TO OUTSOURCE OR NOT TO OUTSOURCE CURRENCY RISK MANAGEMENT?
Marc Tuehl, global head of FX Overlay, HSBC answers the question.
What are the key currency risks that asset managers should be aware of?
In general, people do not appreciate how much risk currency can contribute to a portfolio. The most obvious risk is the price, or the depreciation/appreciation of a particular currency. This can have a significant impact on portfolios that invest in assets across geographies. The second risk is related to volatility, which significantly increased in 2015 with the US dollar strengthening against emerging market currencies and the euro. The other aspect is the potential slippage in execution price. This is a hot topic because asset managers have a fiduciary responsibility to transact on a fair and reasonable basis. Finally, there are also counterparty and/or settlement risks.
Have these risks increased due to regulation and if so, which rules have had the most impact?
There have been both positive and negative consequences of the regulation. On the one hand, the Dodd Frank regime has strengthened the market by mitigating settlement and counterparty risks. The rules have also created a more transparent market when executing trades. However, these changes take time and resources to implement. We also see a lack of harmonisation across regulatory regimes.
There has been a lot of discussion about volatility this year, what are some of the drivers?
The largest driver of FX spot volatility has been the divergent central bank monetary policies. The US is raising rates while the rest of the world is in a lower rate environment and the European Central Bank is pushing rates lower. The second biggest driver has been falling commodity prices. The result is that we saw the US dollar surge against almost all other currencies in 2015, while emerging markets currencies and the euro have weakened.
In your paper – To outsource or not to outsource currency risk management (www.gbm.hsbc.com) – you discuss passive and dynamic strategies. When should asset managers consider either?
The strategies they adopt will depend on their asset liability profile and asset allocation priorities. Each produces different results in terms of volatility, return, cash-flow etc. This is why it is important to understand the objectives and risk appetites prior to choosing a strategy.
Traditionally a passive hedging strategy is used to mitigate the risks of currency movements. For example, if you are a UK fund manager invested in USD denominated US equities, then it is sensible to hedge your currency risk by buying sterling pounds forwards (selling the US dollar). That way, if the value of the dollar falls against the pound, then your FX losses on assets is effectively balanced out by the gains on the hedges.
Passive is a reliable, cost effective way to hedge and works best if the underlying asset’s foreign currency falls. However, it does not adjust to market conditions and you may lose out on participating in currency appreciation.
This is not the case with dynamic strategies which can adapt to changes in the local currency, by taking into consideration factors such as volatility and/or momentum. These strategies can participate in positive movements while mitigating risks when the markets move against the underlying position. We are not only referring to market risk, as cash flow is an area of concern for our clients. We are seeing a lot of interest in these strategies because they can be a source of additional alpha.
With currency management, the starting point is to know the currency exposures on a particular date, the kind of strategy that should be applied, the different ways to execute and how governance and regulatory obligations can be fulfilled.
What happens if currency risk is left unmanaged and what can they do to mitigate these risks?
Currency has often been regarded as part of a portfolio’s natural exposure. If unmanaged though, currency can often be a source of uncompensated volatility. However, if managed effectively, FX may be a source of additional performance. Within risk management, there are three main factors to look at – the overall risk appetite, as well as specifically FX risk appetite, their return expectations and finally, their ability to raise cash for a hedging strategy, especially with illiquid asset classes.
From an operational perspective, asset managers need to implement robust systems. These must be capable of not only processing exposure data from different sources, but also executing FX efficiently. They need to know their risk and can work with custodians and fund administrators to control, assess and manage their exposures.
What are the drivers behind outsourcing and when should it be considered?
In the current climate of regulatory scrutiny and increased volatility, we are seeing asset managers, increasingly looking at their currency management processes. One question to ask is, does the application of resources to the administrative process provide value? If there is no value then they should consider outsourcing, allowing them to focus on their core competencies. This often makes sense for smaller asset management firms who do not have the internal capabilities.
In terms of general benefits, a major factor is the reduction in operational cost. These systems need ongoing investments in technology and infrastructure in the front and back end. Also, operational risk is transferred to a third party provider.
How do you choose a provider when there are many in the market?
Providers range from banks and custodians to niche players. There are a few key considerations to look at in terms of the financial stability and robustness of their platforms. They also must be able to provide liquidity when needed. It is beneficial when looking at dynamic strategies to choose a provider that has expertise in FX as well as a strong franchise. They need to offer detailed reporting of their activities and the impact a dynamic hedging strategy has on performance and risk metrics. For passive strategies, the most important thing is to choose a provider that has large FX capabilities.
In general, how has FX developed as an asset class over the past couple of years?
FX has developed significantly over the past two years particularly in the EMEA region and Asia due to the low yielding environment. There are different styles such as value and momentum but the classic carry trade of selling a relatively low interest rate and going long on a higher interest yielding one, remains the most popular.
Marc Tuehl started his career in 1996 with Deutsche Bank Düsseldorf in a sales role covering foreign exchange and rates products. He moved to HSBC Trinkaus & Burkhardt, Düsseldorf in 2000 working in foreign exchange sales with a focus on structured products. Two years later Tuehl became head of the German desk at LCF Rothschild in Geneva. In this position he was responsible for the advisory of German and pan-European clients within structured rates, FX and quantitative asset management. He became head of currency overlay management at HSBC Trinkaus in 2004 before moving to London in 2013 as global head of FX Overlay.