North American fund managers are overwhelmingly considering diversifying their foreign exchange hedging counterparties in the wake of this year’s banking crisis, according to a survey from FX services firm MillTechFX.
The service provider found that about 81 percent of respondents are looking into diversification after the upheaval that hit regional banks including Silicon Valley Bank, First Republic, Signature Bank and Credit Suisse. Those banks either failed or were acquired amid the market turmoil.
The survey was taken over the summer and included private funds managers, MillTechFX CEO Eric Huttman told Private Funds CFO. The firm sampled 250 people who serve in senior financial roles.
The banking crisis is hastening attention to FX diversification, Huttman noted.
“I’d say that the issues in the banking sector are a catalyst rather than an underlying cause,” he said. “I think it accelerated rather than created the need for it.”
He added that, anecdotally, private fund managers are generally more likely than other financial institutions to have only one FX partner.
When your counterparty goes belly up
The insolvency of an FX partner is a chaotic irony – after all, fund managers look to them to hedge currency risk.
Managers enter into forward contracts with counterparties such as banks in order to protect themselves from FX risks at either their funds’ asset levels or share class levels, Huttman explained.
When a bank fails, it may only be able to honor a fraction of the contract, or none at all – leaving funds unhedged.
Figuring out the status of a contract in such an event can be difficult. Managers may be told their contracts are void by the counterparty itself, or be left calculating likely outcomes based on subsequent events.
“This is part of the problem – sometimes the liquidator will communicate that all outstanding trades are being ripped up, other times there is no communication but is the inevitable result of the bankruptcy,” Huttman notes.
And managers may also encounter cash problems themselves. Cash posted with the counterparty for margin may be tied up, preventing managers from accessing it.
Huttman says that when a forward’s status is uncertain, the entity responsible for a failed bank’s affairs, such as the FDIC, can simply determine which contracts are invalid or still in force.
But managers trying to settle their contracts may also not be able to get in touch with the counterparty when they need to, or regulators may freeze the bank from further activity on the market.
There are instances where the entity overseeing a failed counterparty will permit spot trades involving it but not forwards, Huttman explains. He adds that this means fund managers can close out their positions via spot trades, regardless of whether the failed bank has been in touch with them about the validity of the hedges.
Huttman does not believe that increasing interest in diversifying counterparties is simply a blip following the spring banking crisis. On the contrary, the CEO anticipates that interest will be “the same or higher” when MillTechFX does the survey again next year.
Arguably, mitigating FX counterparty risk should be considered best practice in the future, rather than a novel idea. And diversification can improve FX trade outcomes for managers, who can shop around, Huttman said.
“The reason why I think that there is longevity to this is because it’s in combination with the best execution desire.”