Rising cost of credit drives corporates back to voice trading

The hedging of currency risk by international corporates makes up a significant chunk of the demand for foreign exchange, yet the voice of the corporate sector is sometimes under-represented in discussions on the key challenges facing the industry. In the current environment, the rising cost of credit as a result of regulatory change is one of the top concerns for many treasurers, and some say it is driving changes in the way they interact with the sell side.

As banks are driven to raise the amount of capital held against their exposures, and to hold additional capital against the credit valuation adjustment component of the Basel III rules, they have passed on these additional charges to their client base in different ways, with some charging more than others, which in turn creates a distorted picture for the end user.

"It is amazing just how different the prices can be between some of the top banks in Europe, and it's really quite staggering how different models can produce very different results. It makes life a lot more difficult for us, because you can compare quotes all you like, but ultimately we know some banks are much more competitive out to 12 or possibly even 15 months, whereas other banks are competitive pretty much across the whole of our range," said Paul Phillips, group treasurer at budget airline easyJet, speaking at the FX Week Europe conference in London on November 27.

His concerns are shared by Richard Walker, group head of financial risk management at UK travel company Thomas Cook Group. With exposure across 23 currencies, amounting to a total of roughly £2 billion each year, the company has substantial revenues generated in the euro and the Swedish krona. Unpredictable moves in its core currencies are a challenge for Thomas Cook, as is the spectre of new regulations.

While Walker believes requirements for trade reporting under the US Dodd-Frank Act and the European Market Infrastructure Regulation should be manageable – as long as there is sufficient clarity on deadlines and specific requirements – the need for collateral to be posted against over-the-counter derivatives positions is more worrying.

Although we're very keen to use trading platforms when we can, what tends to happen is the banks aren't really able to price it properly

"My larger concern would be the extent to which changing regulations will ultimately restrict the ability of hedge counterparties to be able to provide non-collateralised OTC credit lines. In turn, this may force corporates into a world where collateralisation is required in order to implement risk management processes. Given the volatility of all financial markets and the impact this may have on the fair value of outstanding derivatives, this may mean corporates have a stark choice to make: whether to protect short-term liquidity reserves, or consider longer-term risk management alternatives," says Walker.

The lack of financial resources in the corporate world to support the posting of collateral, either for centrally or bilaterally cleared trades, has been a hot topic in the industry for some time. But despite the host of other regulations that are also being rolled out, collateral appears to be the top concern.

"We're very opposed to the idea of central clearing," said Phillips. "If we submit to it, we could end up having to put in hundreds of millions of dollars to support out-of-the-money positions by making sure there are sufficient margin calls to cover all this. The flipside is if you're doing that, in theory you're dealing risk-free so you should see better pricing. But as an airline, we look very hard at balance sheet efficiency and to have monies sitting there just in case, over and above monies that are there for contingency anyway, just seems fairly wasteful and not particularly efficient."

Some banks believe the options market provides a means for corporates to offset the additional costs arising from collateral requirements. "With volatility in EUR/USD at depressed levels, it is better to buy options than pay the full credit charge on longer-term transactions. These regulatory and market conditions are completely new for clients, who would never have thought it would be cheaper to buy an option than to pay for the full credit charges," explains Fabio Madar, global head of corporate FX sales at Deutsche Bank in London.

But others believe the increased costs will drive corporates to concentrate the number of banks they deal with, rather than maintaining connections and credit relationships with a large number of counterparties across asset classes.

"If a corporate has three to five strong relationships with banks, they will be much more willing to open up the balance sheet to help clients if the regulations were to push them into the collateral requirements. I think the trend of concentration towards a few banks is going to be a key strategy among corporates going forward," says Thomas Soede, global head of fixed-income electronic markets at BNP Paribas in London.

But while banks continue to push their electronic platforms, with both Deutsche Bank and BNP Paribas having launched new corporate-focused platforms this year, some corporates believe the rising cost of credit makes voice trading more attractive for many trades.

"While the movement in the market is toward greater use of electronic platforms, in today's lower credit environment the reality of credit pricing and availability may mean that using the phone and otherwise maintaining close relationships with all bank and hedging providers is essential," says Thomas Cook's Walker.

Other treasurers complain that, while their preference is to move more business to electronic platforms, their counterparties are not always nimble enough to lock in a particular deal quickly enough on a multibank platform such as FXall or 360T, particularly for longer-dated trades.

"Although we're very keen to use trading platforms when we can, what tends to happen is the banks aren't really able to price it properly. So either we decide what we're going to do, tell the bank an hour in advance, then deal through the system; or we can deal on the phone and book it on 360T, which seems a little bit odd. It's quite frustrating because clearly when you see an opportunity, you want to lock it in as quickly as you can, and so you do end up, more often than not, doing it on the phone rather than through the platform," said easyJet's Phillips.

In terms of the core business of hedging currency risk, one of the major macro trends during the second half of 2013 has been the sharp fall in emerging market (EM) currencies following the first suggestion by the US Federal Reserve in May that it might look to taper its programme of quantitative easing.

"About 80% of our sales are exports outside the UK, so we have significant revenue exposure in the US dollar, renminbi and other currencies, as well as net cost exposure in the euro. The forward points and cost associated with hedging emerging market currencies has become more challenging following market anxiety over tapering," says Ben Birgbauer, treasurer at automotive company Jaguar Land Rover in Coventry in the UK.

As a result of a sell-off in EM currencies, both the Indian rupee and the South African rand fell particularly sharply around mid-year, and while they have since recouped some of their losses, banks warn that corporates were badly hurt by the move and should position themselves for further weakness.

"We think there is a five- to 10-year bullish trend in the dollar that has started first against the yen and then contaminating across the Asian EM world," says Deutsche's Madar. "That is going to have an impact on the next 10 years, and is why we are trying to push the theme that it is time to hedge now."