Corporate FX trading – the unknown unknown?
“There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don’t know. But there are also unknown unknowns. There are things we don’t know we don’t know.” Donald Rumsfeld
Taking a lead from Donald Rumsfeld, we know what today’s FX rate is. We know that we don’t know what future FX rates will be. We know that we need to do something about it. We don’t know what we don’t know about the FX deal the bank has actually booked for us.
Gresham, like most international corporates, uses a variety of derivative instruments to manage Foreign Exchange exposure.
We have a large, multi-currency annuity based revenue stream and predicting our future cash balance in any currency is relatively straight-forward. We are a UK based company and so ultimately we’ll want to be able to translate any foreign currency flows back into sterling. Whilst we can predict the amount of foreign currency we’ll receive it is much more difficult to predict what the exchange rate will be in twelve months and so we take out FX Forwards to manage the exchange rate risk associated with those future currency receipts. FX Forwards are not the only instrument we use as from time-to-time it makes sense for us to take out FX Options using Strips or Straddles strategies. These are all well understood instruments that any risk-averse corporate treasurer will use to manage future FX exposure.
We typically buy such FX forwards and FX options through the FX Derivatives department of one of our banks (from a choice of 7 majors). All our banks are global with expertise in providing FX services to corporates. One would imagine that given the volumes they must trade and the corresponding risk that is being generated (particularly in a time of large FX rate volatility) that they should have a highly automated mechanism for confirming trades in these FX derivatives. We refer back to the still relevant FX task force created in 1996 by the New York Fed tasked with reviewing and documenting Foreign Exchange Process Flow (
www.newyorkfed.org/fxc/mopsrisk.pdf) for good practice.
Over the past 12 months we have entered into FX agreements across our pool of banks (particularly in the USA) and it is interesting to measure how they score in general against the FX task force 16 year old best practices:
Best Practice #2: Straight Through Processing of Transactions
The confirmations (and see more on this below) we receive are often constructed on email from different pieces of information manually sourced from different systems. For example, we see screen shot “pictures” whilst in other cases we see typed text.
Best Practice #4: Trading and Operational Processes should be agreed upon
OK, we’re a small player and maybe we’re not considered worth the effort but the banks don’t seem to have “reached an understanding with the counterparty… and how they should be interacting with each other”. We don’t seem to have agreement on how quickly we should affirm confirmation.
Best Practice #9: Timely confirmation/affirmation
“A bank should make every effort to send confirmations within one to three hours… and no later than the end of the business day”. We typically receive confirmations 72 hours after the trade, or not at all. An issue when especially recently there has been potential for significant market disruption following S&P downgrades.
“Confirmations should be accurate”. Whilst our confirmations, where we get them, seem accurate they are often incomplete or ambiguous.
I could go on and list the other best practices that aren’t followed but I think you get the idea. We’ve also seen these issues whilst providing consulting services at banks. The problems seem to be common across the banking world (at least ours). There have been recent and extreme examples of how the lack of a robust confirmation process can ultimately lead to significant loss – and not just through fraud as was the case with UBS.
I’ll share one final perspective on our corporate experience. I’m not even sure that we’re really receiving a “confirmation”. The language our banks use is casual and observational, “are you able to acknowledge the following trade:” followed by an incomplete description of the trade, with bits of screen shot and excel spreadsheet. As long ago as 1995 the New York fed provided a sample template, which begins with the words “We Confirm” and then goes on to list the minimum set of trade details that have to be provided. The “request to acknowledge” falls short of even these minimum requirements. It’s as though our banks are not completely certain of what they have transacted and this lack of certainty is reflected in the language they use when they transact with us.
We’ve observed this lack of certainty in other parts of the investment banking process and produced a white paper on it (summarised here bit.ly/wCmURD) .
At least I guess we’ve now moved an unknown unknown to a known unknown.
