With FX market volatility set to rise in 2022, Eric Huttman, CEO, MillTechFX, makes the case for enhancing risk management strategies and explains how corporate treasurers can adapt to this ever-changing backdrop.
When considering their key priorities for FX risk management in 2022, it is important that treasury teams first gain a deeper understanding of current trends in the currency market. And the difficulty of navigating the often complex and volatile FX landscape today is encapsulated in the February 2022 Kyriba Currency Report, which found that despite the relatively calm markets seen in Q3 2021, corporations across Europe and North America still reported more than $2bn in headwinds.
Although the collective negative impact of FX exposures was down in Q3 2021 compared with the previous quarter, FX volatility is trending upwards again and is expected to continue for the remainder of the year. Against a backdrop of “supply chain disruption, currency volatility and inflation”, as the Kyriba report warns, CFOs and treasurers will be “expected to demonstrate strong balance sheet and cash forecasting precision with various cash flow scenarios”.
It is therefore vital that corporate treasurers have effective risk management strategies put in place to mitigate the impact of currency exposures.
Navigating FX risk has, however, been challenging for finance professionals for a variety of reasons. PwC’s August 2021 Global Treasury Survey 2021 found that inaccurate forecasting and poor visibility were the biggest challenges facing treasury teams. This made the task of FX risk management akin to hitting a moving target.
These issues had a direct impact on many businesses profitability with HSBC’s latest corporate risk management survey finding that 57% of CFOs (rising to 77% in EMEA) say they suffered lower earnings in the past two years due to significant unhedged FX exposure.
Managing risk is evidently a pain point for corporate treasurers in the search for best execution. With economic changes, such as further interest rate rises on the horizon, here are five ways that treasurers can improve their FX risk management, deliver sustainable growth and, ultimately, protect their firm’s bottom line:
1) Implementing automation and digitisation
Automation and digitisation are high on the agenda for corporate treasurers, with Citi’s Treasury Diagnostics Report finding that 57% are looking at transformative opportunities across both their core business and treasury function. It also found that driving efficiency within treasury and augmenting decision-making are now the top two expectations for investing in emerging technologies.
Cloud-based tools are being increasingly utilised to digitise and automate the entire FX process as a method to improve efficiency and cut costs. By embracing a digital FX marketplace, firms can gain heightened visibility and subsequently reduce risk.
As businesses start to rebuild in the wake of the pandemic, the treasury role could expand and come under even more pressure. To make their function more scalable and to cope with this demand, many are likely to turn to outsourcing.
This move is already underway as evidenced by research from HSBC and Acuris, which found that 44% of finance functions in larger companies have outsourced some of their day-to-day functions.
3) Increasing transparency
Lessons learnt from asset managers and institutional investors mean that corporates are increasingly looking to third-party transaction cost analysis (TCA) to quantify their FX costs and demonstrate strong governance to internal stakeholders and shareholders alike.
TCA was specifically created to highlight hidden costs and enables firms to understand how much they are being charged for the execution of their FX transactions. It goes hand in hand with best execution, serving as an ongoing audit of FX practices.
4) Liquidity management: cash is king
Liquidity and funding requirements are one of the biggest challenges faced by corporate treasurers today, particularly in the ‘new economic environment’ outlined in the Kyriba report in February. Businesses should explore ways to eliminate unforeseen demands on free cash flow, and one such demand might arise from financial risk management.
For example, corporates may have to post collateral against FX hedges in the form of initial or variation margin. After posting cash collateral with an FX counterparty, this capital is essentially dormant; it isn’t earning a return for the company and may not be able to be accessed at times when they might need it most. Treasurers should explore hedging solutions that are margin-free and don’t pose a threat to free cash flow.
5) Prioritising governance
Although this may seem like a monumental task, by focusing on the ‘G’ of ESG (governance) treasuries can begin to make substantial progress towards their sustainability goals. Having strong governance around best execution practices, supported by regular, independent TCAs, could pave the way for introducing more sustainable risk management practices in FX.
The road ahead
Although the major world economies have now emerged from the clutches of lockdowns, the post-pandemic market is set to bring new challenges for corporate treasurers. Macroeconomic factors such as rising inflation, rate hikes, geopolitical tension, and the pandemic have left many CFOs and their treasuries seemingly paralysed by external uncertainty, making the task of navigating FX risk extremely challenging.
The Kyriba report should serve as a warning of these difficulties, highlighting the need for firms to focus on their risk management infrastructure to fully adapt to this changing financial climate. Many are moving towards new technology, which offers more effective currency risk management processes such as centralised, digital solutions that offer multi-bank execution on one platform. These solutions can also help future proof a treasury team’s FX function, with the added benefits of driving operational efficiency and reducing risk through automation and outsourcing.