There are some aspects of today’s treasury function that have really only emerged over the past decade: financial supply chain management, enterprise risk management etc. Some responsibilities have been core to the role of treasury ever since the first departments were set up in the 1970s, of which foreign exchange (FX) risk management is one. Indeed, the first treasury association, the Association of Corporate Treasurers (ACT), was founded in 1979 as corporations set up treasury functions in response to heightened market volatility, relaxation of exchange controls in 1976 in the UK, and international expansion. Forty years on, have treasurers ‘cracked’ the code to effective FX risk management, and what new opportunities now exist? How do smaller corporations in particular avoid adding complexity when seeking to reduce risk? In exploring this theme, I am delighted to be joined by Martin Keller, Head of Product Management, Mittelstandsbank, Commerzbank AG. In addition, Justin Meadows, CEO and co-founder of MyTreasury offers some engaging new insights into trends and opportunities for online FX dealing.
The business imperative
Given the potential impact that adverse FX movements can have on cash flow though value attrition, liquidity as a result of cash ‘trapped’ in foreign currencies, and ultimately on corporate results, FX risk management is a fundamental issue for treasurers. Even the largest global corporations are not immune to the effects of negative volatility. Despite announcing a record quarter in Q4, 2014, Apple’s CEO Tim Cook commented that “Our results would have been even stronger, absent fierce foreign exchange volatility” which CFO Luca Maestri added amounted to around 4% of quarterly revenues. Some would argue that as most companies operating in a sector with the same base currency will be subject to the same market effects, they only need to manage their risk to the same degree as their competitors. With greater analyst scrutiny (for example, FX was the main topic that analysts wanted to discuss during the Apple quarterly results briefing despite the eye-watering results) and growing competition globally however, treasurers and CFOs cannot be complacent about managing their FX risk.
In Deloitte’s 2015 Global Corporate Treasury Survey, volatility and cash repatriation were identified as the greatest challenges facing treasurers, each of which was noted by 50% of participants, at least 10% more than issues such as cash visibility (40%), treasury technology (40%), entering restricted markets (24%) and managing liquidity (29%). This is not surprising, given the high levels of volatility in both the FX and commodity markets, continuing international expansion resulting in exposure to a growing number of currencies, and geopolitical insecurity in many parts of the world. Furthermore, the ACT’s The Contemporary Treasurer 2015 study shows that 83% of treasuries produce board reporting on risk management (which includes FX), emphasising the importance and visibility of treasury’s role in FX risk management.
An emerging focus on FX risk
Given the scale of the challenge, are treasurers focusing enough on this area? In some cases, it appears that treasurers have paid more attention to liquidity risk over the past few years, with the exception of large multinational corporations and those with particularly large currency or commodity exposures. This is starting to change, however. According to the ACT study referenced earlier, treasurers are spending an average of 39% more time on risk management in 2015 than 2014. This is also the experience we are seeing amongst our readers, and amongst the banks that support them. For mid-cap and smaller corporations in particular, the issue is how to address FX risk efficiently, particularly given resourcing and technology constraints. As Martin Keller, Commerzbank says,
“Not only has the past six months been a period of significant market volatility, but treasurers recognise that this is a situation that will remain. As a result, clients want help in collating market information, and determining what to do with it. They are then seeking to design and implement a risk management strategy that makes sense for their business, and ensure the relevant controls are in place.”
“It can be difficult for many companies, particularly mid-cap and smaller corporations, to design and implement an FX risk management strategy that is appropriate to their business. Ultimately, the aim is to secure the underlying business but it is not always clear how this should translate into a hedging strategy. Furthermore, in smaller organisations that lack a defined treasury function, it is not always clear where responsibility for either strategy definition or execution should lie.”
So what are the steps to an effective and sustainable FX risk management strategy?
#1. Taking responsibility
For corporations with a defined treasury function, responsibility for FX policy definition is usually clear, and the need to manage FX risk at a group level is one of the factors in deciding to centralise treasury. As Keller suggests,
“As companies of all sizes expand their activities internationally, their FX risk often becomes more difficult to manage, particularly where subsidiaries buy and sell in foreign currencies. Larger multinationals overcome this growing scale and complexity of FX exposure by centralising FX risk management into regional or global treasury centres with specialist systems and specific expertise.”
He continues however,
“For smaller companies without a central treasury function, this is more challenging, as the process of information gathering, designing and executing a hedging strategy, and implementing appropriate controls takes significant resource, particularly if responsibilities are shared across different functions or subsidiaries.”
In some cases, even where treasury policy is determined centrally, execution may be dispersed more widely, particularly in companies with a more decentralised treasury approach, and/ or where complex local market conditions make it more appropriate for local entities to manage exposure to a particular currency due to its volatility, currency controls or local liquidity conditions. Consequently, every company needs a clear definition of where responsibilities for defining and executing FX strategy should lie. Where these are disseminated, it makes sense to try to use a common platform to maintain a global view over exposures and hedging transactions.
#2. Managing information
The next challenge is how to bring together information to monitor and manage their FX exposures. Keller highlights,
“While most companies have a detailed budget for their home currency, this is less frequently the case for foreign currencies. As their FX exposures increase, they are trying to become more precise, particularly in forecasting foreign currency cash flow and reducing volatility, both in the short and medium term.”
This is rarely easy: large corporations have often grown through acquisition and have multiple sources of exposure information from around the group; smaller corporations may hold this information in spreadsheets and smaller local systems. In both cases, it can be difficult to collate exposure information in a common format, even where a treasury management system (TMS) or ERP is in place. There are solutions available to help to overcome this, including web-based access tools that can be provided to remote users to input or import exposures from spread sheets, ERPs and local systems. This information can then be collated to identify and monitor currency exposures. This is best achieved using specialist TMS or ERP functionality, but treasurers and finance managers of many smaller corporations have not yet been able to justify this investment, despite the potential risks to their business. The cost and barriers to acquisition of these tools is reducing, so many corporations that have not reviewed TMS or accounting systems with treasury functionality recently may now wish to reconsider their approach. Keller adds,
“Treasurers and finance managers adopting a new FX risk management strategy need to focus on issues such as treasury management systems to support its execution and control quickly, not least because it takes time to implement these tools.”
In regions such as Asia, the use of treasury technology (or ERP functionality in treasury) is still less common than in North America and Europe, but as these corporations expand into new territories both within Asia and globally, this is likely to change.
In addition, banks and information providers have a wealth of market information and analysis to help evaluate risks. As Keller comments, however,
“As a bank, we are able to deliver a great deal of information, modelling tools and expert balance sheet advice. The issue for treasurers is very often, however, how to integrate these insights and analytics into their own systems and reports in a meaningful way.”
#3. Defining strategy
The previous two steps are probably the most challenging, but they are really only the precursor to managing FX risk. The next step is to define an FX strategy that meets shareholder objectives and risk appetite. As Keller explains,
“In the past, some corporations made the conscious decision to remain unhedged, and therefore potentially benefit from favourable volatility movements; however, this is far less common today. It is difficult to determine the exact hedging ratios that are appropriate for the business. Typically 100% is too high, as not all forecast exposures will necessarily occur, and most corporations would prefer not to be over-hedged. Eighty to ninety per cent is more realistic, depending on the degree of forecast accuracy.”
Clearly the most appropriate hedge ratio will vary by organisation according to its industry, business model, risk appetite and a range of other factors, but in general, treasurers and CFOs are taking a more conservative approach than we saw during the 1990s and early 2000s. In addition to economic conservatism, this is driven by international accounting standards, which stipulate rules for effectiveness in order to be treated as a hedging transaction for accounting purposes. These also impact on the type of instrument used: for example, most treasurers will opt for simpler instruments such as FX forwards and vanilla options, not least as more complex instruments require more sophisticated technology and more resources. As Keller describes,
“Most treasurers, or controllers that take responsibility for treasury, prefer to adopt a straightforward approach to measuring and managing risk, including their choice of hedging instruments. This makes it easier to control risks and processes, and execute the strategy correctly without the need to dedicate substantial additional resources to this activity.”
#4. Execution and control
Having defined treasury policy, execution brings its own challenges, particularly to make sure that processes are controlled and auditable. Firstly, a TMS, accounting system with treasury capabilities, or treasury module of an ERP is essential to record, value and account for transactions. In addition, it is generally best practice to seek competitive quotes on FX transactions to ensure that the best prices are being obtained, monitor bank performance and spread business fairly across banks.
During my early days in treasury, this involved various people standing around a telephone console, each phoning a bank, and then gesticulating to each other or exchanging scrappy bits of paper with scrawled quotes written on them to work out which bank was offering the best price and therefore who should conclude the deal. Suffice to say, this approach was far from foolproof. The dealer then filled out a deal sheet, including the competitive quotes received, and someone else then input the deal into our home-built treasury system, a precursor to a modern TMS. As the competitive quotes could not be recorded in the system, it was impossible to monitor bank performance over time and prove that the best quote had been obtained, except by trawling through manual deal tickets.
Today, there is rarely an excuse to resort to this fairly chaotic and haphazard method of FX dealing, with online dealing platforms now readily available for a large number of currency pairs and counterparties. In some cases, these are offered by banks for single bank dealing. These are most appropriate when booking the FX component of a cross-border payment with the payments bank. This applies particularly to restricted currencies, as foreign currency cross-border payments need to be supported with payments documentation, which is more likely to be supported in bank-proprietary solutions than independent platforms.
In addition, there are also various independent, multi-bank online dealing platforms available. These allow users to set up a transaction (either manually or fed automatically from a TMS), select a bank or banks to approach for quotes, request a quote and execute automatically. The transaction details, including the competitive quotes, can then be passed through to a TMS or ERP without the need for re-keying, therefore minimising the risk of error or fraud, for settlement, confirmation and accounting. Some portals increasingly provide back-office capabilities too, such as confirmation matching, settlement and analytics. Furthermore, we are also seeing the growth of multi-product portals, as Justin Meadows describes in Box 1. The combination of functionality offered through these portals, and the ease of adoption and implementation, makes them highly desirable not only for larger corporations that can benefit from the opportunity for straight-through processing (STP) but also smaller corporations that may lack a TMS or ERP, but still need to demonstrate efficient, highly controlled execution of their FX strategy.
However, use of online dealing portals is not yet universal. According to SunGard’s 2014 Corporate Cash Investment Report, 45% of participants used a multi-bank dealing portal to transact at least some of their FX deals (half of which used it for all, or almost all of their transactions) and 17% used a single bank dealing portal. Even so, 22% of companies that seek competitive quotes use telephone dealing for more than 40% of transactions.
#5. Outsourcing the process
Online dealing is not the only way of streamlining the execution of FX deals and indeed, some companies, particularly those with limited FX requirements, or with little resource or appetite to manage FX risk, choose to outsource this entire activity to their bank(s). Keller illustrates,
“Automation of routine treasury processes is a key objective for many treasurers, and FX risk management is no exception. Not only are online dealing portals becoming increasingly popular amongst corporations of varying sizes, but tools provided by banks to convert in- or outgoing flows to or from the company’s base currency automatically according to specific rules defined by the company can also play a valuable role.”
Effectively, a company may choose to maintain accounts only in core currencies, and automate the FX transaction with the cash management bank to convert this into a foreign currency to settle liabilities. A similar process can be used to convert foreign currency collections into base currency. This reduces the risk management overhead, as well as the number of accounts that need to be maintained, whilst also streamlining transaction processing. The FX conversion is done at an agreed margin, so treasurers maintain visibility over deal pricing. While this is unlikely to suit larger corporations, there are potentially considerable benefits for smaller corporations or those that lack a defined treasury function.
While managing FX risk can be challenging, by reducing complexity and increasing transparency, treasurers and CFOs can both take decisions with greater confidence, and encourage confidence at board level. Defining FX strategy and operational processes is not a one-off task, but needs to revisited regularly in light of changing market conditions, risk profile and shareholder risk appetite.