A New Dimension to FX Dealing

by François Masquelier, Head of Corporate Finance and Treasury, RTL Group, and Honorary Chairman EACT

Banks are seriously contemplating credit-adjusting the prices they quote on FX derivative transactions. The credit parameter to be included in price quotes would have a significant impact on the cost of hedging, unless corporates use collaterals. It may turn out to be one of the consequences of the current financial crisis.

Is the price right?

In the future, treasurers will have to consider the potential extra margin to be included in forward FX transactions to reflect the credit risk faced by bank counterparties. As is the case in the famous game show created by Fremantle, the question to be asked is whether the price is right. Is the FX pricing fair, given the current market situation? For more than two years, some cautious financial institutions have already been quoting higher and longer maturity FX deals, to reflect the greater risk taken. However, one of the unexpected or unsuspected consequences of the current financial crisis is or could be a significant increase of FX pricing on longer periods. Dealers are beginning to think more seriously about credit-adjusting the prices quoted on FX derivatives in general (‘derivatives’ sensu lato, as defined in IAS 39).

The pressure on banks may force them to adjust pricing up on longer period FX transactions to include this credit risk element. It means that, leaving aside swap points and interest differentials, the longer a forward deal, the more expensive it will be (higher margins). This evolution we have noticed over the last few years seems to be crystallising now. The current inflation is rather surprising for many corporations although it was inevitable, especially after such a deep credit and faith crisis we are currently facing. The non-delivery risk is now a risk to consider carefully when dealing in FX. We all know in Europe that a bank default is no longer a merely theoretical issue. Banks will now try to incorporate the credit risk element in their quotes or look for alternative protection against it.

Cash collateral solution

The method of reducing the extra cost adjustment applied to FX transactions is to sign a cash settlement agreement to collateralise bilaterally amounts corresponding to changes in mark-to-market valuation of the portfolio of FX transactions made with the bank. The idea, as for margin calls, is to secure the potential (unrealised) loss on the revaluation of the portfolio of FX deals. If the portfolio has a negative change in fair value (lower value compared to the inception value), the customer would have to secure this amount with a cash collateral deposit. In the case of a positive change in fair value, the deposit in cash would be made by the bank. Both deposits are or can be remunerated at the EONIA rate, for example. It means that in case of default of the corporate counterparty, the bank would be compensated for the FX deal its customer will not deliver at maturity and it would be able to unwind the contract without any losses (given the cash collateralisation agreed). Conversely, the corporate would be compensated in case of default of the financial institution. [[[PAGE]]]

The documentation to be signed defines the terms under which collateral is posted or transferred between swap counterparties to mitigate the credit risk arising from in-the-money derivative positions. The credit valuation adjustment translates the probability of default during each time period, using the famous CDS (Credit Default Swaps) spreads when available on the market. For the shortest dated transactions, the default probability tends to be low. However, sometimes this probability can be lower in two years because the market is taking the view that those having survived the current problems should then be around for a while.

Of course, the larger and the more diversified the portfolio is, the less collateral would potentially be required by the bank. It is obvious that in case of default (e.g. Lehman Brothers or Kaupthing Bank) the customer can recover and compensate, via the deposit, the loss incurred. Therefore, the treasurers have to analyse and to check whether it makes sense to reduce the cost of hedging / dealing in FX transactions by collateralisation or not. The question is more complex than it appears: what is the corporation’s cash situation, is it short or long? What is the total volume of the portfolio and do some positions off-set others, reducing the collateral accordingly? How to manage these collaterals in case a company deals with several banks? And so on …

Technical and administrative issues

The more FX transactions are dealt, the more the banks are used for dealing, the more collateral would have to be possibly immobilised and locked. It could not be considered as ‘cash and cash equivalent’ according to IAS 7, as it is pledged to the bank. The return offered will not be as good as the one potentially achieved now with money market funds of prime quality. Collateral, for a borrowing company (being ‘short’) can be extremely expensive these days. For groups which are cash poor, it has an additional cost not to be overlooked, especially when spreads are extremely high, as is the case today.

The contract signed with the bank will imply review by lawyers and extra legal costs, at least for first contracts to be signed (similar to ISDA schedules). Fortunately, limits and margin calls will be managed by the bank back-offices. Nevertheless, it will inevitably create extra administration for treasury teams.

Corporate alternative solutions

Corporate treasurers could also decide to have recourse to shorter FX transactions rolled-over over time. Again, it will generate extra administration and interim volatility at roll-over dates. That is the price to be paid for this type of solution. If not, the ‘deteriorated’ FX rates could cost between 0.20% up to 1.20% (at a very rough estimate), depending on maturity. On a five-year ten million USD forward transaction, we can, for example, imagine costs increasing by/up to EUR 80 to 100k. This credit risk element has a related cost to be cautiously considered. The classic dilemma is a huge premium to be paid on FX contracts or imperfect onerous hedging solutions based on several roll-overs. In any case, the solutions to be applied are cumbersome. With a cash settlement agreement, a corporate will be enabled to reduce the credit charges linked to FX dealing of derivatives, as well as to reduce significantly counterparty risk (which is not unusual these days).

Of course, it means use of cash collateral (but on a symmetrical basis). The administrative burden of such an agreement can be reduced by increasing thresholds and frequency of matching and of controls. The sophistication and calculation behind this risk assessment can and will vary from bank to bank. It will therefore impact cost of similar transactions requested with different banks. A good repartition and a split between FX side-businesses will inevitably make handling more complex for treasurers. [[[PAGE]]]

A brand new world for FX dealing

Before Lehman and Bear Stearns (and all others which followed, in the USA and in Europe), treasurers were less credit risk sensitive. Now, dealing with a safer bank in the absence of delivery risk can be essential for long transactions, especially in a hyper volatile FX context. We have very likely entered a brand new financial world and market practices will certainly continue to evolve in the coming years. In general, the implied default probabilities increase as the tenor of the transaction increases. The longer a deal, the more expensive it will be. This important issue will probably have consequences on how corporates are dealing with FX transactions. It can potentially affect their strategies and risk approaches. This consequence does not simplify treasury management. It is interesting to note that the more technology evolves, the more the framework and rules become intricate. Unfortunately, part of the technological progress which has been made fails to be reflected in the day-to-day lives of treasurers .

Some customers may be less price-sensitive when they deal with safer banks. Others may be tempted to shift back to bankers offering best prices. Some banks may also be reluctant to move too fast in order to remain competitive. The reality is that we are in a new dimension. This will certainly become a market practice, no doubt about that. It is simply a question of time.