Corporates must diversify FX counterparties

A year after the Silicon Valley Bank collapse, UBS’s takeover of Credit Suisse and the closure of Signature Bank, working with more FX counterparties needs to remain a priority for businesses writes Jason Gaywood, Head of Corporate Solutions at FX-as-a-Service provider MillTechFX. 

In spring 2023, the banking industry was plunged into chaos. U.S. federal regulators announced they took control of Silicon Valley Bank on 10 March. This was the second-largest bank collapse in the country’s history.

Shortly after, Signature Bank became the third-largest bank failure in U.S. history, with regulators taking control just two days later.

The crisis spread to Europe which culminated in UBS buying out the beleaguered Credit Suisse in a deal engineered by Swiss regulators.

This sent global corporates into a frenzy as they considered the potential for a contagion effect and worried about what would happen to their deposits. There were major concerns around making payroll, paying suppliers and getting paid, and the safety of deposits and collateral.

Although the banking space appears to have stabilised since the turmoil of last spring, uncertainty remains. This is particularly the case in the regional banking landscape following issues at New York Community Bancorp and Republic First.

While there is no sign this will escalate into another full-blown banking crisis, the fragility should serve as a timely reminder of the importance of depending upon a broad range of banking partners.

Access to a range of counterparties

A key takeaway for corporates from recent banking history is the importance of having a strong and diverse panel of counterparties.

A bank’s failure can cause serious short-term liquidity issues among other FX risks, which include:

1. The inability to maintain the FX hedge – 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, then bottom lines could be negatively impacted.
2. Lost collateral – if a corporate 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.
3. In-the-money FX hedges – if a corporate 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 rate), then the business might be at risk from not realising that mark-to-market gain.

Depending on one or two banking partners can be a particular problem for FX. It can be seen as second-order for corporates trading FX for payment or hedging purposes: they transact because they ‘have to’, rather than because they ‘want to’, given their international business activities. Developing and managing multi-bank relationships is therefore often operationally inefficient.

Regional tier two banks will, in some cases, offer smaller businesses a ‘soft dollar’ arrangement whereby they provide a discount on other services if the corporate deals exclusively with them for FX. As a result, they are often reliant on only one or two counterparties, and it can often take months to onboard others, leaving them exposed in the event of further bank runs.

Since March 2023, most businesses have been changing their ways, with 77% of corporates across Europe, 73% in the UK, and 88% in North America looking into the diversification of their FX counterparties as a direct result of the banking crisis.

Pricing can also be positively affected by having multiple counterparties. Given the lack of transparency in the FX market, it can be incredibly difficult to compare prices without having access to multiple banks. Trading at the best available rate at any given time could be made impossible since they have no other market access points.

Access to competitive quotes from multiple counterparties can give corporates the ability to compare the market, ensuring best execution in line with the FX Global Code of Conduct. This stipulates that FX market participants should treat customers fairly and take all sufficient steps to obtain the best possible result for the client when executing orders.

Evaluating counterparty risk

When selecting FX counterparties, many businesses may prioritise prices and onboarding times as two major factors. These are clearly very important factors, but, as the recent banking crisis illustrates, other factors such as the likelihood of settlement are also important.

Businesses 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 business 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 required.

The need for diversification

These issues clearly demonstrate that relying on a select few counterparties can be a very high-risk strategy.

However, better and safer alternatives to the popular traditional single bank-based approach do exist. Electronic trading and technological developments have enabled fintechs to offer alternatives to transacting in FX with a single point of failure.

Thee new trading methods grant access to a wider pool of liquidity from a single interface, providing corporates with more options and the reassurance that if a particular counterparty faces financial difficulty, another can be selected without it being a huge operational burden. In addition, the ability to compare live rates and execute at the best available price has significant cost benefits.

One of the biggest operational challenges corporates face when it comes to FX is onboarding liquidity providers, which may explain why the intention to diversify counterparties hasn’t quite translated into action just yet. However, it’s crucial they overcome this to safeguard their business from banking risk.