As electronic trading has cemented the commoditisation and wafer-thin margins for FX, banks have created specialist teams to advise, structure and pull down the more sophisticated and lucrative high-margin bespoke deals. Edward Russell-Walling reports.
There are only two ways for banks to make money out of foreign exchange these days. One is sheer volume, and the other is complexity. Since volume is a finite commodity, big FX banks are polishing their advisory skills to help them win the more complicated deals.
The FX business has been, and continues to be, transformed by electronic trading. US research group Greenwich Associates suggests that a little over 50% of all FX customers now trade online, and that they are pushing more and more volume through electronic systems.
Existing online users like the lower costs, improved efficiency and greater transparency of screen trading. Last year, the proportion of their online business rose by one-third compared to 2002, Greenwich says.
So, all very satisfactory for corporate converts. For many big FX banks, however, the resulting market polarisation has been rather unsettling. Two banks that have made a strenuous commitment to technology have emerged as new, and distinct, market leaders – UBS, followed very closely by Deutsche Bank.
Market leaders
Between them, the two banks now claim one-quarter of the market, shared more or less equally. They have established a clear lead over the number three bank, Citigroup, which in turn, is well ahead of the rest of the pack.
Challenging this pecking order may be difficult. “Other banks that want to be big in FX will find that it is very expensive,” says Stephane Treny, head of European corporate FX sales at Deutsche Bank. “With our economies of scale, adding new business is not as costly as it would be with a smaller market share.”
UBS is inclined to agree. “Plain vanilla FX is very commoditised, with very thin margins,” says Peter Beaumont, global head of distribution for corporates at UBS. “You need a robust technology, and scale, or it’s too expensive to be in business.” Mr Beaumont forecasts that in five years, the market will have consolidated down to four or five big FX liquidity providers.
Not everyone will let it go that way without a struggle. And there remains a more profitable alternative: “elephant-hunting”, or the search for the kind of sophisticated bespoke deal on which higher margins are still available. To capture these transactions, a number of banks are creating new specialist structures.
“Statistics show that about half of all European corporates are now using FX trading platforms for their basic requirements,” says Jean-Philippe Castellani, deputy head of European FX and derivatives sales at SG Corporate & Investment Banking (SG CIB). “That’s here to stay. It’s not a passing fashion but a structural change. So the more traditional execution business has been reduced. But at the same time, there is growing demand from corporates to service their more complex FX needs.”
To service this demand, SG CIB now devotes more effort to analysing the balance sheets of European corporate clients which have expanded, or are expanding, internationally. The aim is to identify and evaluate risk, not simply from a transactional (the short-term risk incurred by converting payments from one currency to another) but also from a “translational” point of view.
Here, companies face the long-term risk incurred by owning foreign assets – say, a US factory which has to appear on the balance sheet – that have to be converted from the foreign currency into the corporate’s domestic currency. If, as in this instance, the dollar falls, the value of the corporate’s assets are going to fall. That risk remains year after year until the plant is sold.
“A company that has built a plant or acquired a distribution network in the US has dollar assets, which may not be matched by dollar liabilities,” Mr Castellani points out. “So there’s an asset/liability management risk. What’s new is that International Accounting Standard (IAS) 39 says European corporates must mark any hedges or foreign assets to market – not at a historical rate, but at the current market rate.”
From next year IAS 39 determines how European companies must account for derivatives. It not only calls for “fair” valuation, but insists that resulting gains or losses be posted to the profit and loss account. The impact on shareholders’ equity affects key ratios, and IAS 39 is greatly exercising treasurers’ minds.
Mr Castellani makes the point that, unlike transactional risk, balance sheet risk is often long-term, and IAS-friendly hedges may involve a combination of FX and interest rate products. “The products themselves are not necessarily very complex,” he says.
What is much more interesting, he continues, is the way the bank works with the client. “It’s a different type of partnership, where the bank has a consultative role as well as an executional role. It creates a fantastic intimacy with clients and very long-term benefits. And, of course, you can’t have this kind of intimacy with many banks – you must choose one, or perhaps two.”
SG CIB pulls together special task forces to work with these clients, combining specialist product knowledge from FX and interest rate derivatives groups with country-specific and sectoral know-how.
Other banks are responding in much the same way. Like SG CIB, some merely assemble ad hoc teams for specific projects, which may be relatively infrequent. Others have preferred to create more permanent structures, and one of these is Citigroup.
Understand the client
“Our role has changed significantly in the last few years,” says Didier Hirigoyen, global head (corporate) of Citigroup’s risk advisory group. “We realised that providing prices to clients and marketing liquidity and execution capacity was no longer enough – it was no longer the right way to differentiate ourselves.
Didier Hirigoyen: ‘we want to understand the risk identification process at client level’
“We decided that the best way to improve our penetration was to understand our clients’ problems and issues, and to help advise them on the right hedging strategies and approach.” Hence Citigroup’s decision to set up the risk advisory group, while continuing to grow its electronic transaction capacity.
“Before we look at the instruments required, we look at the risk management methodology,” says Mr Hirigoyen. “We want to understand the risk identification process at client level. Then, between identification and implementation, we use analytic and evaluation tools to quantify the risk and to optimise the hedging strategy.”
Lehman Brothers has also set up what it calls a “risk solutions” group, which combines FX, credit and interest rate specialists in a single structuring and origination unit. “We created the group in March,” says Jason Tilroe, European head of corporate and public sector risk solutions. “Before that, the different functions were in different silos. Today, the group is a joint venture between fixed income and investment banking.”
The group starts by framing the issues, challenges and problems faced by the client. “That’s where the bulk of the work is,” Mr Tilroe explains. Such challenges may range from when and where to move cash following a cross-border acquisition, to finding different ways to monetise cross holdings. “Then we consider how to address the problem, what alternatives we have, which is the right alternative and what are the market, accounting and regulatory constraints for each of them.”
Like derivatives professionals elsewhere, the group is thinking a lot about IAS 39. “We take it seriously,” Mr Tilroe says. “It comes up with every client that we deal with. Even public sector entities, which have a different accounting regime, are increasingly focused on accounting standards.” For this reason, he adds, the group now includes an accounting specialist.
The imminence of IAS 39 has not, so far, been good for the bespoke business, though plain vanilla FX has benefited accordingly.
“Until about two years ago, some corporates were very actively buying pure derivatives for technical hedges,” says Mr Treny. “Then the IAS issue arose, and they began to refrain from using derivatives, moving into more standard products.”
Accounting issues
Instead of being driven by economic issues, he says, treasurers have become more sensitive to accounting issues. That said, Mr Treny believes that they have now absorbed and understood the implications of the new accounting standards. And he senses a willingness to return to more value-creating strategies in spite of any potential earnings volatility. “Already they are coming back to derivatives products,” he says.
Mr Hirigoyen recalls much the same response to the US introduction of FAS 133, which is similar in scope to IAS 39. “It definitely affected business, as corporates moved away from more sophisticated solutions,” he says. “But that didn’t last long.” European corporates may be inclined to tolerate more earnings volatility than their US counterparts, he adds, because they tend to be less sensitive to stock market analysts’ expectations.
Mr Beaumont believes that there is a more lasting trend away from what he calls the absolute return management style. “Corporate treasurers went from being proprietary traders in the 1980s to being active, absolute return portfolio managers in the 1990s,” he says. “But the style today is moving towards finding a risk-neutral position and staying with it, whether it’s fully hedged or unhedged.” That, coupled with automation, allows them to cut treasury costs and optimise the process, he adds.
Peter Beaumont: ‘the style today is moving towards finding a risk-neutral position’
If he is right, it will mean even less work for the advisory teams. Either way, the bespoke specialists know they must continue to provide electronic execution if they want to hang on to their clients.
“FX transactions will increasingly be done through electronic platforms and processes,” predicts Mr Hirigoyen. “Customers may not want a relationship with the bank if it does not provide liquidity through a specific platform.”
As another US banker puts it: “You’ve got to pay to play. If you’re not investing in electronic platforms for the client’s smaller vanilla transactions, you won’t have a seat at the table for the more sophisticated deals.”
