Eric Huttman

Counterparty diversity: a prerequisite for FX risk management?

September 2023 in Risk Management

The collapse of Silicon Valley Bank, UBS’s takeover of Credit Suisse and the closure of Signature Bank has shone a light on many vulnerabilities in the banking industry, particularly the risks associated with only having one or two banking partners. Eric Huttman, CEO at FX-as-a-Service provider MillTechFX, explains why there’s safety in numbers when it comes to FX counterparties and how firms can enhance their FX risk management in this uncertain climate.

On March 8th, shares in Silicon Valley Bank (SVB) began to fall sharply due to fears of the bank’s solvency. Venture capital firms began to advise their portfolio companies to withdraw money from SVB and by the end of March 9th, customers had initiated $42 billion in withdrawals. The next day, US regulators took control of the bank, whilst SVB’s UK arm was sold to HSBC for £1. Spooked by the sudden collapse of SVB, customers at Signature Bank began to also withdraw deposits.

As withdrawals reached over $10 billion, regulators took over Signature Bank in the third largest bank run in US history.

The collapse at SVB and Signature Bank was swiftly followed by a crisis at Credit Suisse, which culminated in rival Swiss bank UBS agreeing to purchase the beleaguered firm.
This turbulence raised the question: what lessons can be learnt from these events?

Whilst the banking sector has seemingly stabilised since the turmoil of the Spring, it’s important that senior finance decision-makers at corporates and fund managers review their banking setup to make sure they have the right systems in place to mitigate the impact of any future crises.
As they navigate this uncertain landscape, they should consider assessing their existing foreign exchange (FX) counterparties and using technology to get access to multiple liquidity providers to protect their business from any further fallout.

Corporates and fund managers should consider establishing a robust counterparty risk evaluation framework that considers a range of risk factors

Counterparty risk assessment

When selecting FX counterparties, many firms may prioritise prices and onboarding times as two major factors. But, as the recent banking crisis illustrates, other execution factors such as the likelihood of settlement are equally important.

Corporates and fund managers should consider establishing a robust counterparty risk evaluation framework that considers a range of risk factors. These include monitoring realised and unrealised profit and loss for each counterparty, credit rating from reputable rating agencies, credit default swaps as well as regular counterparty review and monitoring activities.

In addition to reviewing and assessing the counterparty risks, recent market events also highlight the importance of establishing a robust FX execution contingency plan that takes into account legal and operational complexities. If the counterparty becomes unavailable, the firm should be able to quickly and efficiently manage the existing FX trades (such as through novation or close-out) and implement new FX trades as the business requires.

Multiple counterparties

One of the big lessons for corporates and fund managers from recent events in the banking industry is the importance of having access to multiple counterparties.

It is now widely known that a bank’s failure can cause serious short-term liquidity issues. Should a banking counterparty no longer be able to function as an FX provider, then this can affect vital expenditures such as payroll and supplier invoices, even if it’s only for a few days. Other risks include:

In-the-money FX hedges – if a firm has open FX forwards with a failing counterparty and those positions have a positive mark-to-market (i.e. they make a profit if they were to be sold back into the market today at the prevailing spot rate), then the firm might be at risk from not realising that mark-to-market gain.

Loss of collateral – if a corporate or fund manager has had to post collateral with their counterparty in order to book an FX forward, then that collateral may be at risk, in a similar way to cash deposits.

Not being able to maintain the FX hedge – crucially, there is a risk that any pre-existing forward contract will not be honoured. If the purpose of that forward was to mitigate the effect of FX volatility on a portfolio of foreign currency assets, then fund level returns could be negatively impacted. Many CFOs are subsequently making changes for the better, with one in four (28%) planning to diversify their deposits across more banks.

But this lesson also applies to FX operations. In FX, reliance on one or two banking partners can be a particular problem. For corporates and fund managers who trade FX for payment or hedging purposes, FX can be seen as second-order: they transact in FX not because they ‘want to’, but because they ‘have to’ due to international business activities. It is thus often operationally inefficient for them to set up and manage multi-bank relationships.

In some instances, regional tier two banks will offer smaller firms a ‘soft dollar’ arrangement whereby they provide a discount on other services if the corporate or fund manager deals exclusively with them for FX. This means they are often reliant on one or two counterparties, and it can often take months to onboard others, which leaves them open to risk should another bank run occur. The loss of a major FX counterparty could render firms unable to trade, potentially impacting staff pay, supplier invoices and currency exposure.

Recent research from MillTechFX shows that senior finance decision-makers at corporates and fund managers are taking this lesson onboard when it comes to their FX operations. 88% of corporates and 81% of fund managers are now looking to diversify their FX counterparties following the recent banking crisis.

This highlights that firms are taking positive action to diversify their counterparty base to avoid having all their eggs in one or two baskets.

Having multiple counterparties can also have a positive impact on pricing. Due to the opacity of the FX market, it can be incredibly difficult to compare prices without having access to multiple banks. At any given time, they may not be able to trade at the best available rate as they have no other access points to the market. Getting competitive quotes from multiple counterparties can enable corporates and fund managers to compare the market so they can ensure they get the best rate and achieve best execution.

Responses from Corporates

Responses from Fund Managers

A new, technology-driven approach

It’s clear from this debacle that cost and transparency issues aside, reliance on one or two counterparties can be an extremely risky strategy.

Fortunately, there are alternatives to the traditional single bank-based approach on which so many corporates and fund managers have been forced to rely. Technology and the advent of electronic trading have enabled new entrants to offer an alternative way to transact in FX that addresses risks associated with a single point of failure.

They offer access to a greater pool of liquidity from a single interface, providing corporates and fund managers with more options, safe in the knowledge that if one counterparty faces financial difficulty, they can select a different one with potentially minimal operational impact on their business. This also has cost benefits as it enables them to compare live rates and execute at the best available price.
By expanding beyond traditional brokerage or banking relationships, corporates and fund managers can get access to the kind of liquidity normally reserved for the largest trading institutions, along with associated cost savings. Vitally, they get the safety that comes with having multiple counterparties.