FX providers adapt to the financial crisis

Deutsche Bank's Clifford Cheah, head of global finance and foreign exchange in Asia, offers his views on how the changing FX landscape has transformed the way banks do business.

The foreign exchange industry has faced a range of challenges since the onset of the financial market crisis. Banks have had to adapt to a tighter credit environment while meeting demand for liquidity and managing clients' exposure to declining mark-to-market valuations. We talk to Clifford Cheah, Deutsche Bank's head of global finance and foreign exchange in Asia, about the new world order of foreign exchange.

What have been the greatest challenges for FX providers since the onset of the credit crisis and how has this changed the way you do business?
Of particular difficulty for all banks has been balancing clients' need for liquidity against a backdrop of widening bid-offer spreads, rising market volatility and the constraints of a tighter credit environment.

Wider spreads have increased the risk for institutions in terms of counterparty exposure, particularly on structured trades, while ensuring consistent pricing on the flow side has very much depended on an institution's access to large pools of investor liquidity. While FX markets are known for being the world's most liquid, the extreme market events seen during the summer of 2008 did result in pricing on some Asian currency pairs varying considerably among providers, illustrating the extent of stress felt at the time. While spreads have since come in, this highlights the importance of an institution's ability to reach as broad a client base as possible, ensuring pricing can be provided regardless of market conditions.

In terms of volatility and credit constraints, banks have had to ensure their internal risk management systems allow capacity for new business to be maintained. Having the right technology is obviously a key part of this, but so is taking the right approach. We have focused on evaluating client risk at the portfolio level rather than simply focusing on individual trades. Not only does this give us a more complete picture of a client's risk profile, it also benefits the client by taking advantage of portfolio correlation and netting to potentially receive better pricing and more open credit lines.

This approach involves ensuring the client has the product most suitable for their means and needs while using detailed trade confirmation that encourages the use of ISDA and the Credit Support Annexe (CSA) collateral guidelines, which is a way to increase the collateral set against a derivatives trade.

This approach has very much proved its worth over the crisis to date, particularly in the second half of last year when market contagion was at its highest. Given the opaque outlook for markets globally, we think this will continue to be an important differentiator between FX providers.

A number of Asian corporations have announced losses on FX hedging. Do you foresee a shift in willingness for companies to manage their currency exposures?
Companies in Asia understand the need to manage currency exposure, but there has historically been an unwillingness to pay for that protection. With volatility likely to remain elevated in the medium term, there has been a greater willingness from companies to pay for certainty in terms of their currency exposure. You could say the focus has gone from receiving premiums on risk management trades to paying premiums.

Our structuring team offered embedded stop-loss features in a number of popular hedging structures prior to the summer spike in volatility and these proved their worth, even if they were a little more expensive compared to their less-protected alternatives. We are continuing with this approach and have introduced a range of more conservative products for corporate clients in Asia to manage currency risk. These products include trigger payments and greater collateral requirements, which better protects the client and allows us to transact more business by minimising our own credit exposure.

What has been the biggest trend in terms of client activity since last summer?
Volatility and falling global interest rates sparked massive demand for restructuring of both asset and liability-side trades, particularly in the second half of 2008. We were incredibly busy helping clients unwind risk management products that were more suited to low volatility markets, while helping investors exit carry trades that were adversely impacted by global monetary easing in the second half of last year. 

A popular strategy during the bull market, carry suffered in 2008 as global interest rates began to converge. Diversifying investors into better performing strategies or into baskets of less volatile currencies was a key task last summer.

Access to deep pools of investor liquidity has also been extremely important when restructuring trades amid highly volatile markets as it helps risk to be transferred efficiently and at the best possible price.

Do you therefore think the days of highly structured, complex products are over?
I think complexity will always have a role, particularly in terms of managing bespoke risk, whether related to an investment portfolio or to a company's currency or credit exposure. All too often complexity has been associated with leverage, which in today's high volatility environment is not something we are recommending our clients use in most instances. It is important to remember that complexity can add value -- by adding an extra layer on a vanilla trade to cap downside risk or reduce volatility, for example.

If anything, we may see growing use of complex (un-leveraged) trades as volatility has made off-the-shelf structured products less effective in terms of risk management than they were previously. Our structuring platform is very much focussed on creating bespoke trades at present, rather than products for general distribution, as quite frankly risk management shouldn't be a one-size-fits-all approach in markets like these.

How significant has the financial market crisis been in terms of investor interest in FX?
The value in using FX as an asset class and as a portfolio diversification tool has certainly been made apparent over the past 18 months. While equity and credit markets tracked downward, we saw a number of FX managers post positive performance in 2008, whether as part of a broader macro strategy or as stand-alone managers.

Volumes from Asia into our investable FX product suite have increased and, on a broader market level, the number of providers in Asia offering electronic FX trading services to retail and institutional investors continues to grow.

Away from the question of investment returns, investors generally have had to re-think their approach to managing currency risk on overseas investments, particularly as FX and asset price volatility has risen. A simple illustration of this would have been a Korean-based asset allocator facing the twin hit of a depreciating won and rapidly falling global equities in the second half of last year.

The questions being asked have been common to all markets over the crisis: how much do I hedge, how often do I re-balance and what is the best way to manage my exposure? While it's difficult to provide a blanket answer to all these questions, we have seen investors monitor their hedging programmes more closely and much more frequently.

What do you see as the key trends for Asian currency markets?
For corporates, the current market environment will continue to have an impact, whether in terms of foreign earnings, debt or acquisitions. Currency volatility has clearly been a challenge and as discussed earlier, companies are beginning to change their approach to managing this risk.

An emerging trend I find interesting is the growing use of currency hedging in regional M&A transactions. Unlike M&A activity within the US and Europe, the vast majority of transactions in Asia involve a mismatch between the currency of the asset being acquired and the currency that the acquisition is being financed in. This mismatch creates considerable risk from currency movements throughout the acquisition process. Hedging this risk has become increasingly common among Asian acquirers and we expect this to continue.

For investors, I think the popularity of using FX as an asset class will continue to grow, both as a means for portfolio diversification and an alternative source of excess returns. Asian currencies continue to provide unique performance characteristics compared to global currency movements and I believe more products with Asian currencies as the underlying will emerge. On the liability side, we expect more resource and attention to be paid to FX risk on foreign investments as markets remain volatile, particularly in terms of monitoring and re-balancing hedging positions.

In terms of the broader market landscape, Deutsche Bank continues to work with regulators throughout Asia to grow the liability management and investment choices available to market participants. This process is ongoing and one we feel is of great value towards the development of local financial markets throughout the region.

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