Eliminating the FX problem at the source to increase its management efficiency

To improve foreign exchange (FX) management, which has been identified as an issue because it is too often manual, it is necessary to address the problem at its source when identifying the underlying risks. The lack of coordination and Straight Through Processing (STP) between operational and treasury tools makes FX management partially inefficient. A risk does not arise when it is communicated to treasury and hedged, but when it becomes at least a “firm commitment” (according to IFRS 9). Let's ask ourselves how and with which tools to finally become fully efficient

Identifying the FX risk at its source

The objective of currency risk management is to limit the financial risks associated with operational activities. This risk is called "transactional risk". It is not the balance sheet risks (known as "translational risks") nor the risks of financing in foreign currencies (managed directly by the treasury department) that pose problems. On the other hand, it is the risks linked to the underlying operations (i.e., operational activities linked to the business) that complicate the management of FX risks because they are initiated or created by the operating subsidiaries in the course of their activities. In order to be well covered, a risk must be understood, known and above all informed in a timely manner to the right person (i.e., the group treasurer). It is this connection and its efficiency that allows for good management. If a grain of sand interferes in the process and delays the transmission of information on the risk and its nature or distorts it, the treasurer, however good he/she may be, will not be able to cover it properly or effectively. This is the key to properly managing foreign exchange risk.

Mirror management

Foreign exchange risk management is a kind of mirror image. A risk arises (e.g., the sale in foreign currency of a product that will result in a forward receipt in a currency other than the functional currency) that requires a financial hedging product (typically an Over-the-Counter / OTC derivatives). Obviously, it all depends on the group's policy and strategy in this area, but generally, 100% of on-balance sheet risks are hedged and a gradual portion of off-balance sheet risks are hedged. In practice, when a European company sells for 5 million GBP, it will sell the amount at term (date of expected receipt of funds) and buy the equivalent in EUR at the price initially agreed. In an ideal world, the accounting exchange rate of the sale will be the same as the forward sale rate (excluding swap points), thus fixing the revenue in a fixed and precise manner and protecting the operating margin generated by the operating subsidiary. In summary, the subsidiary informs the treasury of a risk that it is hedging with an external hedging operation and replicates the contract (i.e., in intra-group operation / TP) to its subsidiary. The transaction is therefore neutral or "square" because the inter-company transactions cancel each other out, or "neutralize" each other. But the accounting and financial mechanism will only be perfect if the risk, when identified, is immediately communicated to the treasurer so that he can cover it. A time difference of an hour, a day, a weekend, a week, etc. can be fatal in a context of maximum volatility. If during the day the USD/EUR moved by one figure (i.e., 100 pips), on one million USD the extra cost would be about at the current rate of 0.94% (less than one percent or EUR 8.8k).

More than ever, time is money...

Time is money, as the saying goes. This is perfectly applicable to foreign exchange management. Waiting is a risk (but also obviously an opportunity) to pay more (or less depending on the case). The treasurer, who is the guardian of the temple (of finance), must take care to protect the operating margin that is sometimes held. Not perfectly covering a risk or aggregating them gradually can completely eat into the business margin, which is often already complicated to ensure. To limit the risk linked to reaction and information time, there is only one solution: process automation. The machine never sleeps, works on vacations and weekends and avoids the impact of time lag on coverage. This is the phase that is commonly referred to as the "pre-trade" phase, as opposed to the coverage and "post-trade" phases. The latter two phases are certainly important and are generally covered by cash flow. However, without the identification phase, the best hedge executions, and the best hedge management until the end of the hedge are not fully effective. Most treasurers forget this crucial part. However, if we identify the risk faster, we can only cover it better without friction or time impact. We can also use automation to apply the principle of individualized coverage (known as "one-to-one approach”) regardless of the amount. Imagine an online travel agency selling trips to California. Each trip is a risk because if you bill your European customer in EUR, the cost will be for the hotel and maybe the plane in USD. The dynamic and immediate (because individualized) micro-hedging makes it possible to perfectly protect all the margins of the tour operator (note that these margins are generally weak and thus fragile if the currency appreciates strongly). Macro-hedging, on the other hand, is certainly lighter administratively, but how much more complicated under IFRS if you apply hedge accounting. Refining FX management is virtuous and allows for efficiency. But on the other hand, it implies an adapted system as there are only a few (e.g., KANTOX) to automate the management of a risk in a tool (e.g., for our online travel agency, its reservation system and database - with outstanding amounts, cancellations, etc...) and the TMS tool.

Manual execution / processing

The execution of the hedge, contrary to popular belief, is manual. You are given a risk and you hedge it by going to a trading platform. You ask for a price and the platform allows you to execute and confirm it. But today, CMA systems (i.e., Currency Management Automation) allow you to feed the platform directly 24/7 and without the treasurer getting involved. Because what is the added value of executing a foreign exchange deal? There is no added value because it is repetitive and time consuming. Not to mention that it is risky because of its manual nature and the multiple entries. An underlying risk lives its life, it evolves, changes, and sometimes disappears. For example, during COVID, many products were no longer produced or delivered. A contract may be cancelled due to a lack of parts or commodities. Its price can be revised upwards through contractual clauses, etc... As you can see, a risk lives and its coverage must live symmetrically. If you pay a deposit, a tranche, the cover must be reduced by the same amount, etc... The interfacing between the underlying risk library and the OTC derivative hedging management tool is crucial but often absent. One wonders why because without it, there can be no perfect FX management.

We can conclude this article by strongly recommending that every treasurer tackle this part of FX risk management to be more relevant and efficient. This must be one of your challenges in the race to digitize cash management, a challenge for every treasurer today. And if you had any doubts about the benefits of what has been explained above, ask a specialist to estimate the gains and ROI for free, you will be amazed.

François Masquelier, CEO of Simply Treasury, your Treasury Strategy Advisor – Luxembourg – January 2023

Disclaimer: This article was prepared by François Masquelier in his personal capacity. The opinion expressed in this article are the author’s own and do not necessarily reflect the view of the European Association of Corporate Treasurers (i.e., EACT).