FX managers discuss risk management philosophy, China hedging, FX program review, regulatory compliance, and maximizing the TMS at their September 2014 meeting.
When members of The NeuGroup’s FX Managers’ Peer Group got together in New York City in September, there was a lot to discuss. Co-sponsored by Thomson Reuters and Reval, discussions included overviews of TMS selections and implementations; integrating acquired entities; expanding the currencies hedged under either cash-flow or balance-sheet hedge programs, or both; emerging markets challenges in general with a bias toward China. Further highlights from the meeting included:
1) Regulatory update—Dodd-Frank and EMIR. Thomson Reuters updated the group on clearing and trading mandates for non-deliverable forwards under Dodd-Frank, and Dodd-Frank and EMIR reporting requirements. Whether self-reporting or contracting with a third party, you have to “join” a trade repository. It can take a lot of time to onboard with services like DTCC, but if you are an FXall customer, it can take much less because of already established relationships between FXall and the repository.
2) Risk management philosophy and communication. This session, a discussion on risk management philosophy, led by two members, offered a compare and contrast dynamic. This was timely as several members at the time of the meeting were in the process of reviewing FX programs and their goals and underlying assumptions. Business or management/CFO changes often prompt these reviews, but if not, it is something that should be reassessed anyway from time to time.
3) Treasury workstations and analytics tools. Led by Reval, members discussed systems-enabled analytics. One takeaway was that heads of IT are more comfortable now with cloud-hosted services, which opens up more opportunities for treasury to choose specialized applications.
4) Hedging China. Two member showcases showed approaches to dealing with the evolving RMB internationalization and members’ increasing exposures in this market. What many realize in doing business in the region is that before you can even begin to trade in China, the ISDAs can take a very long time, even with global (non-Chinese) banks.
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What to Know: Dodd-Frank and EMIR
Thomson Reuters shed light on the issues needing corporate attention, giving an overview of the Dodd-Frank and EMIR state of play, including where things stood on clearing and trading mandates for non-deliverable forwards (NDFs).
KEY TAKEAWAYS
1) Most banks are on SEFs now. Some big banks have been laggards due to their issues around (a) prime brokered trades (not considered in the original legislation as lawmakers appear not to have known about their existence, according to a Thompson Reuters expert) and (b) SEF trade confirmations superseding ISDA confirmations, but at the time of the meeting, this was expected to be worked out in the near future.
2) Inter-affiliate trade reporting not required, for now. A big difference between Dodd-Frank and EMIR is that DFA requires inter-affiliate swaps to be reported while EMIR does not. The CFTC, however, has issued a no-action relief letter on this, which, unlike most no-action letters, does not currently have an end date (see: http://www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/13-09.pdf).
3) Earliest NDF clearing for corporates is late 2015. The CFTC’s six-month rulemaking period starts the clock on when NDF clearing becomes mandated; corporates are in the last wave to phase-in clearing, so at the current rate, the earliest mandated clearing would be in late 2015.
4) A bank can be your clearing broker and liquidity partner. Or not. Or not simultaneously. Banks will “meet” you where you want to clear, so strictly speaking, one clearinghouse suffices but you can join more than one. Currently, the CME and LCH clear about 14 USD-based NDF currency pairs – including RUB, INR, BRL – with tenors up to two years. Corporates will most often join a clearinghouse via a clearing broker, commonly a bank. Banks are not allowed to give a price advantage to customers who also clear with them, so companies may choose to do the trade with one and use another for clearing. These are independent decisions. For comfort, companies should ask what banks do to separate/protect your liquidity from their other clearing clients.
OUTLOOK
While currently voluntary, one of the first, if not the first, FX product to be subject to mandatory SEF trading is the NDF. While the end-user exemption would apply in the same way as for other swaps, a significant move of NDF trading from OTC to SEFs and the consequent standardizations of notional amounts and settlement dates, could affect pricing and liquidity for the corporate side in what will remain in the OTC space.
Hedging China
With China taking on growing importance for many member companies, hedging the exposures will become paramount sooner or later.
KEY TAKEAWAYS
- Short CNY positions compromised by lack of forecasting confidence. One member company’s main exposure is short CNY because of local manufacturing (about 45 percent of sales), while 55 percent of sales is imported and sold in China in USD. Offsetting exposures in individual entities and CNY profit are hedged (onshore) with offsetting stand-alone derivatives executed simultaneously to protect these entities’ statutory results. Only a portion of the short CNY position is hedged with cash-flow hedges, due to low confidence in the forecast.
- Embedded derivatives arise from multicurrency environment. Because imports into China are not only from USD-based facilities, the imports create a third currency embedded derivative between order booking and revenue recognition. An expert at Reval noted that some companies “point” an embedded derivative at a cash flow and can thus get hedge accounting for it.
- Getting the ISDA right for trading in China can take time. For one member company it took 18 months, even with a global (non-Chinese) bank.
- Trapped cash problems increase with lower interest on balances. One USD-functional member has a long CNY cash-flow exposure and long CNY balance-sheet exposure due to trapped cash. The latter is typically hedged 50-60 percent on a three-month rolling basis. The company switched in Q2-2014 from using CNY NDFs to using CNH, because of better correlations with onshore spot rates. Interest earned on cash balances used to exceed the cost of hedging in the past, but the economics are less favorable now. The company is currently weighing the pros and cons of hedging the cash-flow exposure on- or offshore. And it’s treasury deems the offshore process to be more efficient, but the business may prefer the onshore process, which gives them a hedge rate they can use internally (an FP&A win but little else).
OUTLOOK
China is an increasingly important country that requires close monitoring. This is due to the constantly changing landscape for cash and FX risk management techniques that are now available due RMB internationalization, special free trade zones, pilot programs and the coming broader availability of banking services like pooling. In addition, the currency itself is being allowed to fluctuate more than it has in the past, leading to hedging challenges that, coupled with increasing exposures, need to be managed.
Risk Management Philosophy and Communication
This members-only session started a conversation on corporate risk management philosophy and objectives, as well as how these drive what is hedged (profits, cash flows, balance sheet, etc.) and what methodology and instruments are used. It also looked at how these concepts, decisions and results are communicated externally and internally.
KEY TAKEAWAYS
1) Time for a review. Whether because of growth in emerging markets, increased transactions due to a shifting manufacturing footprint or just because they are always looking for ways to do things better, the group thought it was a good time to compare notes on guiding principles in risk management and how the program aligns with its actual goals.
2) Goals center around reduction of volatility. There is an about-even split among those who responded as to whether the key goal is economics-based (cash) or accounting-based (earnings). Four companies hedge FX on a portfolio basis while most still hedge by currency.
3) Centralized management with some flexibility. FXMPG members are already employing a very centralized risk management approach for the most part, with more survey respondents citing an active/dynamic program rather than a strictly systematic one. This may be a matter of nuance and degree, but there is some flexibility in the execution of hedges within a framework.
4) Treasury owns hedge results. According to the survey, treasury owns the hedge results by 2:1 over shifting this ownership to business units. It is more common (67 percent) to compare realized results to unhedged outcomes than to compare them to a budget or plan rate (33 percent)..
5) Peer comparison and constant currency as key report items. One member shared a few slides used internally at her company to communicate FX results. One key item to illustrate the efficacy of the program is to compare (using publicly available data) key competitors’ YOY growth due to currency on a quarterly basis, which allows the company to demonstrate lower volatility in this metric than industry peers. Another important item is a side-by-side comparison of “as reported” and constant currency growth numbers.
OUTLOOK
Several members are in the process of reviewing FX programs and their goals and underlying assumptions. Business or management/CFO changes often prompt these reviews, but if not, it is something that should be reassessed anyway from time to time.
Exposures arise from global sales, Asia sourcing and intercompany charges
Many members of the FXMPG are seeing their companies grow in China and thus are seeing the challenges of getting a handle on hedging. using the country’s currency twins: onshore CNY and offshore CNH. One company has been focused on CNY but is making a switch to CNH. It’s been a smooth transition so far although it would like a more dynamic way to hedge its China exposures. Another company used to be unable get hedge accounting for its China investment, so it put on CNH deposits a few years ago. However, now that there is a CNH forward market, there is the possibility for both better yield and a change to CNH forwards (although the underlying exposure is fixed capital in CNY.
Treasury Workstations and Analytics Tools
Investing in appropriate tools and systems is one of the key enablers of treasury doing more with less. Reval led the session. It noted that about 80 Reval clients worldwide use the whole suite (all modules) but that 80-90 percent of new clients opt for the whole suite and not just individual modules.
KEY TAKEAWAY
1) Evergreen challenges. A recent Reval survey indicated that accurate exposure ID, collection and forecasting remain challenging. Further, the analytics of assessing net exposures and most efficient mitigation are key outstanding goals as well.
2) Netting benefits and CFaR. Reval talks about different levels of netting where a sophisticated system facilitates higher levels of netting, which in turn can significantly reduce the number of FX trades to be performed and lower the cost of the hedge program:
- First level: Net exposures from entities with the same functional currency
- Second level: Net exposures with the same currency pair, but different functional currencies.
- Third level: Gather exposures from various entities and determine net exposure and trade against a single currency.
3) De-designation and re-designation is a headache. One of the most arduous tasks in Reval, according to one of the members is the quarterly de- and redesignation of hedges, which can take a couple of days. A more automated process would be a welcome addition.
OUTLOOK
One of the trends currently benefiting treasury is that, while internal IT resources are scarce and often hold back treasury’s projects for more enterprise-wide ones, heads of IT and IT security are becoming increasingly comfortable with cloud-hosted services, which opens up more opportunities for treasury to choose applications and services that are specialized and suited to the task. As these vendors have improved on their integration and communication with ERPs, for example, treasury can have their applications of choice without upsetting the wider corporate systems infrastructure.
CONCLUSION
Every so often, a wave of changes prompts a look at current practices and the desire to take a fresh look at how things are done and why. After a period of significant change in regulations as a result of the 2008 crisis coupled with business growth, business changes, mergers, acquisitions, divestitures and a reshuffle of the importance of certain markets (some to become more important, others less so), the FXMPG hit this point in 2014. As a result, the group took a look at the philosophy and underlying reasons for hedging, as well as the strategy and approach. A part of the agenda at the upcoming meeting will deal with concrete hedge-program changes in the wake of reviews conducted in 2014.