From Commodity to Strategy: A New Era for FX

by Helen Sanders, Editor

Foreign exchange undertaken by corporations has often been dismissed as a commoditised product in recent years, with wafer-thin margins and a predominance of electronic trading, particularly for commonly-traded currency pairs. This is changing, for a variety of reasons, not least the expansion of multinational corporations in Asian, Latin American and African markets, and the emergence of corporations headquartered in these regions that do not use ‘traditional’ currencies such as USD or EUR as their base currencies. In addition, as treasurers continue to enhance financial and operational efficiency, reducing FX risk and cost is an important element of their optimisation strategy.

Shifting corporate FX requirements

Despite the apparently ‘workhorse’ nature of most corporate FX activity, i.e., to fund foreign exchange liabilities and exchange surplus FX receipts into base or another required currency, FX has emerged as an important priority for treasurers. Morgan McKenney, Global Head of WorldLink® Payment Services, Treasury & Trade Solutions, Citi Transaction Services explains,

“Globalisation, urbanisation and digitisation are macro trends driving dramatic changes in how market participants operate to transform challenge into opportunity. According to a recent study undertaken by Citi, FX exposure management and local currency payments regulations are amongst corporate treasurers’ key priorities, highlighting the importance of an effective approach to foreign exchange and cross-currency payment management.”

This includes multinational corporations headquartered in developed markets that have expanded the range of currencies in which they need to operate, but also multinationals from less developed markets, as Ebru Pakcan, Global Head of Payments, Treasury and Trade Solutions, Citi Transaction Services continues,

“As multinational corporations emerge from developing markets, their priorities may differ from those headquartered in developed economies, not least as their currency flows are different and their base currency is less likely to be a major trading currency such as USD or EUR, leading to greater reliance on, and activity in local currencies.”

Complexity and materiality

Historically, many companies focused on a limited number of currencies, with relatively immaterial activities in a wider range of currencies. These were often left unhedged and held on accounts. Today, activities in Eastern European, Asian, African and Latin American currencies are far more substantial, so treasurers need a far more proactive currency risk management strategy. This shift has a major impact on all aspects of treasurers’ FX strategy, from their hedging strategy, operational processes and structures, right through to the criteria for selecting their counterparty banks.

The importance of pricing?

In a changed economic and regulatory environment, the strategic nature of banking relationships has shifted dramatically over the past five years. Financing typically forms the core of a corporate-to-bank relationship, with other activities such as cash management and FX ancillary to this. Just as cash management is by no means a commoditised business that can arbitrarily be offered to a bank providing financing, FX is no different. When FX dealing portals were first introduced, there was an expectation that treasurers would approach their approved banks and simply select the best quote on each occasion. While this may be the case for commonly traded currency pairs, treasurers are looking for more from their FX banking partners than simply individual prices. Daren Blaker, Head of UK Corporate FX Sales, RBS discusses,

“Foreign exchange is generally considered to be an ancillary product, particularly as part of a wider lending relationship, whereby corporates will typically invite their lending banks to bid on any FX transactions that they have. Clearly, there is no obligation to accept any bank’s bid and price is not normally the key differentiator. What does differentiate banks in their clients’ eyes is the ‘value-add’ that they provide, that could be in the form of market analysis, insightful research, innovative ideas or handling sensitive transactions.” [[[PAGE]]]

James Kwiatkowski, Thomson Reuters agrees, but emphasises that transparency over dealing decisions remains an important priority,

“Pricing is an important decision factor for corporate dealers when transacting FX deals, and indeed our execution quality analysis capability is very popular amongst our corporate clients. FXall is a relationship banking portal, so quotes can only be accepted from a company’s authorised relationship banks. Within the panel of relationship banks, corporates are not obliged to accept the best quote, as other factors may also contribute to the choice of bank; however, an audit trail enables treasurers and auditors to monitor trading decisions as well as providing feedback to banks.”

Before selecting quotes on individual transactions, treasurers need to decide which banks will comprise their dealing panel. James Kwiatkowski continues,

“Corporates will have different priorities when selecting a bank; for example, while one may give the best rates at a certain time of day, another may be relied upon to give a price when the customer needs it, such as at end of day. It is therefore not only one-off pricing that matters, it is also the strength of the relationship and the track record of behaviour.”

Matt Richardson, Head of Treasury Services, FX - EMEA & APAC, J.P. Morgan Treasury Services emphasises the range of criteria that exist across corporates of varying profiles,

“The way in which corporate treasurers select their FX counterparty banks has changed in recent years. While pricing is clearly one factor, connectivity, transparency and flexibility are essential to enable services to be adapted to each corporation’s specific needs. For example, competitive pricing will be important to a company with a low volume of high value FX transactions while systems integration and straight-through processing are also priorities for companies with a high volume of typically lower value transactions. Furthermore, while most banks focus on G20 currency pairs in which they have nostro accounts and are more likely to be market makers, many corporations need to exchange less common currencies. These companies are therefore looking for banks that are able to support the currency pairs they require. Whereas trading institutions are more likely to select counterparty banks for each currency pair, corporate treasurers are more inclined to select fewer banks.”

Although corporates have different criteria from trading institutions, the need to transact a variety of currency pairs may mean that the dealing panel may evolve or expand over time, as Ebru Pakcan, Citi outlines,

“As the range of currency pairs that corporate treasury departments manage has expanded to include Asia, Africa and Latin America, given their growth and activities in these markets, pricing transparency and the ability to effectively manage changing requirements in these markets have become more important in selecting a banking partner.”

Furthermore, as Daren Blaker, RBS continues,

“A ‘good’ bank from an FX perspective is one that supports its clients’ wider FX requirements, that has an effective delivery mechanism, and that offers expertise in the more challenging markets that are growing fast, Asia and China in particular stand out. The value of this expertise should not be underestimated in assisting corporates to manage their foreign currency requirements and therefore manage one of their key risks effectively; consequently, this is an area in which RBS has invested heavily.”

Solution and service delivery channels

One issue noted by all the contributors is the importance of delivery mechanisms, which includes channels, integration and intelligence on FX transactions. As Matt Richardson, J.P. Morgan notes,

“Given the economic and regulatory environment, treasurers are seeking to reduce costs and complexity, which become more compelling requirements during difficult conditions.”

The use of channels for efficiency, control and cost reduction for FX does not only refer to the ability to access a bank or currency pair via an online dealing portal. Firstly, as Daren Blaker, RBS discusses, while electronic dealing methods are important, they do not replace personal contact and specific handling of more complex business,

“We have seen a huge shift amongst larger corporations towards electronic methods, particularly multi-bank portals, for obtaining quotes and dealing FX transactions. While this is clearly appropriate for more commoditised transactions where pricing and straight-through processing are the priorities, electronic methods are not always suitable for more confidential, strategic flows and those in more challenging currencies. Although we are seeing an expansion in the currencies supported by the major electronic dealing portals. It is important to balance the operational efficiency of electronic dealing with a direct relationship with the banks and the wider market, not least to ensure that FX decisions and policies continue to be valid in the prevailing climate.”

Secondly, James Kwiatkowski, Thomson Reuters highlights that while the automating the transaction process may be important, it is only one part of a wider treasury infrastructure for visibility, efficiency and control,

“We are continuing to see a growing focus on identifying and managing risk, but even today, many large corporations manage significant portions of their treasury activities using spreadsheets. Consequently, once they recognise the need to automate their treasury operations, such as FX, they are looking for more than simply trade execution functionality: rather, they are looking for a cohesive approach to workflow management, hedging, transaction management and analytics.”

One of the challenges for corporate treasurers when constructing an integrated, cohesive execution and transaction management strategy is that multiple banking channels and departments may be involved in delivering the range of transactional services that they require. Matt Richardson, J.P. Morgan discusses,

“One challenge for many banks is that FX and cash management are quite separate functions, with separate technology and service delivery. This contrasts with corporate treasurers’ demand for integrated solutions. While banking departments and services are becoming more cohesive, this is often a slow process.” [[[PAGE]]]

Morgan McKenney, Citi also notes that global banks are investing in more closely aligned services,

“Greater connectivity between FX execution and cash management channels is becoming more important to enable seamless cross-currency payment solutions. FX and payments are typically managed by different parts of the bank. At Citi, we are focused on greater collaboration across these functions and capabilities to bring more integrated and seamless solutions to clients.”

The need for integrated solutions is not only a technology issue, but also includes the type of advisory services that are available, as Ebru Pakcan notes,

“While companies need their banks to support efficient, robust FX delivery channels, they also rely on their expertise in managing payments and collections, and the associated FX requirements and exposures, in order to devise an integrated cash management strategy.”

Where technology solutions are available, there may be restrictions on the way that they are deployed, as Matt Richardson, J.P. Morgan comments,

“Technology is a key driver of treasury processes, including FX, and includes the use of mobile devices for transaction approval and monitoring. In some restricted markets, though the technology may be available its use may be forbidden by regulations, and treasurers need to be aware of this when devising a global technology infrastructure for FX management. To address this challenge, some treasurers are adopting advanced document management processes to automate the production of the relevant documentation to accompany FX transactions.”

The centralisation debate

The focus on efficient delivery channels for FX (and other financial activities) is typically part of a wider effort for greater automation, efficiency and control. As Daren Blaker, RBS comments,

“The other consistent trend we are seeing amongst our corporate customers, and one that is partly linked to the increased use of e-commerce platforms, is the ever-increasing focus on operational efficiency. In many cases, centralisation is a primary enabler of these objectives, providing greater visibility, control and efficient processing of flows. In the larger corporations, cash and treasury management centres may be established regionally, but a single global centre is more common, enabling the company to consolidate exposures across the group and cover the resulting net exposure in the market. We expect the trend towards centralisation to continue as companies focus on cost control and efficiency across their activities.”

While centralisation is a common trend, it is not necessarily a panacea for every treasury function, as Morgan McKenney, Citi highlights,

“While we work extensively with clients to deliver greater payments efficiency, such as through a centralised shared service centre, a company’s approach will vary according to their organisational structure and geographic reach, together with their sourcing, sales and distribution models.”

Ebru Pakcan, Citi continues,

“We are seeing a number of organisations that are exploring in-house banking and ‘payments–on-behalf-of’ processing, but a company’s appetite for implementing these techniques will differ. There remains a large proportion of decentralised treasury and cash management functions, depending on their organisational structure, business model and culture. Similarly, although shared service centres are common for accounts payable, and to a lesser extent, accounts receivable, many companies have not yet considered centralising these activities. Overall, however, there is an upward trend in centralisation discussions.”

Matt Richardson, J.P. Morgan explains that centralised processes and structures can be adopted in quite different ways,

“Treasurers are taking different approaches to managing their FX risk during an extended period of volatile market conditions. Some have implemented a centralised treasury infrastructure for FX and cash management, while others choose to manage FX at a local business unit level where the exposures are incurred. Some choose to consolidate their FX requirements before dealing in the market. Others however exchange currency as required, which is an approach that may lack economy of scale, but is simpler in practical terms and reduces currency risk. Companies’ approach to FX management will also depend on the natural hedges that exist across the business, and their currency mix. For example, it may not be possible to hold a currency in an offshore multi-currency account. In addition, treasurers will have varying appetites for complexity and centralisation.”

He continues,

“Consequently, there is a wide diversity of styles and approaches to FX management. However, we have witnessed certain trends over the past few years. Treasurers are rationalising account locations with a view to achieving greater visibility and control over their cash, FX requirements and exposures. FX transactions may still be conducted locally, but technology enables centralised reporting and auditability of processes.”

Visibility and integration

Irrespective of the degree of operational centralisation that treasurers wish to, or are able to achieve, visibility over FX exposures across the business is essential in order to establish a comprehensive view of the company’s risk. This may require some careful analysis of processes within each business unit, as Matt Richardson, J.P. Morgan advises,

“Treasurers need to be aware of the potential hidden FX costs inherent in their accounts payable processes. While subsidiaries’ transactions may appear to be in one currency, subsidiaries may be converting funds locally, which can result in substantial costs being incurred. We therefore encourage treasurers to explore their FX flows in detail across the entire business to identify potential enhancements or efficiencies.”

Globalisation and regulation

As companies move into new markets and adapt their sourcing and distribution models, it becomes more difficult to stipulate the settlement currency, resulting in a wider range of foreign currency payment and collection requirements. This is likely to continue to drive continued integration between FX and cash management solutions and delivery channels. Regulation is also influencing the way that FX services are delivered, and issues such as price transparency. Ebru Pakcan explains,

“The requirements under Dodd-Frank to provide transparent management of FX spreads on cross-border remittances throughout the process from remitter to beneficiary are challenging, particularly given complex correspondent banking models. Transparency is, of course, very important to corporate treasurers as they seek to avoid hidden costs and ensure that they can compare services on a like-for-like basis. In the future, we are likely to see further regulatory developments to support this requirement.” [[[PAGE]]]

The regulatory burden is not restricted to banks, as James Kwiatkowski, Thomson Reuters illustrates,

“Many corporations that use non-deliverable forwards (NDFs) and currency options now need to comply with Dodd-Frank, and they are looking to their banks and vendors to assist with compliance, such as dealing in regulated NDFs. Rules are already in place for price discovery from multiple banks, and this is likely to change further in time. Companies therefore need to keep on top of regulatory change and consult their vendors for advice and compliance solutions.”

Foreign exchange management is a core responsibility for treasurers. As globalisation continues, and revenues derived from emerging markets that have more closely regulated or less liquid currencies increase, this task becomes more challenging. The internationalisation of RMB, a journey on which the Chinese government and regulators have embarked, will remove considerable complexity from treasurers’ currency management strategy. Although an offshore RMB market has emerged, and the opportunities for cross-border flows are increasing, China remains a challenging region when developing a cohesive, integrated FX strategy. What is becoming increasingly apparent, however, is the ongoing convergence of cash management and FX. Banking solutions will therefore need to continue adapting accordingly, shaped by both shifting market dynamics and a changing regulatory environment.