can be achieved by engaging an independent supplier of FX transaction cost analysis (TCA). Ongoing FX TCA can create immense value for clients who are looking to have visibility and control over an opaque fee structure and make significant reductions in their execution costs. As per Mr. Harrington’s quote, how can you begin to improve a process that you can’t measure? 

At Bondford we are looking to democratize access to FX TCA tools, helping SMEs to achieve more consistent, competitive FX pricing. If a bank or broker knows that their client is engaged with a supplier of FX TCA, they too know they have lost their information advantage. Derivative pricing for their client is no longer opaque and they are incapable of widening spreads without it being noticed. From this position, clients are also better able to enter into meaningful discussions and negotiations, both with their existing counterparts and new ones. 

Next Steps?

Are you concerned that you are being overcharged by your bank or broker? Would you like to know how much FX costs you on an annual basis and the potential cost-savings that could be achieved? Contact us today to get a free TCA report. We’d love to hear from you.

Hedging currency risk with derivative contracts such as forwards and options can be extremely effective, as tenor and notional can be set to match underlying risk exposures.

However, in some cases firms can reduce currency risk via ‘natural’ hedging.  In the simplest case this involves netting forecast foreign currency expenses against forecast foreign currency revenues.  Some firms will take this into consideration when structuring business operations, for example by installing a production cost base in the same region as a foreign currency revenue exposure.

A second method of naturally hedging currency exposure is to raise debt in foreign currency so foreign interest offsets foreign revenue.  It may make sense to issue foreign currency debt when the following criteria are met:

1. The company actually needs to borrow
2. Foreign currency interest rates are similar or lower than domestic rates and there is no material difference in credit spread for foreign currency borrowing
3. Repayment terms (timing and size) provide suitable offset to exposure cashflows with minimal unintended consequences

Let’s examine each of these in turn:

1. It doesn’t make sense to borrow to create offsetting liabilities unless there’s a business need to raise debt. Deciding on the optimal capital structure of any enterprise depends on multiple considerations, particularly the relative cost of capital. Raising debt in itself adds other risk in the form of interest rate risk and strict cashflow requirements to service. It would therefore be very unusual for this strategic financing decision to be driven by possible currency hedging benefits.
2. Rates should be lower. Put simply it is unlikely to make sense to reduce currency risk via debt issuance if it comes at a significantly higher cost of borrowing. However, looking at it the other way around, if foreign interest rates are much lower, in itself this can be an excellent reason to take foreign debt. For example a corporate in a high interest rate environment (e.g. Philippines or India) borrows in a low interest rate currency such as USD or especially now, EUR. In certain cases these loans are taken out even if there’s no corresponding USD or EUR revenue, simply because the rate is far lower than domestic rates and even though this will create a new currency risk of the foreign liability.
3. The repayment terms should be considered. On the one hand, issuing a short term (1-3yrs) amortizing loan could provide maximum revenue offset and minimum balance sheet remeasurement risk. However, this would leave the exposure unhedged at the end of the loan term.  Alternatively, a non-amortizing loan with a balloon repayment of principal at the end would more effectively provide longer term hedging but it would be subject to greater balance sheet remeasurement effects.  A key consideration here is whether the company has any long-term foreign currency investments to offset (assets, equity, physical assets, goodwill).  Companies that have overseas assets and foreign revenues are more likely to borrow overseas and benefit from hedging cashflow exposure (via coupons) as well as asset remeasurement (via principal liability remeasurement).

As with many aspects of currency risk management, in addition to the points above there are a variety of additional considerations to think about including extra administration and country risk associated with issuing foreign debt, overall leverage ratios and relative tax rates.

Many companies don’t fall into a ‘standard’ box and may desire input and analysis before deciding on the optimal course of action to manage foreign currency risks. Our approach at Bondford begins by identifying and quantifying exposures both in terms of cashflow and balance sheet. This exercise enables us to then and compare different mitigation strategies relative to objectives and KPIs (for example forwards vs. foreign debt issuance). With these tools we are able to then define and calibrate a suitable currency risk strategy for each client.