Discover essential FX hedging strategies and currency management best practices from our foreign exchange experts.
Balance Sheet Hedging: the automation imperative
The previous blogs on hedging programs to remove the P/L impact of FX gains and losses were devoted to:
- The reasons why CFOs and treasury managers may want to remove the accounting impact of FX gains and losses;
- The mistakes they often make as they implement the corresponding balance sheet hedging programs;
- The market-based programs they can apply to answer these challenges.
In this final blog of the series we want to present the automation requirements of a well-run balance sheet hedging program designed to achieve a clean, zero-line in terms of FX gains and losses.
Mini-case study: U.S. exporter of medical instruments
A US exporter of medical instruments sells $1.72bn in markets across several continents. Key export markets include: the Netherlands (31.4%), Mexico (18.7%), Brazil (14.2%), Germany (13.9%) and others.
The company aims at reducing the impact of FX gains and losses on its P/L. Before testing our market-based solution against realised data, we uncovered a number of inefficiencies, some of them due to the use of manual processes:
- Time lapse to risk mitigation. As the finance teams pull accumulated pieces of exposure from the ERP at arbitrarily-set dates, there is an average 16-delay between the moment balance sheet items are recognised and the risk mitigation exercise.
- Spreadsheet risk. More than 35 spreadsheets are reconciled monthly, with a high risk of manual data input errors, copy-and-paste errors, formula and formatting errors, on top of key-person risk. Swap execution is also manually carried out.
- Unhedged exposure. Due to the heavy manual workload, 6 to 8 currencies are left unhedged. While the total exposure to each of these currencies does not surpass 5% of the total, they are amongst the more volatile (BRL, PHP and ZAR).T
- Forward points management. Finally, the company has to contend with a heavy cost of carry as both the Mexican peso and Brazilian real trade at a forward discount to the dollar (6.24% and 3.48% respectively on one-year forwards).
Balance sheet hedging: integration and automation
As they seek to effectively remove the P/L impact of FX gains and losses, treasurers need to automate their processes. Before rushing to automate their workflow, however, they should avoid a ‘siloed’ approach and carefully ponder the distinction between integration and automation. This is not an abstract point. Let us see why.
- Integration. Many treasurers are keen on saving a few extra pips when they execute FX transactions with their banks. That’s fine. But then, a ‘silo’ mentality leads them to take an inadequate, time-based approach to balance sheet hedging. The resulting time lapse to the risk mitigation exercise usually costs much more than the pennies saved from the banks.
Note that, when there is integration, systems provide data to each other. But this provision can be manual. For instance, a system can generate FX trade data that can be manually uploaded to Multi-Dealer trading platforms such as 360T.
- Automation. That’s when automation, properly speaking, enters the picture. Instead of having members of the treasury team go through each trade one by one, automation requires them to create business rules—in this case, the rules that configure a market-based approach to balance sheet hedging.
While the ERP or TMS supplies the data, the software solution applies the rules previously set by the treasury team. Those rules, when applied, result in currency markets being monitored and/or in trades being executed, a data flow chain with no human intervention.
“Automation implies integration—but you also remove the human element from making the FX trading decisions. With Currency Management Automation the human decision process is ‘front loaded’, meaning treasurers’ decisions go into the specification of the business rules parameters — John Carbajal, Kantox co-founder and CTO
How and what to automate? A look at the end-to-end FX workflow
The different phases of the FX workflow —the pre-trade, the trade and the post-trade phase— involve a series of processes, each with its own automation requirements. The following table provides an overview of these requirements, phase by phase.
Conclusion: balance sheet hedging redefined
Balance sheet hedging is being redefined as we speak. It is no longer enough for companies to design an effective program to remove the P/L impact of FX gains and losses, only to watch it stumble because of insufficient automation.
In terms of FX hedging programs, this means:
- Effectively integrating the different phases of the FX workflow
- Using data- and market-driven programs, as opposed to ‘moment-driven’ solutions
- Leveraging opportunities to maximise exposure netting
- Optimising interest rate differentials between currencies
Balance sheet hedging can and should be systematically improved. With Currency Management Automation solutions, market-driven FX hedging programs to remove FX gains and losses can help CFOs achieve their own KPIs. More importantly, balance sheet hedging:
- Reduces net income variability, generally seen as way to boost firm valuation
- Helps to optimise taxation when higher levels of net income are taxed at higher rates
- Allows managers to confidently use more currencies in business operations
