As the market increasingly turns its attention to FX hedging, not only is the market hedging more (an overhang reaction to last year’s highly volatile market), but the strategies around FX hedging are also undergoing change as participants take an increasingly proactive approach.
The aftermath of 2022’s high volatility – which peaked in Q4 – has led firms to increase the degree to which they hedge, with the market acutely aware of the persistent threat of significant geopolitical situations across the globe. Specifically, the combination of rising interest rates, high inflation and geopolitical uncertainty.
Speaking to The TRADE, Eric Huttman, chief executive of independent FX-as-a-Service, MillTechFX, explained that “hedging is one of the primary ways that fund managers can mitigate the risk posed by this uncertain climate, and while there will always be some that don’t hedge at all, anecdotally, we’ve seen many decide to hedge a higher amount of their exposure to protect their returns.”
Firms do not want to find themselves the victims of a short memory, aware that complacency could be disastrous, and so are focused on maximum preparation for potential future volatility.
Read more: Falling European SI volumes shows traders’ changing approach to risk during volatility, survey finds
Despite FX volatility falling slightly in the more recent term – the degree to which clients are hedging has therefore gone up, not down.
Huttman told The TRADE: “Hedging is a well telegraphed programme that you can do when there is heightened uncertainty elsewhere,” asserting that demonstrably many are not trading FX out of a particular desire to do so, but rather out of need.
Specifically, he explained that “people are wanting something which is for them easier to get a handle on […] It’s much harder for a corporate to hedge consumer uncertainty, but they can hedge against FX risk […] And if wider risks increase, the desire to manage a risk that is easier – in relative terms – to manage increases, and that’s been a core part of the reason why hedging has gone up over this period.”
Speaking to The TRADE, Oksana Pidkuyko, managing director, head of client analytics, financial markets at Standard Chartered stressed the potential positives of this increased volatility, stating that – if handled correctly – the changing landscape could bring potential benefits.
“There are ways to ‘turn volatility into your friend rather than foe,’ and can in fact be advantageous with a flexible and dynamic hedging strategy.”
Shifting strategies
One way in which behaviours have changed is in terms of the length of tenors being used to hedge, with Huttman confirming that their clients – asset managers and corporates – have begun to use shorter dated hedging instruments in a bid to manage cash flow better and retain an element of nimbleness in the case of market movement.
Specifically, many fund managers are locking in rates of up to six months or less, as opposed to using long-dated FX forwards of up to a year or two.
This is in line with Standard Chartered’s findings in its corporate treasury survey, which found that ‘when to hedge/ defined strategy’ was one of the top three risk management challenges for corporate treasurers, along with market volatility and the accuracy of data.
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Amid an uncertain environment, firms are also more aware than ever of the importance of knowing exactly where their capital is being held and just where their exposure is – with a trend surfacing of market participants looking to hedge more of their exposure.
“Corporates and fund managers are wanting to spread their eggs across more baskets and have not one bank, but several banks or several liquidity providers, where they can spread their credit risk,” explained Huttman.
This reaction is arguably understandable given the previous high profile unfoldings of both Silicon Valley Bank and Credit Suisse and the latter’s subsequent acquisition by UBS. At the time, both moves saw the usually placid bond market exhibit equities-esque behaviour, with volatility rising and spreads widening.
Speaking to their own clientele, Pidkuyko told The TRADE: “Our discussions with clients highlight that there is rarely such thing as ‘One Best strategy fits all’. Instead, it is more about balance between finding appropriate hedge ratios for each instrument to satisfy both the core and strategic hedging requirement for the company.”
Going forward, one trend slated to see an upturn is uncollateralised hedging, MilltechFX’s findings have found, with 30% of fund managers having cited it as the most important aspect of their own FX processes according to a report.
Huttman told The TRADE: “A key challenge fund managers face when hedging is the margin required to be posted against that position as collateral. If the initial margin no longer covers the mark-to-market of a hedge, due to movements in the spot rate, the fund may be required to post additional, variation margin.
“Any capital posted as collateral, sitting dormant in a margin account and not invested, potentially earning higher returns, can cause a drag on fund performance. The FX risk, being mitigated with forward contracts, has been replaced with a potential liquidity risk.
Uncertainty is clearly here to stay and thus will continue to affect the future outlook for hedging strategies. As Thibault Gobert, head of liquidity pool at Spectrum Markets, asserted earlier this year, it is important to note that the cost of hedging for market makers has increased in the last year – due in part to Basel III’s framework requirements and OTC derivative reforms brought about by Mifid II, Mifid, and Emir.
Speaking back in March, Gobert highlighted that “this will become even more important where additional challenges occur such as […] throughout phases of extreme volatility.”
Speaking to The TRADE about future attitudes towards FX hedging, Huttman explained that fund managers should “consider balancing the cost of hedging against the risk of not hedging and the potential impact this may have on their returns.”
Looking to the future
Going forward, technological processes are also set to adapt in lock step with strategies themselves, with Pidkuyko specifically highlighting a “significant focus” of TMS systems review in order to “ensure consistency across the group and to improve accuracy in exposure monitoring and consolidation before deciding how and how much to hedge.”
In addition, the increasingly prevalent AI is also a relevant factor, said Pidkuyko, with some corporates proactively leveraging this technology to improve efficiencies, aiming to “create internal versions similar to ChatGPT to avoid repetitive tasks and streamline processes”.
Overall, it’s clear that the market is increasingly appreciating the importance of FX hedging and are working to unlock the maximum amount of potential through their strategies. As volatility continues to be increasingly unpredictable and black swan events become ever-prevalent, volatility trading strategies in general are set to continue to grow in prominence, evolving from a relatively niche area, historically, to an ever-important, core part of trading.