FX Management: a politics-driven performance

Cash management, Macro and Markets

FX Management: a politics-driven performance

September 2019

Three years on from the UK’s referendum there is no escaping “the B word”. A breakfast briefing in Dublin offered a snapshot of how sterling has performed in recent years against the backdrop of Brexit

IACT president Dympna Donnelly
IACT president Dympna Donnelly with Deutsche Bank presenters David Leigh, Konrad Haunit and Johnny Grimes at the Association’s 11 September 2019 breakfast meeting in Dublin

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The session on FX and FX management on 11 September 2019 in Dublin was hosted by the Irish Association of Corporate Treasurers. IACT president Dympna Donnelly introduced the trio of Deutsche Bank speakers: Johnny Grimes, global head of transactional FX and regional head of Deutsche Bank Corporate Bank Ireland; David Leigh, global head of FX spot and electronic trading at Deutsche Bank Corporate Bank and Konrad Haunit, head of FX, institutional & treasury Coverage, D/A/CH Global Capital Markets.

Grimes opened the presentation by noting that it complemented a couple of earlier sessions over recent months on how macro events impacted on the FX markets. He also took the opportunity to mention the bank’s plans for adding a new Dublin branch focused on corporate cash management, inviting attendees to complete a brief questionnaire on the services they value from a banking partner.

He handed over to Leigh, who gave an overview of the development of electronic trading at Deutsche Bank since he joined in 2005. Through investing in its electronic capabilities the FX division has been able to grow the number of client tickets it handles by several orders of magnitude whilst maintaining a roughly flat headcount. Today’s employees also place a much greater emphasis on quantitative analysis of price movements in the FX market.

There followed an overview for the audience on tracking the pound (GBP) since the June 2016 Brexit referendum and how the impact of the politics on the market microstructure had been “very educational”. A chart showing the movements in GBP over the period (Figure 1 below) confirmed that “price action around larger moves has been predominantly politics-driven”.

Figure 1: Movements in GBP, pre- and post-Brexit referendum

Source: Bloomberg

In recent years, there has been much talk of “flash crashes” and the political backdrop in GBP, which had already fallen sharply after the shock of the referendum result, created the market conditions for such an event in early October 2016 with the pound dropping 6% in minutes. The sharp, temporary fall was attributed to several potential causes, including a so-called “fat finger” error and over-zealous algorithmic trading.

Whatever the cause, flash crash incidents in recent years has resulted in spreads growing wider and impacting on those payment processes which relies on fixed rates held for 24 hours as the risks of liquidity events are priced in. Deutsche Bank’s solution that uses real-time streaming prices for cross border transactions can eliminate this spread, reducing costs for clients.

Leigh cited the Bank of England’s 0.25% base rate hike in November 2017, preceded by widespread expectation in the market of an increase, as the only non-political event to cause GBP price movement in the past three years. He added that the most recent sell-off of the currency, which earlier this month briefly fell below the US$1.20 level for the first time in three years, had involved relatively light trading volumes.

In addition to its depreciation against USD, GBP has also been weak against the Japanese yen (JPY) post-referendum, reflecting the fact that the currency is widely used for positioning on funding and also Japan’s prolonged era of low-to-zero-to-negative interest rates. The decline against the euro has been less pronounced as the FX markets are indicating that they expect Brexit to impact more heavily on EUR than on USD.

 

The options market

The FX options market, which reflects expectations of future volatility, has witnessed several major spikes since late 2018. Traders want to know how the market looks currently. Leigh reports that corporate clients are currently in ‘wait and see’ mode and have contingency plans in place for worst case scenarios such as a no-deal Brexit accompanying the UK’s eventual departure from the EU.

Client behaviour has changed and as with the banks, processes have steadily been automated, with decision making on execution strategies involving less and less human involvement.

"However, the new tools rely on there being an underlying consistency of market liquidity. If this is constantly bouncing around, then fair price in the market is also constantly changing"

said David Leigh

The volatility of recent months had, at least for the moment, put a brake on the trend towards increased automation. “People have increasingly been consulting their bank on the best timing for trading and execution,” he reported. “As Deutsche Bank has developed tools internally, we’ve made them more widely available – such as the launch of the Autobahn mobile app.” With the bank’s forecasts on market liquidity more widely available, clients can time their access to the market for when liquidity is in greater supply.

Answering a question from the audience, Leigh confirmed that participants in the options market have also changed. “Following the referendum result there was a major focus from the investment community and much corporate activity around mergers and acquisitions.

“Many companies had been mulling potential M&A deals in the UK and their targets suddenly became cheaper. As post-Brexit politics drags on without resolution, interest will wane and people will take a more wait-and-see stance.”

 

Managing risk

Konrad Haunit offered an overview of FX risk management conversations between the bank and its clients, which in recent years have focused on two main drivers.

“For exporters, the Chinese renminbi is steadily becoming a larger FX exposure in line with other emerging markets, with South Korea showing the fastest rate of growth in the past few years,” he reported.

"The financial markets have also changed with continuing volatility between EUR and USD since the Eurozone crisis of 2012. The market observed (implied) confidence intervals are changing substantially over time and hedging costs have risen substantially"

Some of the banks’ hedging models are based on the purchasing power parity (PPP) model, but its efficiency had increasingly been questioned as “PPP is ignorant of a number of specific developments, which may be key drivers.”

Haunit said that an option being considered by some clients is portfolio compression, which, for example, made it possible to reduce a basket of 50 major currencies by eliminating over two-thirds and reducing it to just 15 without materially changing the degree of risk.

Another notable trend has been within China’s capital markets, whose structure and fungibility have both changed. He said that recent stresses had affected both the onshore and the offshore renminbi, making it important that clients were able to select the market in which they executed a hedge. “The de-coupling of the onshore and offshore Chinese capital markets is likely to prove increasingly relevant going forward,” Haunit forecast.

In the meantime, a number of Deutsche Bank’s clients are utilising the bank’s risk models, others are opting to run their own and a significant number have employed basket options to manage their FX risk.

To further assist them, this month sees the launch of Autobahn Mobile, the bank’s new smartphone app for FX that complements the desktop version as a source of information and recent trading activity but in an integrated, mobile-friendly format. Both the FX for Cash API and the multi-currency cash concentration offering are generating growing interest from treasurers looking to automate the aggregation and risk management of their foreign currency cash balances.

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