New restrictions will make it costlier for corporations to hedge erratic currency markets—but could also make the financial system safer.
Foreign exchange swaps and forwards, which are widely used by corporations to hedge their currency exposure, account for a growing share of the $5 trillion-a-day forex market. The cost of hedging forex risk is rising, however, with new margin rules set to go into effect in Europe and some Asian markets next year. Large asset managers and financial institutions will need to maintain the liquidity to meet margin calls under the new “variation margins,” which will change daily with the market value of the instrument used. The greater capital and reporting requirements could convince some corporations and investors to leave more forex risks unhedged in the future.
Forex swaps, forwards and currency swaps totaled $58 trillion at the end of 2016, equivalent to 77% of world GDP and almost triple the value of global trade, according to data from the Bank for International Settlements (BIS). Corporations use these instruments to hedge international trade and investment, as well as foreign-currency denominated bonds.
“We have seen growth in hedging as the political landscape has become uncertain, leading to a more unpredictable and erratic currency market, with no clear direction or trend,” says Alain Kamagi, co-founder and managing partner of UNTL Capital. Demand is growing for forex swaps and forwards as leading corporates look to smooth out their international revenues by actively managing their hedges, Kamagi says.
Swaps are the instrument of choice for hedging, with a 75% share of the market, followed by forwards, with 22%, and currency swaps, with 3%, according to BIS.
Using forex swaps, two parties exchange two currencies and agree to reverse the transaction at a later date. In most cases, one of those currencies is the dollar. Currency swaps are similar to forex swaps, except that both principal and interest-payment streams are exchanged. In addition to swaps, many companies use forex forwards—agreements to exchange currencies at a specified time and price in the future—for hedging against currency swings. Because they can be tailored to meet the specific needs of a corporation, they are often used instead of exchange-traded futures, which involve standardized contracts.
While trading in the spot forex market has decreased in recent years—in part due to new regulations and well-publicized trading scandals—there has been an increase in the use of currency derivatives. Foreign exchange swaps and forwards amounted to more than $3 trillion a day, or 60% of total forex turnover in 2016.
The new margin charges are intended to increase the safety of the system. After swaps and derivatives were implicated in the 2008 financial crisis, the G20 Pittsburgh Agreement in 2009 determined that derivatives in the future would need to be cleared through a central counterparty or subjected to mandatory exchanges of collateral. So far, only non-deliverable forwards (in which there is no physical settlement of the contracts) have shifted significantly to central clearing, says Axel Pierron, managing director of global consultancy Opimas. “It remains to be seen if the new rule on posting variation margins for FX over-the-counter derivatives will have a similar impact on the FX swap market,” he wrote in a recent report.
More trading could shift to exchanges. Higher capital requirements under Basel III have made it more costly for banks to hold uncleared OTC derivatives positions. Meanwhile, a number of exchanges have purchased forex trading venues, Pierron notes. Bats Global Markets bought HotSpot FX, Deutsche Börse acquired 360T, and EuroNext added FastMatch.
In the EU, the requirements of MiFID II will be applied in the forex market in January 2018. High-frequency traders and algorithmic traders will be required to disclose their algorithms to the regulator and test them in an approved environment. That could lead to further declines in trading by this group of market participants, due to the increased regulatory burden, Pierron says.
Kamagi of UNTL Capital says the limitation on speculative trading has been caused by the pullback from Tier 1 forex prime brokers in the space, leading to a major dislocation of market participants. “This [retreat] is leading to the emergence of new non-bank players coming into the prime of prime space, looking to take advantage of the opportunity created,” Kamagi says. “This will eventually lead to a resurgence and growth in speculative spot trading.”
Hedge funds and accounts that have a forex prime broker will be the least affected by the new rules, since they already post collateral. “The biggest impact will be on real money accounts (mutual funds), multinational corporations and middle-market companies that don’t operate on margin or post collateral for their trades, but operate through direct bank credit facilities,” Kamagi says.
Returns on “real money” accounts will be impacted since they will have to leave some money uninvested to post for collateral, Kamagi says. To improve the efficiency of collateral management, corporates will have to open accounts at forex prime brokers, which will act as central clearers, he adds. In return, these funds will get better price discovery and execution, and forex liquidity should improve.
Corporations will now begin to reevaluate their relationships with banks and shift more business to the bigger players, as they will require larger syndicated credit facilities, Kamagi believes. “The smaller corporates may either elect not to hedge their exposure, or to look for other sources of funding to post for collateral,” he says.
The increased collateral requirements could help to curb the excesses of speculative trading that led to the financial crisis. Britain has agreed to adopt the new European rules for the time being, even though it has voted to leave the EU.
Meanwhile, new questions have arisen about the potential risks to the financial system from the huge volumes of derivatives being traded. BIS analysts Claudio Borio, Robert Neil McCauley and Patrick McGuire say in a new report that about $13 trillion of corporate debt is “hidden” because of an accounting rule that allows derivatives to be counted as off-balance-sheet items, even though these transactions are functionally equivalent to borrowing and lending in the cash market.
The amount of hidden debt is more than the total of declared global debt. “We know little about who is holding the missing debt or the risks it may pose to financial stability,” the BIS analysts say.
While this hidden debt is not on the balance sheet, it still must be repaid when it comes due. Because swaps are less liquid than the spot market, corporations will need to maintain strong relationships with liquidity providers. The short maturities of most FX swaps and forwards can create maturity mismatches and generate large demands for liquidity, particularly during times of stress, the BIS report says.