FX Risk Elimination, Cost Savings, Centralisation 

EACT Breakout Session

Many corporates think that when they have implemented post FX-trade automation, to capture their FX trades in a central system such as a TMS, that they have captured all the value in automation. This session, presented by Kantox, a currency management automation software firm, suggested that this is not necessarily true.

In terms of commercial exposure, it was said that there are different types of FX risks. The first is balance sheet risk, which arises between the moment the invoice is raised and the point the invoice is settled. This is the shortest duration risk but is the only risk that can impact the P&L. This risk is often a C-suite  concern and thus can be a focus of many companies.

However, as this risk often starts the moment a purchase order (PO) or sales order (SO) is created, it can be deemed a transaction risk. This measures the commercial risk between the firm commitment to the order and its conversion. Businesses with price-setting power might focus on this risk, as they can define different prices per SO/PO.

A longer-term view is represented by cash flow risk. This starts at the moment of price-setting for sales or purchases. Cash flow risk exists as budget rates or price lists are set on a periodic basis and cannot be changed ad-hoc when there are fluctuations in the currency pairs.

There are challenges in hedging commercial exposure risk, depending on the hedging programme applied. A cash flow hedging programme is exposed to forecasting risk, where being compelled to hedge a deal that has not yet been realised presents a danger of under- or over-hedging.

Companies may experience a lack of flexibility in their hedging programmes. Usually either a certain percentage of exposure is hedged or a progressive/layered approach is used. However, at the moment of budgeting, if a certain percentage is hedged, it fully locks in the price. This is good from a risk management perspective but often C-suite  questions arise as to why it was hedged at all if, at the end, rates move in the right direction.

From the moment a business budgets for an upcoming period, there may be a cost of carry, covering the premium for six to 12 months of forward hedges. And with on-book and firm commitment hedging programmes (when all significant terms such as quantity, price, and timing are specified), there is a heavy demand on time, with PO/SO and invoices requiring frequent monitoring. There may also be a high number of hedges, taking up more time and potentially creating a lack of traceability. Furthermore, a residual risk exists between the moment an invoice is sent and received, and the moment that a hedge is executed (this could be up to one month).

Financial exposure risk can be derived from intercompany loans and cash pooling. But the need to monitor new intercompany financial positions daily, and regularly hedge these exposures, is time-consuming.

If the same policy is applied for all currencies, it may prove extremely expensive for some more exotic currencies. The cost may lead some companies to decide not to hedge these, even though typically they are often the most volatile currencies.

One solution is to deploy a system that enables the implementation of different rule-sets per currency pair, based on interest rate curves. Kantox, for example, automates FX exposure data gathering, optimising hedging execution frequency to ensure users benefit from the flattest part of interest rate curves. The system can monitor the far leg (forward) rate on the market and, where appropriate, will postpone trades to save on hedging costs (a function known as book-holding).

The risk for international groups with multiple subsidiaries is that different local subsidiaries may manage exposures locally, executing hedges with local banks. This is inefficient. A single unit has less negotiation power with banks compared with its headquarters (HQ), resulting in a higher cost of hedging. Even if local subsidiaries send trade requests to HQ, this resolves the problem of the execution cost but still presents missed netting opportunities.

The satellite or back-to-back model also generates increased FX risk if local subsidiaries are deciding on the form and amount of hedging but lack the knowledge and resources to achieve optimal outcomes. What’s more, if HQ is located in a different time zone to some of its subsidiaries, as well as limiting central visibility and control, those local businesses may not be able to access immediate liquidity.

Technology has a lot to offer in this space. By using a solution such as Kantox that enables the option of book-holding, HQ can act as in-house bank for FX, but with the key difference that group treasury can opt to give subsidiaries a rate straight away, before going to market, effectively offering them 24/7 liquidity.

By not immediately executing an external FX trade it may appear to generate some risk for HQ. However, delayed external hedging gives HQ the time to receive more hedging requests from other subsidiaries, enabling exposure netting. It also creates cost of carry (CoC) savings because external trades are executed under a less pressured timescale.

HQ’s risk is also mitigated with Kantox because its platform monitors market rates. Rules can be set to ensure, for example, that if rates are stable for a specified currency pair, the hedge remains postponed. But the moment a specified threshold is met, the hedge is executed. This dynamic hedging module can be implemented at subsidiary level, ensuring every hedging request received by HQ is in line with policy. The solution also facilitates netting at HQ and subsidiary level, further controlling hedging costs.

By automating the full hedging cycle, it enables greater traceability and control of trades. And when hedge accounting and financial accounting are also automated, using rules defined either at HQ or subsidiary level, companies can be certain that they are capturing all the value of automation.