A Blended Approach to FX Hedging

Why a combination of voice-based and electronic trading platforms can reduce the overall cost of hedging FX risk.

A decade ago, the introduction of electronic trading, in conjunction with straight-through processing, increased the efficiency of hedging foreign exchange (FX) exposures. Electronic trading platforms also make it possible to hedge smaller exposures, and they enable companies to hedge exposures in real time as they arise, instead of on a monthly or quarterly basis. As a result, a large portion of FX hedging is conducted on electronic platforms. In fact, the proportion of FX trades executed via electronic platform is currently 46 percent, up from 20 percent in 2004, and the volume of electronic FX trades increased by almost 500 percent over the same period (see Figure 1, below).

Some corporations now use electronic execution to supplement their voice execution, but many use a digital platform for 100 percent of their hedging program. The justifications for using only electronic trading are generally that the platform offers superior pricing and that the company’s hedging strategy and products are “plain vanilla.” In extreme cases, hedging via the electronic platform is company policy and voice execution requires approval as an exception. This can be problematic, as inefficiencies can arise when a company uses only electronic platforms for FX trading.

At the same time the number of experienced salespeople in the FX market is declining, the importance of hedging is increasing because foreign earnings are becoming a larger part of net income for U.S.-based businesses. For example, in 2011 foreign sales within the consumer staples industry were around 47 percent, up from 37 percent in 2005. Some banks have tried to supplement deficiencies in their FX sales staff by introducing separate groups to provide strategy or quantitative analysis consulting.

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Apart from Bank Z’s analysis of its win/loss ratio with Multinational ABC, the company’s stated goals may negatively affect what prices the algorithm offers. If ABC proactively distributes its FX hedges among a group of relationship banks, sometimes awarding trades to banks that don’t offer the lowest price and other times removing banks from the bidding process when they exceed pre-set concentration limits, Bank Z’s FX salesperson will advise the managers of the electronic platform to keep the bank’s margins higher. Bank Z will aim for its bids to come in second place because eventually ABC will award Bank Z a share of its business, and at a higher margin than the first-place bank achieves. If every bank uses this same strategy, it will quickly erode any perceived cost efficiencies for ABC of using an electronic bid process.

 

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