In times of increased uncertainty and volatility in the currency markets, we would expect many of our corporate clients to be protecting themselves against the impact that sudden swings in exchange rates could have on their earnings, as well as taking the opportunity to benefit from the potential upsides.
This was certainly the case during the European Referendum in June 2016. However, the outcome of current negotiations is far from a binary ‘in or out’ and could lead to a similarly broad range of results for the value of sterling. Given that spread of possibilities, some companies are leaving their exposures unhedged, to the greatest extent possible, hoping that the way in which sterling eventually moves will be to their benefit.
Corporate treasurers typically use hedging strategies such as forward contracts to protect against potential adverse movements in future exchange rates, and so one would normally expect a higher proportion of forward contracts during periods of uncertainty and currency volatility (in this case caused by Brexit). But in the businesses and management teams of many clients, the inverse it true – we are seeing a significant fall in the proportion of corporate clients hedging their currency risk.
Analysis by our traders at Argentex has found that despite a 28% increase in total currency traded by us last year, the percentage of the volume that represented forward contracts – fixing an exchange rate now for future delivery – fell to just 32%, compared to 42% in 2017.
“The uncertainty brought about by the increasingly tiresome political discussions between the EU and the UK is most challenging to management teams, treasurers and finance directors”
Activity in forwards contracts, which lock in future exchange rates, has halved since 2012, while the proportion of spot trades has been rising. This suggests that companies are refraining from hedging and instead they’re waiting to the very last minute until they need to buy FX and then they transact in spot markets.
In addition, the uncertainty brought about by the increasingly tiresome political discussions between the EU and the UK is most challenging to management teams, treasurers and finance directors who need to manage their company’s capital over medium- to long-term time horizons.
As a result, we are also seeing that the average tenor (the length of time that a forward contract extends to) has declined 35% since 2016, suggesting that corporates feel there is a lack of visibility. As a result, in addition to more companies leaving their currency risks unhedged, they are doing so for shorter periods of time for fear of making the wrong call.
So why aren’t treasurers hedging their FX risk?
Fool me once…
Many corporate treasurers have already found themselves and their hedging positions caught out once by Brexit. When the referendum surprised the financial markets with its ‘leave’ vote in June 2016, it was the finance teams that were blamed for FX-related losses. As a result, they are unwilling to take the risk again.
In addition, treasurers are well aware that there are always internal factors that they can control – such as budget costs, currency forecasts and the general logistics of Brexit planning – but they are unwilling to stake their fortunes on the volatile pound.
Optimistic sterling forecasts
Whilst banks such as Morgan Stanley and Nomura are forecasting an exchange rate of 1.5200 and 1.5900 by year end, underpinned by a prevailing view in boardrooms that a positive Brexit outcome is likely. This is in our view, overly optimistic on sterling.
We believe there is a danger that firms are significantly underappreciating the downside risks of Brexit to the pound, which may also be contributing to the trend of reduced hedging.
Furthermore, the upside potential from a further delay may be diminished by further political fall out whatever direction that Teresa May turns. Brexit risk may be mitigated in the short term but if it is simply replaced by election risk, more specifically the potential for a Corbyn-led coalition or majority government which some have argued could be worse than No Deal for the economy, then concerns for the pound will remain.
Securing board buy-in
In the run-up to the 2016 referendum, many corporates of all sizes were hamstrung by the strong boardroom beliefs of CEOs and Chairmen that the Remain camp would win the day. The same may still be true as negotiations continue.
In the last few years, many treasurers have taken on increasingly strategic roles within their companies, and the current market arguably brings necessity for treasurers to ‘speak truth to power’ and provide valuable advice to the CFO and the board.
“Treasurers need to have a clear understanding of their FX exposures”
To do this, treasurers need to have a clear understanding of their FX exposures, and they need to have partners and advisors who enable them to react quickly to both adverse events and market opportunities. Amongst the media onslaught, clearer communication of market conditions within an organisation may help encourage a culture of more two-way communication between treasury and the business.
Uncertainty around the eventual direction that Brexit will take (and when) makes it more important than ever for treasurers to get their houses in order with regards to FX risk management. Despite calls for a second vote, it is becoming clear than Brexit is here to stay.
Corporates need to understand that they need not be hostage to external FX fluctuations. ‘Taking back control’ has been a rallying cry throughout the Brexit process, and forward contracts allow UK corporates to do just this – limiting their downside risk and making the most of the potential upside. We regularly advise clients on how to develop FX solutions in a cost-efficient way, while affording them the necessary flexibility to meet their foreign exchange and business requirements over the coming months.
About the author
Carl Jani is Co-CEO of Argentex, an FCA regulated provider of foreign exchange services across EMEA.