Always prepare for the unexpected in FX markets

The foreign exchange market is the largest and most liquid market in the world. According to the Bank for International Settlements Triennial Central Bank Survey, trading in FX markets reached $6.6 trillion per day in April 2019, up from $5.1 trillion three years earlier.

The FX market is notoriously volatile. But the trillions traded each day allow large volume transactions in the major currency pairs to be absorbed with little disruption, or impact on spot or forward market spreads and pricing. This piece does not seek to address the volatility of the FX market (which is ever present), but to highlight how unexpected events can have an impact on both the cost of hedging and a business or fund’s liquidity.

The spreads (or execution charges) that Chatham Financial negotiates on behalf of clients reflect a well-functioning and competitive market. However, like all financial markets, there are periods of stress when fast-moving prices cause significant liquidity deterioration resulting in increased bid-ask spreads (the difference between an immediate sale and an immediate purchase of the currency pair).

This deterioration in liquidity is the result of two main factors. The first is when the largest liquidity providers (predominantly global banks) significantly cut back on their quoting activity, smaller institutions step-up. Smaller dealers charge wider bid-ask spreads and a steeper forward discount. The second reason is that to protect their own trading books’ P&L from the increased volatility, all FX dealers will widen their spreads which can be justified when there is less liquidity.

When the World Health Organization declared that the Coronavirus was a pandemic, and the global economy shutdown, financial markets went into a tailspin as investors evacuated risk assets and trades, piling into cash, government bonds, and the U.S. Dollar. CLS, a major settler of trades in the foreign exchange market, reported five of the 50 largest all-time daily spot volumes came in March 2020, with monthly record volumes in euro/dollar, dollar/yen, and sterling/dollar. These record volumes translated into significant daily movements. This caused interbank FX spot spreads to widen to 2.5 times their average for the year in major currency pairs and as much as 4.5 times in some cross rates¹. In addition, the recorded average daily volatility for March was almost double the previous monthly high.

As seen in the chart below of the 1-month swap points in GBP/USD (which represent the interest rate differential between the two currencies), it wasn’t just spot market liquidity which fell away during March. There was a significant deterioration in FX funding liquidity, measured by the deviation from the covered interest rate parity.

The impact of this liquidity deterioration naturally spilled over into the pricing of spot and forward contracts on the buy side. Some banks used the market volatility to increase the credit charges applied to unsecured forward contracts. Without the relevant market knowledge and expertise, as well as the pricing tools, many companies and funds were executing trades completely unaware of the increase in spreads and charges. While you can’t prevent, or anticipate, financial market stress that leads to less liquidity and increased market spreads, there are ways to ensure fair and transparent pricing when executing FX transactions, including engaging an independent advisor.

Equally as important as being prepared for illiquid markets is managing collateral to be ready for large price movements. During March, from a high of 1.32 (GBP/USD), GBP fell nearly 14% in less than two weeks, reaching a level last seen in 1985. The size and speed of GBP’s decline presented a headache for any businesses or funds that had hedged GBP against USD. There are other examples of moves of as much 30% in some currency pairs over the same period (e.g., EUR/NOK).²

Movements like these can quickly lead to significant margin or collateral calls from banks or brokers. This “call” must often be settled within 24 hours to avoid the trade being terminated, crystalizing a potentially huge loss and leaving the business or fund unhedged. To prepare for periods of heightened volatility, it is vital to have an appropriate number of counterparty banks or brokers, with threshold amounts or margin limits that provide significant capacity to absorb deeply negative mark-to-market valuations of hedges. Having uncollateralized or zero margin facilities of as close to 20% of the nominal value of your contracts will protect your business or fund from facing significant margin calls.

James Burke, author of the book Connections states, “Why should we look to the past in order to prepare for the future? Because there is nowhere else to look.” 2020 has been an unprecedented year, especially as it relates to the human cost of the pandemic and the associated policy response. However, the experience has taught us to be better prepared for the unexpected. The same is true for managing FX exposures.

At Chatham Financial, we support clients by negotiating spreads and charges, and benchmarking transactions to ensure the pricing terms are as agreed. Our depth of market access, through advising on hundreds of billions in annual transactions, gives us critical insight and information. This enables us to challenge our clients’ counterparties pricing where it is uncompetitive.

Managing liquidity through sufficient margin-free hedging capacity is another key aspect of our service. From negotiating ISDAs, to achieving the best possible terms and highest threshold amounts, to modelling adverse scenarios and ongoing support with managing the portfolio of hedges.

¹ Cross rates are a currency pair that does not involve the USD (e.g., EUR/GBP)

² Norwegian Krona