Play Defense When Using Bank Derivatives

The opacity of OTC trading favors the banks. Here are specific tactics companies can use to level the playing field.

The foreign exchange (FX) market is one of the highest-volume markets in the financial world; annualized FX trading equates to an astounding 13 times global GDP. Multinational corporations are, necessarily, major participants in the FX market. In order to hedge their currency risk, these companies trade large volumes of FX-based derivatives. However, the playing field for these trades is often tilted in favor of their banking partners.

Multinational corporations usually obtain FX derivatives from banks through over-the-counter (OTC) trading. The unregulated OTC derivatives market generally offers companies the best selection of instruments, but a series of scandals in which banks have been caught gaming various OTC markets indicates that caution is appropriate.

Guarding Against Price Manipulation

One of the most effective methods for minimizing costs is to bid out every trade, especially every trade that is a significant size. To guard against price manipulation, multinational corporations need to establish trading relationships with multiple counterparties and ask for bids from each one. For a treasurer who’s shopping around an FX transaction or derivatives trade, it’s crucial to know where the market is. Companies should not depend on their banks for quotes of the spot rate or forward points.

 

Taking Advantage of Exchanges

Controlling Counterparty Risk

Limiting Banks’ Re-hypothecation Rights

One other approach to reducing the counterparty risks posed by banks is to limit their re-hypothecation rights. Figure 2, below, demonstrates how re-hypothecation works. In the illustration, Company X is required to post collateral because it is out of the money on a series of trades with Bank A, its counterparty bank. Bank A, in turn, is out of the money with respect to some transactions it’s engaged in with Bank B. So at the end of the day, Bank A must post collateral to Bank B. Rather than coming up with its own funds to use as collateral, Bank A prefers to cover its agreement with Bank B by “re-hypothecating” the collateral it receives from Company X.

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