Treasury Today Country Profiles in association with Citi

The tug of trading

Man doing tug of war

Foreign exchange (FX) risk management has become an increasingly integral part of the treasurer’s role. But are there opportunities for companies to profit through FX trading? And even if there are, should treasurers really be taking advantage of them?

Safeguarding cash at all costs – even if it means zero return – has become a symptom of post-crisis treasury, with the cost centre model dominating. Yet Gautam Jain, Global Head of Client Access at Standard Chartered believes a change is underway. “There is a subtle shift happening in the sense that treasuries are now slowly bending towards operating as profit centres – this is a general central market trend which will continue to pick up.”

Does this mean that we will see treasurers turn into traders as they look to capitalise on the market movements that they are so used to hedging against? Or will foreign exchange exposure remain something to be managed, not manipulated?

The swinging pendulum

There is no definitive right or wrong answer to the cost or profit centre debate but it is sure to generate strong emotions either way. Regardless of the arguments, the choice of treasury operating model should be based on that which is most suitable to the structure and agenda of a company.

Rick Martin, Group Director of Investor Relations and Treasury at Virgin Media is one treasury executive who opts for the more traditional, cost centre approach and does not engage in FX trading for profit. “We are all looked to with considerable intensity to safeguard our cash and to add value – but I see this as being done through optimising our WACC (Weighted Average Cost of Capital), and through securing prudent returns on capital; the former driving us to concentrate equity ownership in the hands of those who want it most and, at the same time, getting across the company’s investment thesis.”

A European treasurer of an international manufacturing company agrees that speculation through FX trading is not the ideal way for a treasury department to improve its cash balance, but he is an advocate for building upon the inherent ‘business of the company’, ie hedging. Speaking from his experience as a financial trader, he says, “In addition to the hedging, why not add some trading for profits in a very structured and monitored operational way, with traders gaining from foreseeable short-term movements?”

The treasurer, who prefers to remain anonymous, also believes that if the financial infrastructure of a treasury is built in a similar way to how the FX activities of a bank operate, then its ‘natural flows’ should make it possible for an experienced trader to take advantage of the market relatively easily. Taking a major international financial institution, for example, the majority of its FX flows consists of branch consumers making retail FX transactions, large corporates buying FX for their next invoice payment, in addition to the bank’s own internal active investment decisions and so on.

If a corporate treasury can integrate this style of natural flow functionality into its FX operations, successful trading should be a lot more achievable, says the treasury executive. “Corporates that are successful at trading have a finance entity that is in charge of the FX hedging for the entire group. Such a corporate has natural flows within the subsidiaries of the group from different geographical locations with various currencies.”

He also says that it is relatively less proactive and stressful to be an FX trader in this type of institution, since although it still requires speed, accuracy, skill and good systems, it is possible to ‘ride the wave’ of these natural FX flows.

Profiting safely

Although FX is typically known as a low-margin business, there is potential for significant profit in the FX market – however very large profits are usually only seen when sinister forces are at play. Taking an example from the retail space, Kashya Hildebrand recently sold CHF400,000 (£270,000) for US dollars, making a 19% profit within the space of two months. Soon after this enormous profit hit the papers, it emerged though that the former hedge fund trader was apparently tipped off by her banker husband Swiss National Bank (SNB) Chairman Philipp Hildebrand as he prepared to protect the Swiss franc for the first time in three decades.

So under ‘normal’ market circumstances, is the return of FX trading worth the risk? One area both sides of the treasury fence (cost centre vs profit centre) will agree upon is the difficulty in determining how much of a profit can be made from FX dealing. However, where to draw the line between the treasurer’s responsibilities as gatekeeper for the company’s cash and as a driver of revenue is a far more contentious issue.

The European treasurer says that the main role of the corporate treasury function regarding FX is to protect the company from currency fluctuations that would put hard-earned sales margins at risk. But he also believes the trading function still has a (lucrative) place in the corporate. Larger corporates, because of their often significant exposure to commodity markets (that have a very high correlation to the FX market), are often better positioned to actively trade currencies, based on their experience in trading in a multitude of countries. They may also have trained trading staff on hand.

However, Tim Carrington, Global Head of Foreign Exchange at RBS Global Banking & Markets believes that corporates still need to concentrate on their hedging, rather than profit making: “What a lot of corporates still don’t understand is that if they don’t hedge their FX – on a shipment heading to Thailand for example – they are, in fact, losing the difference between their rates and the market. If you are a corporate and you don’t hedge that shipment, you are by definition taking an FX risk.”

Mental margins

With growing pressures to perform, both from internal and external stakeholders, the profit centre approach to treasury management will, no doubt, prove to be a temptation to consider at one point or another. Whether FX forms a part of this is a tough decision to make, and it is important to understand the complexities and hard work involved in a successful trading approach before implementation. It is hard work, not simply the luck of the draw.

The anonymous treasurer says that; “FX trading is a kind of handicraft – it is something that you learn and is part of you. You have to be very accurate and have a strong character. It is not simply a role that you can be lucky at – you need to strive to be professional and an expert.”

FX trading is no longer about big hits and long lunches. It can be a difficult process that can go very wrong, especially if a skilled trader with an impeccable work ethic is not on board. For standard transactions, such as spot transactions, the skillset required demands the capability of turning things around very quickly. A working day could involve inactivity for long periods of time but then furious bursts of work in a very small timeframe. Although these transactions generally carry a relatively small risk, spot traders must study movements, source liquidity, and need to understand the business’ core requirements as their action is so immediate.

For derivatives and options structures, or dealing with emerging market currencies, the process can become quite time-consuming. For this reason, having contacts with multiple banks is beneficial as getting in touch with the correct bank can save/make cash for your treasury, says John J. Hardy, Head of FX Strategy at Saxo Bank.

“The bigger banks will run a currency book and they may have exposures in the market – particularly the options market – that could mean they prefer a certain market exposure relative to another institution as it offsets something in their book. The more illiquid the currency and/or the more exotic the option, the greater potential there is for a differentiation of price since FX is an OTC market, so it’s a good idea to consult multiple desks for pricing, particularly for less liquid products and currencies.”

As derivative trading is based on a relative value date, there is a larger risk involved as the risks are held until that maturity date – but there are also potentially rewarding returns. However, whatever the gains, the FX trader needs to be satisfied with the smaller results. Staying within the parameters of approved limits and adhering to general standards for trading is the safest method for success, according to the treasury executive.

Speaking from his experiences in a financial institution, he explains: “You typically start at the maximum loss that you can bear from FX trading ie €5m per month. This will be the stop/loss for the month. Reaching this level is the worst case scenario but once it is exceeded, trading will be stopped – at least for that month.”

Having profit targets that are relative to the allowed loss limits is the most realistic and least risky way of achieving profits. Yet, sensible FX dealing is all about the little wins – trying to execute and win one big deal is a recipe for disaster. Carrington maintains that as FX margins are negligible, the sheer volume of transactions and the capacity to execute these volumes is the way to make money.

Of course, the level of FX activity a corporate trader achieves will not equate to that of the bank trader, but they will, nonetheless, have profit targets to aim for. Breaking such targets down into weekly or daily objectives (depending on the amount of trading activity of the company in question) will allow the trader to identify a more accessible goal, thus helping to deter such rash decisions as going for the ‘big win’.

Whether these guidelines will actually be adhered to depends largely on the corporate’s compliance ethos and the free rein that the trader has. Hardy notes that those in the public eye tend to take more care with their decisions, with personal funds more carelessly managed on the whole than corporate cash. But if a trader is in any way risk-inclined (which naturally traders are), breaking limits to achieve a bigger pay cheque may not be a huge moral step to take, he says. “Risk takers tend to be aggressive people so they might be more inclined to make rash decisions.”

Thus, it is essential that oversight principles are maintained, to prevent ‘rogue trader’ occurrences, such as ex-UBS trader Kweku Adoboli or Nick Leeson, says the treasurer. “The daily stop loss should be constantly monitored by another trader or another institution to ensure that this point is never exceeded. Experience has proven that when the daily stop/loss has been reached, you must simply write this off as a bad trading day.”

Is this the right time to trade?

Globally, traders are chasing commodities and commodity currencies as they believe this is the best option to take – with regions like Australia, New Zealand and Canada still having low sovereign debt loads and detectable yield on their government paper. For example, gold exports (and the precious metal’s current attractive price) contribute significantly to Australia’s GDP – thereby improving the value of its currency and attracting strategic FX traders.

But market players are being a little too optimistic about the stability of the global economy, says Hardy. “That game only lasts as long as the appetite for risk continues to rise and people are complacent about the economy. We have a period of weaker demand ahead and it is going to require some adjustment.”

Martin agrees that traders need to acknowledge a more realistic macro outlook and that it would take a brave treasurer and a brave company to implement treasury as a profit centre given the high levels of unpredictability with respect to the European debt situation, for example. However, he does recognise that with the correct structure and method, there are potential profits to be achieved in today’s environment: “The current volatility brings remarkable opportunities for returns. The risk/reward proportions are markedly larger now than they were previously.” So, with this proverbial carrot dangling, will more treasurers be willing to take a bite?