Why Is FX Hedging a Challenge For Treasurers?
Aug 21, 2022
The last couple of years have been quite turbulent when you look at how volatile economies have been. This isn’t at all surprising considering the crises that caused major economic upheavals that may have changed the world as we know it for the years to come. And while its impact has been felt in just about every aspect of modern life, its effect on foreign exchange (FX) is something worth looking into.
Foreign exchange risk management is incredibly important. This is doubly true when you consider the growing risk driven by international expansion, high levels of market volatility, and regulatory changes. Because of this, treasurers have adopted a more hands-on approach when it comes to monitoring and managing FX exposures.
It wouldn’t be an exaggeration to say that FX hedging is one of the most important parts of a treasurer’s job. With the looming potential for large swings, if one fails to hedge, it’s vital to get this right if you want some semblance of protection from economic upheaval. This is easier said than done as FX hedging is also one of the most difficult aspects of a treasurer’s job. Whether it be defining the right hedging policy for businesses or taking account of stakeholders’ risk, hedging can be a major concern for even the most seasoned treasurer. To get a better grasp of this, it’s imperative to understand what makes FX hedging so challenging. By understanding why it is difficult, treasurers may gain valuable insight that will help make it more manageable. If this is something that you’re interested in learning more about, read on as we break down why FX hedging is a serious challenge for treasurers.
What Makes FX Management Difficult?
After the global pandemic, FX management continues to be a major pain point for even the most seasoned treasurers. Among the different factors explaining the rise of Forex trading, we can list and emphasize volatility and manual processing. Inefficiencies in some TMS solutions, the lack of a connection between operations and treasury, and the globalization of businesses including more emerging countries and exotic currencies also work to foster growth. Margin preservation is quite crucial for businesses, along with reporting and accounting needs. For all these reasons and many others, FX management remains one of a corporate treasurer’s top three risks.
Foreign exchange exposure management is crucial when you consider the volatile economic context to protect business margins. It’s important to note that some currencies may even refrain from selling to some counterparties in order to negate FX risks.
Another thing that makes FX management so challenging is manual processing. In fact, this is a gross understatement as FX management has become manual to a fault. This is peculiar considering how repetitive hedging can be. While a majority of the treasury community relies on the hands-on manual process when it comes to their approach to FX management, this simply is an outdated way of doing things and opens treasurers up to a slew of issues as well as human error. Not to mention manual processing is extremely costly from a time and labour perspective, which makes it incredibly difficult and inefficient.
Volatility also poses a major threat to treasurers. While market fluctuations have always been a part of FX management, the pandemic has pushed this to a whole new level. This has had a significant impact on FX management and can be quite costly if not properly hedged and monitored. The time-sensitivity of it all also makes things more difficult and the daily swings can obliterate margins within a couple of minutes.
Reporting on financial and accounting/international financial reporting standards (IFRS) is a difficult task to accomplish without additional IT tools. That is why some vendors have bought other solutions to complement their main products or why treasurers use add-ons or extract, transform, and load (ETL) solutions to make the job easier. The same issue is noticed in European Market Infrastructure Regulation (EMIR) reporting.
What Can Treasurers Learn from The Recent Challenges?
While recent events have made it harder for treasurers, it would be unwise to not take these as learning opportunities. The economic upheaval caused by recent crises can be used to identify issues that need to be addressed. For the most part, there are two major lessons that treasurers need to take away from it all: FX hedging needs to be centralized and the processes involved need to be automated. Not only will these changes make FX management more efficient but it also helps treasurers combat volatility and generate added value.
The first problem starts with estimating the total and net exposure of the company in foreign exchange. Without good estimates and forecasts, it’s impossible to effectively manage exposure to changes in foreign exchange rates. Identifying exposures accurately is essential and requires discipline, coordination with affiliates, tools, policies, a sound strategy, and rules for allocating expenditures. Identifying an unusual level of exposure early will help prevent a problem from getting worse.
As volatility increases, time becomes the key to managing exposure to foreign exchange markets. Depending on the underlying businesses, the company's strategy, and the approach taken to managing exposure to currency risk, you have to have the ability to hedge immediately 24 hours a day. Who can say they can do so? The sooner you hedge your exposure and the more automatic your process is, the better you will be protected against losses. If a business runs at very low margins and is expected to run at low margins for some time because of rising costs of health care, it’s even more important to be able to sort out sudden drops in revenue caused by currency fluctuations.
What Hinders FX Hedging?
If the solutions are clear, why are treasurers not adopting new strategies to improve FX risk management? Well, the main thing you have to understand about this is that it’s difficult to change things without explaining why it’s necessary to adopt new strategies and demonstrate their benefits. People simply are not aware of the importance of internal controls to mitigate risks. While it may seem obvious, most treasurers nowadays are content with doing things the way they’ve always been doing things. This can be a serious problem as FX management as we know it today relies heavily on manual and hands-on processes. This prevents treasurers from allocating their resources (including time and effort) towards analysis.
This issue becomes even more evident when you consider rampant market volatility. This is best embodied by the Turkish Lira or Ruble, both of which have hit historically low levels. Due to volatility, it’s become even more important to hedge due to margins tightening because of the economic crisis. Indeed, treasurers must adopt a more strategy centric approach when it comes to FX management beyond just looking at the finances.
How Can Treasurers Leverage Technology to Manage FX Risk?
Seeing as inaccurate forecasting and subpar visibility are two of the most significant challenges that treasurers face, addressing this issue is key in order to better manage FX risk. Forecasting currency movement is important if you operate a corporation. If you can accurately forecast currency movement, then you can be better prepared for short-term and long-term currency risks. Without the ability to forecast, your corporation is more vulnerable to currency fluctuations.
Luckily, the shift to remote and hybrid work has revealed the advantages of digitisation. Treasurers have been stretched thin which has forced them to innovate and explore new solutions. Digitisation and automation allow treasurers to free up time in order to focus on other objectives.
What Are the Risks That Treasurers Need to Manage?
It’s important to discuss the risks that come with market recovery and how this can affect your bottom line as a corporate treasurer. The main thing that you have to understand here is that marker recovery poses a few challenges that you will need to navigate in order to achieve your goals. As markets recover, you will need to balance the difficulties of accurately forecasting FX exposures against the need to manage FX risk. Basically, this is the only way you can protect your profit margins.
Treasurers must also focus on adopting technologies that can help them improve your day to day operations. These technologies will aid you in addressing operational complexity, cash-flow optimisation, and financial risk management. While these technologies will help you greatly, seamlessly integrating them into your operations will be quite tricky as it will require some getting used to. So much so that some businesses have even gone as far as to consider fully outsourcing end-to-end FX execution services. These solutions will not significantly impact cash-flow management, either. Treasurers can still implement uncollateralized hedging, requiring no meeting of initial or variation margin, which they might have with their existing foreign exchange counterparties. This ensures that the foreign exchange risk is not replaced by a liquidity risk.
What Difficulties Can One Expect When Pursuing FX Solutions?
Pursuing best execution for FX trades can be extremely difficult for corporate treasurers since it often means managing multiple counterparty relationships at the same time. Say a corporation has completed all the necessary steps and has a multibank panel at its disposal. Each counterparty may have different procedures and systems to navigate, and the corporate may have to make an investment in an aggregator platform to centralize prices, as well as in middle- and back-office processes like reconciliation and confirmation.
However, there is a new class of fintech companies emerging that enable corporate treasurers to connect to multiple banks through one interface and receive live rates. This type of clearing process used to be the preserve of only the biggest banks. This is a genuine improvement on an old system, since it streamlines operations, reduces costs, and increases efficiency.
To avoid further complications, it’s crucial to seek out solutions that take into account transaction cost analysis (TCA). Through the use of TCA, you will be exposed to a transparent breakdown of all FX costs. Through this, there will be proof that a pre-agreed cost promise has been met and delivered. TCA may also be shared with your CFO, board of directors, and shareholders in order to be fully transparent about your processes.
We hope this article proves to be useful when it comes to furthering your understanding of FX hedging and the challenges that it poses for treasurers. Now that you have a better grasp of the difficulties, you should be able to improve the way you manage risk. In order to effectively hedge, it’s crucial that you assess the current situation. Only by doing this will you be able to identify pain points and weaknesses. It’s vital that you know how you can improve and come up with solutions to automate processes to hedge 24/7. In order to manage risk, you have to take a more systematic approach in applying FX policy or strategy. While you can take a hands-on approach, automating this process will help make the process infinitely easier and more efficient.
Centralization of FX management is something that you’ll want to keep in mind when approaching FX hedging. One of the main best practices for the HQ treasury level is the increased efficiency gained from concentrating expertise in a single area. However, predicting volatility will not be easy. There is no way that this problem will go away soon. Time will remain our main challenge, as we guess. We have found that machine learning can help, as it is dynamic and able to fully integrate different models of volatility and impacts into our P&L. If you have any issues, talk to your peers or specialists in the field to come up with a new best-in-class solution.
When it comes to managing FX risks, you’ll want to do all you can to ensure that your interests are protected. Bound is an auto hedging platform dedicated to making currency protection better for businesses of all sizes. For more information on what we can do for you, we implore you to visit our website today!