Banking woes & counterparty diversity – Fund Managers need to rethink their FX infrastructure

The recent woes of Silicon Valley Bank, Credit Suisse and First Republic Bank has brought counterparty diversity and due diligence back into the spotlight for many fund managers. When it comes to FX risk management, many fund managers are considering the best way to implement a more robust FX infrastructure and insulate themselves from future shocks.

What are the risks?

Firstly, it’s important to frame what the risks to a fund manager are, should a banking counterparty no longer be able to function as their FX provider. There are obvious business continuity issues and if you are a fund manager who overlooks different share classes, invests overseas or converts management fees into foreign currencies - then you will not be able to perform these functions until you have a new facility open with a different FX counterparty.

Other risks to consider might include…

1. In-the-money FX hedges – if a fund manager has open FX forwards with a failing counterparty and those positions have a positive mark-to-market (i.e. they make a profit if they were to be sold back into the market today at the prevailing spot rate), then the manager might be at risk from not realising that mark-to-market gain.

2. Loss of collateral – if a fund manager has had to post collateral with their counterparty in order to book an FX forward, then that collateral may be at risk, in a similar way to cash deposits.

3. Not being able to maintain the FX hedge – crucially, there is a risk that any pre-existing forward contract will not be honoured. If the purpose of that forward was to mitigate the effect of FX volatility on a portfolio of foreign currency assets, then fund level returns could be negatively impacted.

Lessons learned

Spanish philosopher, George Santayana is famously quoted as saying “Those who cannot remember the past are condemned to repeat it” which was ironically paraphrased and repeated by many other prominent historical figures.

The 2008 Global Financial Crisis is one event in recent history that brought to light many faults and failings in the banking world.

One key takeaway for any fund manager should have been - don’t put all your eggs in one basket when it comes to banking relationships.

Still, that’s not particularly helpful advice for a fund manager that isn’t currently well diversified and has overlooked this potential business risk.

As the dust settles on the recent turmoil in the banking market, fund managers can learn several lessons from this event and help ‘future proof’ their organisation should similar shocks reoccur.  

Due diligence & monitoring

Recent events underscore the importance of due diligence when selecting banking counterparties.

It is essential to thoroughly vet potential banking partners and assess their financial stability, risk management practices, and reputation before beginning a relationship.

Ongoing due diligence should be carried out regularly, until that relationship comes to an end, which might involve:

• Daily monitoring of CDS levels and AML/compliance alerts.
• Checking for updates from ratings agencies.
• Regular communication with the front office at each bank and annual reviews.

It is vital to keep track of any changes in the financial stability of banking counterparties and adjust a panel of banks accordingly. By doing so, fund managers can help ensure they are partnering with financially stable banks that can provide reliable services.

Counterparty diversity

Counterparty diversity is a pre-requisite for FX best execution and best execution should be a priority for any fiduciary firm. By having a panel of banks at their disposal, fund managers can ensure they have access to a variety of liquidity providers, which can improve the efficiency and execution of your trades.

However, for some fund managers, FX might be considered a non-core business activity meaning counterparty diversity may have been overlooked.

When it comes to foreign exchange trading, counterparty diversity means having relationships with multiple banks and not relying on just one to execute trades. In the context of recent events, this is important because if one bank were to fail, it could have serious consequences for your fund's trading activities, and potentially lead to significant losses.

Reducing direct counterparty risk

The ability to hedge foreign exchange risk without having to post collateral in the form of initial margin or variation margin offers numerous benefits to almost any type of investor.

No margin hedging allows fund managers to remain fully invested while mitigating their FX risk.

It also enables fund managers to better forecast future cash flows as they are not at risk of daily margin calls. They can therefore focus on the core task at hand, maximising returns.

Fund managers should also consider, that because capital hasn’t been deposited with their banking counterparties in the form of initial margin or variation margin, their collateral isn’t at risk if their bank faces hard times.

So, what are the barriers to having and maintaining multiple counterparty relationships?

To summarise, fund managers should consider three things to help insulate their FX function from future turmoil in the banking market:

1) Raise the bar on counterparty due diligence and monitoring.

2) Have a multi-bank FX panel at your disposal.

3) Seek to negotiate no-margin hedging terms with your FX panel.

However, in our opinion this is easier said than done.

In a post from 2021, we wrote about the roadblocks to fund managers accessing FX best execution, and best execution is synonymous with counterparty diversity.

We commented that setting up new FX relationships can be labour intensive and difficult which was recently supported by the MillTechFX CFO FX Survey “The intensifying FX challenges for Fund Managers”.

In our survey of 250 fund managers we should also note that -

• 88% of respondents said it took them between 6 months and 1 year to setup their current FX infrastructure meaning fund managers should plan ahead and should not assume they can quickly set up FX facilities elsewhere.
• 35.6% of those surveyed said that onboarding liquidity providers (i.e. getting setup with FX counterparties) was the most challenging aspect of their FX operation which is directly related to having a multi-bank FX panel.
• 34% said that securing credit lines was their biggest challenge when dealing with FX, meaning that negotiating no-margin hedging terms is difficult to achieve.

The Solution

The good news is that the MillTechFX ‘FX-as-a-Service’ solution can facilitate multibank execution on day one. Rather than having to manage multiple onboarding processes simultaneously, fund managers can plug into our ready-made marketplace that offers counterparty diversity as well as no-margin hedging.

At MillTechFX we carry out strict, ongoing due diligence of counterparties so the end client doesn’t have to. This means they have a second pair of eyes to monitor performance and potentially move exposures away from that counterparty in good time.

Onboarding timeframes are drastically reduced compared to our observations from the survey and fund managers can set up facilities in as little as 4 weeks. Transitioning to a multibank framework can often seem like a daunting task but this can allow fund managers to pivot quickly if they are not currently well diversified.

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