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Hedging Strategies 101: Layered Hedging
16-01-2023 | treasuryXL | Kantox | LinkedIn |
Avoid the cliff and protect your cash flows! When volatility is at an all-time high, the right currency hedging strategy can set you apart. And save your business from an uncertain future. Transform your FX risk with a layered hedging strategy that will help you withstand unexpected changes in FX markets and protect your margins.
When implementing an FX hedging program, finance professionals responsible for risk management must be aware of the ins and outs of their business. This will be the starting point to uncover potential gaps in the hedging strategy and also opportunities to implement the program that fits perfectly.
Let’s understand how a layered hedging program works and how it could fit with your FX strategy.
Why is a layered hedging strategy important?
Layered hedging programs allow CFOs and Treasurers to handle the related problems of FX markets volatility, shifting interest rate differentials, and less-than-stellar cash flow visibility.
The goal of a layered hedging program is to smooth out the hedge rate over time to lower the variability of company cash flows. Additionally, a layered hedging program that is created from scratch can deal with the problem of forecasting accuracy.
Instead of ‘protecting’ an FX rate, layered hedging programs build the hedge rate in advance. And because hedges are applied in layers, in a progressive manner, you do not need a 100% accurate forecast at all.
Who can benefit from a layered hedging program?
Not all hedging programs are the same, as they tackle different goals for managing FX risk. Before you implement a layered hedging program and start dedicating time and resources, you need to think about certain conditions. These relate to your current business model -including pricing structure, the FX exposure you want to hedge, cash flows, etc.- and your company’s specific needs when it comes to FX hedging.
This type of hedging program is best suited for firms that need or desire to keep steady prices not only for one individual campaign/budget period, but for a set of campaign/budget periods linked together. In layered hedging:
(a) Prices are usually not FX-driven, meaning that the FX rate plays no role in pricing strategy.
(b) The impact of the ‘cliff’ -a sharp adverse fluctuation in currency rates between periods-, cannot be passed on to customers at the onset of a new period.
(c) The exposure to hedge is a rolling cash flow forecast for a set of periods linked together.
Unlike other cash flow hedging programs, like static hedging where prices are either frequently updated or updated at the onset of a new budget period, pricing does not act as a hedging mechanism in layered hedging programs. And that puts cash flows at risk, so a solution must be found elsewhere.
In comes the star of layered hedging, smoothing the rate.
Smoothing the hedge rate over time
The secret of achieving a smooth hedge rate over time is to create commonality between trade dates for a given value date. Take, for example, a 12-month layered hedging program. The value date of October is hedged in 12 different months, from October in the previous year down to September.
Next, the value date of November is hedged in the same manner, starting in November of the previous year down to October. And so on and so forth. Note that the two value dates -October and November- share eleven out of twelve trade dates with the same spot rate. That’s the concept of the mechanically created commonality that lies at the heart of layered hedging programs.
However, the process of ‘layering the hedges’ is not as simple as it may seem at first glance. There are some common challenges that Treasurers and CFOs face when manually performing FX risk management activities.
Common challenges in layered hedging
Before crafting the optimal layered hedging program for your business, there are three common challenges that need to be considered. These are crucial to the success of the FX hedging strategy. And they relate to the configuration of the program, the intrinsic constraints of the business, and the level of automation currently available to the team. Let’s take a closer look.
(1) The degree to which the hedge rate is smoothed, for example by adjusting the programs’ length.
(2) The optimisation of forward points. For example, hedge execution can be delayed if forward points are ‘unfavourable’.
(3) The distance between the average hedge rate and the spot rate.
(1) The degree of forecast accuracy.
(2) Possible limitations imposed by liquidity providers who might not let a firm trade forward contracts that expire, say, more than two years out.
(1) Spreadsheet risk, including data input errors, copy & paste errors, formatting and formula errors.
(2) Key person risk, as only a handful of individuals understand the formulas that underpin the ‘monster’ spreadsheets.
Eliminating the uncertainty
Layered hedging programs are a powerful FX risk management tool to face the trifecta of problems created by a highly volatile scenario. These hurdles include currency risk —including the risk of a cliff, as we saw recently with the GBP-USD exchange rate—, shifting interest rate differentials, and less-than-stellar cash flow visibility.
Now that you know the ins and outs of layered hedging, you can start transforming your FX risk management workflow. And forget about the challenges that may come when facing uncertainty. That’s a pretty powerful advantage in a scenario of pandemics, inflation and war!
Optimal hedging strategy with Currency Management Automation
If you want to leave behind the challenges of manual work when it comes to currency risk, consider implementing automation software.
Kantox is the only solution that streamlines the currency management process through powerful automation of the entire FX workflow. This enables businesses to reduce currency risk, protect profit margins and price more competitively.
Who should “give a push” and work on APIs?
12-01-2023 | treasuryXL | LinkedIn |
A new year, a new edition in which we discuss the latest treasuryXL poll results. It is encouraging that once again many treasurers participated in the vote. We examined the voting patterns of treasurers and gathered the perspectives of experts Jack Gielen and Konstantin Khorev on the topic of APIs in treasury.
Source
Who should “give a push” and work on APIs?
It is commonly understood that APIs are prevalent in today’s digital landscape. However, corporate treasurers can also reap benefits from API technology and its advantages. If you are unsure about the importance of APIs in Treasury or need more information, you should definitely watch the recording of the joint webinar together with Cobase on the future of APIs. It is encouraging that once again many treasurers participated in the vote. The current treasuryXL poll remains open and we encourage you to continue to have your voice heard! You can cast your vote on this link.
Question: Who should “give a push” and work on APIs?
First observation
That looks quite straightforward: partners should join forces. Do the treasuryXL experts agree, or what is their view on this?
View of treasuryXL experts
Jack Gielen (Cobase)
Jack voted for the option that partners should join forces.
It is good to see that regarding the results of this poll, the market agrees that the success of corporate APIs and OpenBanking requires cooperation and cannot be dictated by 1 party. This means Treasurers clearly understand the complexity of the playing field. At the moment, although there are many initiatives by individual parties, there is a need to create a good partnership where the whole eco-system works together
The main benefits that APIs could realise if banks and companies were to work together are:
These benefits translate into being able to use the systems the treasurer has chosen more efficiently and better, more up-to-date insight into status, exposures and required actions.
Recently, Cobase set up the webinar “The Future of APIs” in collaboration with treasuryXL to discuss this topic. I was particularly impressed by the level of knowledge Treasurers have gained over the past year which was also reflected in the questions. APIs and the benefits are clearly on the map but there is also an understanding that there is still work to be done before those benefits will really be realised. Ultimately, the priority with the end customer, the treasurer, will determine how quickly other market players act.
Konstantin Khorev
Konstantin voted for the option that partners should join forces.
I agree with the majority view that the implementation of APIs in the treasury field should be a collaborative effort. Banks will play a key role in implementing these changes, but it is also crucial for corporates and TMS providers to set and specify the requirements. This ensures that the solutions being implemented align with the unique needs and goals of each individual corporate, and TMS providers can develop the tools and services necessary to support these needs. By working together, we can achieve a more efficient and effective treasury management system.
Recently, my latest article on this topic was published on treasuryXL. In it, I try to make it plain that APIs are a nice and easy solution, although they come with some limitations and challenges. At the same time, I believe that the future of bank connectivity lies in API technology. What do you think?
How can fintech rise to the challenge of AML compliance?
12-01-2023 | treasuryXL | Refinitiv | LinkedIn |
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Fintech and illicit activity
The fintech space is highly dynamic and agile, but this industry of innovation and opportunity is substantially impacted by a constantly evolving financial crime landscape.
Emerging technology, quickly adopted by fintech and leveraged to make every facet of our lives easier, is similarly harnessed by financial criminals seeking to engage in illicit activity.
New findings from Refinitiv and FINTRAIL – based on interviews with experts in different fintech across a range of geographies – reveal the top challenges faced by the fintech and focus on three key challenges currently at play in this dynamic space.
Read the white paper: AML challenges for fintechs: Insights for the future
What are the three key challenges facing fintech?
Online fraud
Fraud continues to grow across the globe and is a key pain point highlighted by the fintech we spoke to.
One of the top fraud-related challenges currently in play is application fraud, where sophisticated financial criminals typically impersonate individuals or make use of synthetic identities.
Illicit actors are leveraging powerful technology to do this – manipulating information, tapping into advanced graphics techniques and exploiting vulnerabilities wherever possible.
In the United Kingdom, where fraud is the most commonly experienced crime, reported losses totalled £2.35 billion in 2021. In the United States, fraud trumps all other proceed-generating crimes and 2.8 million consumers made fraud reports in 2021.
– AML challenges for fintech: Insights for the future
The fintecs we spoke to are responding in a range of ways, from providing better customer education and raising awareness to protect vulnerable customers, to ramping up collaboration initiatives between the private sector, governments and law enforcement agencies.
Digital assets and cryptocurrency challenges
Crypto continues to grow, and hand-in-hand with this, regulation within the sector is also increasing.
Against a highly dynamic situation, where products and technologies are evolving at speed, virtual asset service providers (VASPs) need to keep pace with a changing regulatory curve, especially when it comes to complying with differences across jurisdictions.
Even fintech that don’t bank digital assets need to stay acutely aware of the crypto-related risk as they may interact with VASPs, and consequently, need to understand potential regulatory obligations.
Sanctions
Sanctions are another key challenge for fintech, and little wonder given the global sanctions landscape that has unfolded throughout most of 2022.
AML teams have been scrambling to keep pace with the exponentially rising volume of sanctions, especially – but not only – those related to the Russian invasion of Ukraine.
Not only has the absolute volume of sanctions been increasing, but individual sanctions have been becoming increasingly complex, leading to rising compliance costs for fintech as well as their traditional financial services industry counterparts.
Non-compliance can have far-reaching consequences – ranging from financial to reputational and more.
A best practice response
The fintech we spoke to are acutely aware of the need to protect against widespread illicit activity and of the requirement to remain compliant at all times.
At the same time, they operate in a lean industry of constant change, exponentially growing customer bases and a breakneck pace of business.
This means that building a best-practice response to financial crime must be carefully considered, efficient and effective.
Leading-edge AML technology, robust data and skilled compliance professionals – whether in-house or outsourced – can offer the solution to help manage and mitigate financial crime risk and the key challenges outlined above.
High on the list of fintech priorities is striking the all-important balance between operational efficiencies, positive customer experiences and regulatory compliance – and with the right data, technology and human insights, this delicate balancing act can be maintained.