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Risk Management in Adverse Markets: FX Forwards and Collateral

Risk Management in Adverse Markets: FX Forwards and Collateral
by Jon Eckler on

Insight

The crash of 2008 proved that no institution is immune from a full-blown liquidity crisis.  While counterparty risk management processes have since evolved, insufficient collateralization programs for FX Forwards victimized Financial Institutions of all sizes during 2020 COVID-19 volatile markets. 

Financial Institutions manage FX Forwards risk using several practices in addition to Netting Agreements and prudent right of set-off terms.  Specific to collateral risk management, these practices include counterparty credit reviews, diversification of counterparties, management of deal size, currency pair volatility, and duration-tenor thresholds.  Still, the unimaginable consequence of the COVID-19 Pandemic on markets caused material losses to some of the foremost industry players – one notable global giant took a fatal blow instantly collapsing.  These losses stemmed from isolated failed margin calls on Forward Contracts and Derivatives.

Risk mitigation is only as potent as the technology that drives it.  Risk management technology that is disconnected or not interfaced in real-time with the core dealing software platform might suffice in ordinary or perhaps in volatile markets.  However, in adverse markets such as the market crater created by COVID-19, some of the best credit minds and risk platforms in the industry did not react fast enough.

With ever increasing competitive pressures, more Financial Institutions offer zero-deposit/margin-free FX Forward facilities measured as a function of client creditworthiness, transaction size, and forward tenor.  Contemplating a risk management framework that addresses risk of collateralized, partially collateralized, and uncollateralized facilities capable of withstanding wild market swings requires some fundamental pillars:

  1. Integrated Automation: computing collateral (or remaining credit lines) as a function of unrealized gains and losses must be a real-time engine.  Deal flow, counterparty liquidity and contingent exposure from Orderbooks or Options must operate in unison.
  2. Digitized Liquidity: traditionally staffed dealing desks tasked with managing currency exposure require automation to cope in adverse markets. At a minimum, pricing and execution should be a straight-through-process to the extent that risk mitigation trades can execute without human intervention as de-risking protocols dictate. 
  3. Defined safety-valves: pre-configured and automated exposure and volatility valves should be instituted to liquidate, stop-loss or bracket exposures during wild market runs particularly in adverse times.

These pillars stand alongside the rest of the operational FX Forward infrastructure. Initial and variation margin management; overseeing proactive versus reactive customer collateral terms; perpetual limit monitoring and credit monitoring; and statements and reporting should not operate in a silo but instead function collectively with all pillars.

In deteriorating markets, faith in the balance sheet health and general creditworthiness weaken.  A risk mitigation platform that is seated on automation, integration and efficiency adds a necessary layer of safety during turbulent times.

There is a noteworthy front-office dimension to FX forward collateralization. FX specialty firms successfully sell to their customers hedging tools to mitigate foreign currency exposure – FX forwards being a primary product. Often a material value proposition, many of these firms tout high-touch and high-service models with their clients resulting in successful customer relationships. However, there remains a service disparity between working with a client to hedge versus subsequently helping the client manage the hedge.  After executing the initial forward hedge, from abnormal spikes of volatility to outright adverse markets conditions, there are elegant ways to further protect the client.  If a wild market run aggressively drags the customer out-of-the money, preemptively placing stop loss orders or bracket orders are basic methods of managing the hedge. Surprisingly, this type of post-trade hedge management is rarely afforded to the lower echelon of the SME market.

Strictly from a risk standpoint, simple practices of post-trade hedge management will prevent FX Forward collateral eroding to zero or negative territory before reacting.  The automation of stop loss orders or bracket orders allows the client to exit the hedge if the market moves adversely against them and re-protects on the other side of the bracket if the market swings back. Inevitably, both parties are better off with proactive (and perhaps predetermined) post-trade hedge management. Both parties are more protected as compared to an unmanaged hedged forward.

Pillars of automation, integration and efficiency can propel customer relationships with a stronger mutually beneficial risk mitigation toolbox.

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