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How to optimise your FX risk management infrastructure

How to optimise your FX risk management infrastructure

FX risk management
Transaction Cost Analysis
FX Basics
FX infrastructure
Margin-free hedging

Posted by MillTechFX

'4 min

1 June 2022

1 June 2022

As the old adage goes: in calm water, every ship has a good captain.

The currency markets may have been going through a period of relatively low volatility in recent times, but with interest rate rises on the horizon, CFOs at corporates must not get lured into a false sense of security.

For many, currency management remains a huge and costly problem.

The challenge of managing currency risk

Throughout 2021, corporates had to adjust their priorities rapidly to reflect the changing economic environment in which their firms operated.

Navigating FX risk has been challenging for a variety of reasons. PwC’s recent Global Treasury Survey 2021 found that inaccurate forecasting and poor visibility were some of the biggest challenges facing treasury teams.

This made the task of FX risk management like hitting a fast-moving target. This was compounded by the supply chain crisis and CFOs having to quickly adjust against a backdrop of working from home due to lockdown restrictions.

Unfortunately, many clearly don’t think they have the best possible solution in place, with only 23% viewing their treasury as “best in class” in this area.

Many corporates believe they are continually getting a bad deal from the FX markets.

They have had no choice but to suffer the double whammy of significantly overpaying for their currency execution and hedging requirements and the operational agony of implementing and managing multiple relationships to seek (though often in vain) best execution.

Optimising FX risk management infrastructure

With economic changes, such as further interest rates on the horizon, here are four ways that CFOs can improve their FX risk management infrastructure, deliver sustainable growth and, ultimately, protect their firm’s bottom line:

1- Transaction Cost Analysis (TCA)

To effectively manage and hedge FX exposures, it’s important to first measure the cost and quality of your execution and to get a view on these hidden costs.

Transaction Cost Analysis (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.

TCA can enable firms to gain a competitive advantage when trading FX but also potentially to comply with a best execution policy that is reported back to shareholders.

Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.

2- Compare the market

Having the ability to put trades up for competition is typically central to ensuring access to the best price – which is key to effective hedging.

But many treasurers can be hampered by the inability to access tier 1 FX liquidity and the best institutional-grade execution terms, meaning they are often reliant on a single custody bank or broker to meet their execution and hedging requirements.

Fortunately, there is a new generation of fintech companies emerging that enable corporate treasurers to access a single interface to access live rates from multiple banks and execute at the best rate, all whilst reducing the operational burden traditionally associated with this kind of market access.

3- Margin-free hedging

Corporates who hedge, using forward contracts for example, must also consider that placing a hedge typically requires margin to be posted against that position as collateral. Further, if the initial margin no longer covers the mark-to-market of a hedge, due to movements in the spot rate, the corporate may be required to post additional, variation margin.

Any capital posted as collateral is effectively sitting dormant in a margin account and not available as working capital. The FX risk, mitigated with forward contracts, has been replaced with a potential liquidity risk.

One way around this issue is to trade via an uncollateralised FX facility so that a CFO can hedge using forwards and not worry about posting margin. Some solutions crucially offer this service without jeopardising best execution, ensuring total cost transparency.

4- Outsourcing

We have seen a rise in the outsourcing of specific FX functions, mainly those that are deemed ‘non-core’ to improve efficiency and achieve best execution. This is evidenced by the fact that 44% of CFOs in larger companies [1] have outsourced some of their day-to-day functions due to increased processes automation and/or digitisation, according to HSBC and Acuris.

Research published by the investment consultant Russell Investments “Still Overpaying for FX” concluded that for an average $1 billion fund, savings of $330,000 per annum would have been achievable from the adoption of an agency approach where FX trading is outsourced to a third-party specialist. In some cases, funds could have saved much more.

The Russell study explicitly suggested the consideration of a model whereby a third-party specialist agent is appointed to manage FX trades and pursue competition among a panel of counterparties to achieve the best possible price

Time for an upgrade

Corporates deserve better quality FX hedging tools. They need a simple tech-enabled solution that cuts costs, reduces operational burden, and improves their FX workflow.

In the changeable world of FX, it might not be smooth sailing for much longer and – as ever – being prepared for all market conditions is critical. Choosing the right technology partner can help you stay on course when you need it the most.

Get in touch to find out how MillTechFX can help you optimise your FX risk management infrastructure.

[1] With revenues over $5bn.

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