Mandates to cut staff, more-onerous regulatory requirements and emerging market challenges force FX managers to become ever-more efficient.
Topping the agenda for members at the winter 2014 meeting was regulations, and member efforts to comply. The group heard from sponsor Standard Chartered on a variety of angles related to the mechanics of regulatory compliance, both for banks and corporates. Further, members looked into various aspects of changes, either completed or considered, in FX programs: accounting rates, balance-sheet hedging, and the way FX fits into treasury. Finally, with business growth in complicated and volatile places, the members took another look at emerging markets, including China and Africa. Further highlights from the meeting included:
1) Assessing use of daily accounting rates. SAP’s off-the-shelf product uses daily rates by default and requires customization to use anything else. When one member company switched from existing ERP to SAP, it decided to also change from a monthly rate to a daily rate for a less customized, more efficient implementation and one that would be easier to update/upgrade. However, using daily rates takes more work, and it is up to users to decide if an easier SAP implementation is worth it. Daily rates require more maintenance, but they also offer more flexibility and give a real-time view for example of revenues, which many companies and their investors value highly.
2) Balance-sheet hedging can be reduced with correlation-adjusted VaR. In order to reduce transaction costs, another member company changed the analytics it uses to monitor its 43 currency exposures. It changed from a policy that focused on the amount of exposure alone without considering currency volatility or correlations to one that looked at VaR and correlation analysis; this allowed for a more informed selection of positions to hedge, a reduction in unnecessary trades and a finer tuning of tenor.
3) Structuring treasury and FX for efficiency. Another member company had undergone a major treasury centralization, which tied in with the session theme of how to streamline FX operations within treasury to increase overall efficiency. Treasury and FX risk management play a key role in supporting contract negotiations at the presenting company, so structuring them to maximize this supporting role helps meet margin targets in long-term contracts while maintaining competitive pricing.
4) Emerging market challenges. As “multinational” has increasingly been replaced by “global,” the last 20 years have brought some emerging-market lessons to one member company that are becoming ingrained in its global corporate expansion. The firm now identifies a number of risks before bidding for a contract, and uses the contract structure to mitigate them as much as possible. Currency, inflation, local banking and work-stop risks are just a few that need not be post-signing surprises.
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Transition to a Daily-Rate Program
One member led this session by reviewing the rationale for, and early assessment of, its change to a daily accounting rate from a monthly one. The session started with some business background: the cash-flow program is rooted in that daily product and service revenue is booked in Ireland (a USD-functional entity), and quarterly global expenses are cross-charged to Ireland, resulting in exposure from 5-10 currencies. The balance-sheet hedge program actively manages 26 currencies, including 9 NDFs, and the exposures are available monthly at close.
KEY TAKEAWAYS
1) Beware of “off-the-shelf” implementation model: The company migrated from Oracle to SAP in 2012. The company’s SAP strategy was to implement it off the shelf to save on customization costs and subsequent upgrade hassles/costs. In the off-the-shelf SAP, daily rates are the default while anything else would have to be customized.
2) Weigh the pros and cons of each approach. It’s important to do the analysis to see what approach works best for you. For instance, some processes are manual but still might offer certain benefits unavailable via automation. (See chart below).
OUTLOOK: As with any business decision, there are cost-benefit trade-offs to consider. Given that the company’s FX team is still debating the pros and cons of the switch to a daily-rate program, it’s worth considering what type of costs are saved in implementation vs. what costs might be incurred going forward as a result of a more labor-intensive method, not to mention the increased trade costs of daily unwinding. However, companies in certain industries and their investors often focus greatly on the topline revenue growth number and as such, a keen eye on this in real time has its own value.
Challenges in Emerging Markets
One member shared his thoughts on and experience with FX risk management in emerging markets, which represent big exposures for his company. In fact, the company has 53,000 employees working on more than 22,000 projects in 140 countries on all seven continents. Many projects are in places where few foreign companies have extensive experience.
KEY TAKEAWAYS
1) Identify the key risks before contract bidding. This company considers multiple risks before submitting a bid, including but not limited to repatriation and convertibility, expropriation, counterparty, inflation, tax risk, etc., in addition to FX risk and the liquidity of FX spot and forward markets.
2) Mitigate risk in the client contract. The company has various ways of reducing risks at the contract stage, such as considering whether an onshore or offshore contract is better, which currency is preferable, taking out local loans, inflation adjustments and work-stop clauses.
3) Trade NDF currencies on e-platforms. The firm executes the majority of its NDF trades electronically (vs. 40 percent of last summer’s pre-meeting survey respondents who do no electronic NDF trading at all), and coordinates NDF maturities with onshore trades. Some trades are competed, others are leave orders.
4) “Taper talk” is big risk driver in 2014. Standard Chartered highlighted a few themes that paralleled the investor market’s view on currencies in the emerging markets. Fed tapering might contribute to increased vols in emerging markets, but Asia macro fundamentals are looking positive and 2014 inflation manageable; however, corporate profitability in EMs has seen a downturn.
5) Offshore renminbi use is rising. CNH deposits in Hong Kong are growing; trade settlement in RMB is on the rise; dim sum bond issuance is surging; and daily CNH trading turnover is also growing significantly. As a result the renminbi globalization index (RGI) was up sharply in January (y-o-y), and New York is now contributing to this growth. SC also highlighted in his presentation some key aspects of recent changes in regulations that will promote cross-border flows.
6) The new frontier—Africa. Standard Chartered ended the session with an overview of the bank’s presence in Africa. SC is the biggest international bank in Africa with a presence in 15 countries in Sub-Saharan Africa (covering 90 percent of this area’s GDP). Two hundred branches cover 6,500 client relationships and serve their banking and FX needs across the continent (also via correspondent relationships).
OUTLOOK: Emerging markets challenges still require a somewhat different approach than managing FX risk in more mature markets. Many companies may have determined that at least some of their EM exposures don’t yet reach certain materiality thresholds that trigger hedges compared to their “bigger” markets, especially considering the cost of hedging some currencies, but the volatility levels and sudden rate moves may have outsized effects on the P&L in any given quarter. To the extent natural offsets can be found and exposures mitigated in contracts, business models and asset-liability matching, the need for costly hedging can be greatly reduced.
Treasury Transformation Goes Beyond Centralization
The presenting company underwent an 18-month project to achieve:
- Bank “plumbing” with more flexible solutions based on common global structure and SWIFT formats
- A single global financial system in SAP
- Analytics, trading platforms and FX hedging capabilities
- A streamlined intercompany settlement process
…resulted in impressive operating efficiency gains:
- Processes in place to switch banks quickly for core cash management
- Workload reduction
- Reduced treasury operating budget
- Lower bank transaction charges
- Quicker settlement and elimination of FX exposures, new FX systems
- Improved control/security and ability to respond to market changes
Balance-Sheet Hedging: Correlation-Adjusted Value at Risk
One member walked the group through a quick overview of a change in balance- sheet exposure analytics at his company, with the goal of cutting down transaction cost and not paying away bid/offer spreads.
Treasury monitors about 43 currencies on the balance sheet. While some of them may be small in notional terms, the revaluation on unhedged positions could impact the USD P&L. The previous policy was to hedge all exposures higher than USD 1,000,000, without taking currency volatility or correlations into account. As a result, there were a great number of often expensive trades.
KEY TAKEAWAYS
1) Pegged currencies still have risk. This company has exposures in several pegged currencies. Most of the time, it’s just a cost to hedge them but the one-off risk needs to be recognized somehow. But how?
2) Is the answer in VaR and correlation analysis? The company’s treasury found that a VaR analysis alone could suggest a reduction in “unnecessary” trades but some exposures remain, for example long EUR and short SEK positions. The team set out to answer these questions:
- What is the right tenor?
- What is the right correlation co-efficient to determine strength of the relationship between two currencies?
- How often do we need to review the correlation?
- What major currencies do we want to trade?
3) The correlation study. The company measured correlation on a 3-month basis; volatility both on a 1-year and 3-month basis, and used a 2 SD method to calculate Value-at-Risk for EUR, CAD, SGD, GBP, and MXN. Currencies not correlated to one of these were grouped separately, and it was determined that currencies in the “other” bucket may be offset if correlated to any currency in the other group by +/- .75. Each currency was given a maximum VaR tolerance of USD 50,000, as measured by the greater of 1-year or 3-month volatility. Finally the total VaR of all groups was also measured and a maximum daily VaR closely monitored.
4) Some changes six months later. The analysis showed that some tinkering was required.
- Remove GBP as a major currency position; and
- Replace the 3-month correlation with an evenly weighted average of 1-week, 1-month and 3-month correlations (but it will be considered invalid if the 1-week is less than half of the 3-month).
5) Add a trigger alert. Finally, the company added a trigger to warn the trader of significant changes in FX rates, i.e., when the month-over-month price change is +/- 2 percent. The alert does not necessarily trigger a trade but does prompt closer monitoring.
OUTLOOK: When faced with the increasing costs of a frequent-adjustment approach to balance-sheet hedging, not to mention the time the process consumes, a correlation-adjusted VaR approach may be useful to identify where hedging does and does not make sense from a cost-benefit point of view. However, the approach does require a thorough understanding of VaR and close monitoring of correlation changes so that the model stands up to scrutiny long term.
Structuring Treasury and FX for Efficiency
This session’s stemmed from an internal review by a member company to determine how the organization of treasury and FX can be streamlined for efficiency. The world’s largest company in its industry by revenues, it has offices and operations in 50+ countries and sales in over 120.
In 2008, the company began a project to transform treasury, centralizing control and decision-making to a few centers using technology-enabled solutions (global structure, SWIFT formats, SAP) in order to provide a full range of treasury services to the business in a value-adding, efficient and cost-effective way, i.e., the global full-service model (see illustration below).
KEY TAKEAWAYS
1) Centralization brings many benefits, but also challenges. The benefits of treasury centralization are well documented (most members agree it’s the best model). The company has reaped many of them through its transformation project (see sidebar). Remaining challenges – especially due to emerging-markets
growth – include managing growth and profitability and complexity and regulatory demands with a lean but not overworked team, so operations need to be structured for maximum efficiency.
2) Structure key functions for efficiency. The FX group’s key role is support for contract negotiation teams whose goals are to meet margin targets in long-term contracts while offering competitive pricing. Efficiency is achieved by dividing up deal-approval authority levels between assistant treasurer/treasurer (large/complex deals), senior financial risk manager (large/complex deal shaping, review and approval, with escalation points), and regional treasury leads (smaller deals, policy compliance). They are supported by policy, guidance, contract language analysis, FX risk management models and market data support.
OUTLOOK: To take centralization benefits to the next level, more and more companies view causes and effects of risk management and cash activities as interlinked and in need of a holistic, integrated and collaborative approach; thus they should rethink roles and responsibilities, optimal staffing levels, organizational structure and backup procedures.
Conclusion and Next Steps
The mandate to do more with less is hitting home in a significant way in 2014. Many treasury teams have had to reduce headcount or have not had headcount increases approved, despite an increase in exposures, e.g., in emerging markets, and regulatory compliance requirements. In fact, several FX “teams” are down to one. In this environment, it is no wonder the organization of treasury and risk management itself is under review to eliminate inefficiencies and streamline processes, as the organization case illustrated. Meanwhile, other cost constraints have forced a closer look at the effectiveness of balance-sheet hedge programs in particular, to root out unnecessary hedging while maintaining a desirable level of volatility reduction. However, cost saving reflexes may prompt actions that in retrospect may be found to have added workload for still debated benefits, as demonstrated by the daily rate case.
Summer Meeting: September 9-10 in New York City.