FX Risk Management Goes High-Tech
Foreign exchange, which at $4 trillion in daily turnover is one of the largest and most liquid asset classes, is a hotbed of activity among sell-side market participants, who are building out electronic trading platforms.
While these platforms act to drive liquidity sourcing in the dealer-to-customer space, they also raise issues for the buy side in terms of risk management.
“One of the things about FX risk management that is unique to FX as an asset class is that because FX has a line item on the income statement that specifically calls out a component of FX risk [the FX Re-Measurement line item], companies tend to focus only on this line item when considering their FX risk,” said Jose Sabastro, product director, risk management technologies at Chatham Financial, a risk advisor.
Deutsche Bank this year launched its next-generation FX trading platform on its Autobahn system. The platform features a combined electronic and voice trade blotter across all execution channels, and direct access to Deutsche Bank’s FX and cross-product research and real-time commentary alerts directly from the trading floor.
Separately, Thomson Reuters acquired FXall, a provider of electronic foreign exchange trading systems to corporations and asset managers. The combination will enable Thomson Reuters to provide management of trades though the entire lifecycle, delivering a more streamlined trading process and more efficient execution, the company said.
In many cases, currency risk resulting from revenue/expense/cash flow may be the primary source of economic risk to a company, but it is not captured on the FX Re-Measurement line.
“This line can be fairly disconnected from the economic risk and hedging, hence this line can at times lead to doing the opposite of what is needed to mitigate a company’s true economic risk,” said Sabastro.
Chatham Financial has launched ChathamDirect, a Software-as-a-Service (SaaS)-based platform that enables corporate treasurers and other buy side participants to identify, hedge and account for their true economic FX risks.
Banks that operate single-dealer platforms for FX trading are reconfiguring their platforms to connect to other dealers’ platforms and to swap execution facilities (SEFs), upon which most FX derivatives will need to be traded in accordance with the Dodd-Frank Act and MiFID II.
While the connectivity itself is not a huge cost, the ability to manage the transactions across various SEFs, including collateral management and risk management, puts a tremendous amount of stress on the platform’s operations, according to a report by research firm Celent.
“It has taken the financial crisis and the resulting onslaught of regulatory reform for investment managers to understand that having a fragmented system architecture compromises operational efficiency and introduces risk while delaying time-to-market for new products,” said David Kubersky, managing director of SimCorp North America, a software provider.
Among the major pain points for the buy side are exposure management, trade execution, valuations and hedge accounting.
“Exposure management is one of the first steps in the FX risk management process and gathering exposures is one of the most difficult parts of the process,” said Sabastro at Chatham Financial. “For companies who are trying to manage multiple currency risks, gathering and netting what their exposure actually is can be quite difficult.”
Integration with trade execution systems and platforms streamlining execution of trades is also a thorny issue. ChathamDirect streamlines this process by automatically submitting the data to the platform where the trades are executed.
“The data then automatically flows back into ChathamDirect where the valuations and hedge accounting tasks are automatically kicked off,” Sabastro said.
Once trades have been executed, companies then need to be able to produce mark-to-market valuations that are independent, robust, and that can be easily understood and explained to auditors if needed.
“This is true for both termination values and is especially true for credit valuation adjustments [CVAs] where taking potential future exposure into account can be very complicated,” said Sabastro.
ChathamDirect’s valuation module, on a nightly basis, automatically generates both termination values and CVAs that take potential future exposure into account. “The models being used in this module are the same models that our consultants use to execute over $1.5 billion in notional per day on behalf of our clients,” said Sabastro.
On the tail end of the cash flow hedging process is hedge accounting. The FAS 133/ASC 815 hedge accounting standard can be very complicated and counterintuitive in some cases. In addition to the complexity, the administrative burden of complying with the hedge accounting standards can be overwhelming.
“Companies need to generate and manage hedge designation memos, effectiveness tests and journal entries for their trades,” Sabastro said. “They also need to generate reports and disclosures for their investors and for management.”
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