FX structurers see mixed demand for cross-asset hedges

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Foreign exchange structuring desks are seeking to cash in on the increased cost of long-term hedging in the rates and credit markets that is resulting from new capital requirements by offering cheaper FX structured products to buy-side clients.

Basel III, which includes a credit valuation adjustment (CVA) capital charge for trades not cleared through central counterparties, means rates and credit trading will consume far more capital, and banks are passing on the costs to end users. While the FX market faces its own regulatory challenges, capital requirements are not as punitive as in other asset classes, which is why some investors have looked to FX structurers to more cheaply replicate what they had previously done in the rates and credit markets.

"The cost of long-term hedging is highly topical at the moment," says Stephane Knauf, head of FX services and products at Citi in London. "As more and more banks charge for CVA and look at optimising their use of risk-weighted assets, some long-term hedges have become very expensive for buy-side clients. There has been a lot of work to solve this problem, and one appealing solution is for FX structurers to offer long-term solutions by rolling short-term FX derivatives. It's not a perfect hedge, but by doing that you are minimising cost to the clients."

But not every desk has had success in this area. "We've tried to get these kinds of alternative solutions off the ground, but it has been difficult," says one senior FX structurer at a European bank. "For instance, if a client is looking for an inexpensive commodities hedge, rather than use the S&P 500 they could take a position on the Australian dollar, which is closely correlated to the strength of the commodities market. But the client won't necessarily trust that correlation to hold up in a severe market stress scenario. It's been a tough sell."

Dori Levanoni, co-director of global macro at asset management firm First Quadrant in Pasadena, California, isn't surprised buy-side participants have their doubts. "The only sure-fire hedge for a tail event is a put on the FTSE or the S&P 500. But buying puts on equity is the most expensive thing you could possibly do. With FX hedges, you're just hoping that the correlations hold. It's not so much a direct insurance policy, more a chain of logic that may or may not play out in reality."

There has been a lot of work to solve this problem, and one appealing solution is for FX structurers to offer long-term solutions by rolling short-term FX derivatives

Despite these concerns, some banks are finding plenty of clients ready to trust the structures on offer. Jeremy Monnier, head of FX structuring at Deutsche Bank in London, estimates that 20% of clients have included FX in their management of tail risk, either by adapting their currency hedging strategy or through outright plays on correlation.

"Correlations come and go, but a select few are generally reliable. If something dramatic did happen in the markets, it's highly likely that the connection between FX volatilities and the S&P 500 would hold strong. We've had success getting European clients into strategies that benefit from dollar appreciation in the medium term as a way to hedge a possible deterioration in the eurozone, some of them with no FX exposure whatsoever," says Monnier.

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