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FX volatility – don’t fall for the free lunches
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FX volatility – don’t fall for the free lunches

Samantha Bett Corporates, FX, Private Equity, Project Finance & Infrastructure, Public Sector, Real Estate, Social Housing August 2018

The best-selling album of 2018 (so far) is the soundtrack to the movie “The Greatest Showman”.  The movie tells the life story of P.T. Barnum and has been a smash hit. “There’s a sucker born every minute” is a phrase commonly attributed to Barnum (although there is no evidence that he actually said it).  It appears that some foreign exchange sales teams continue to operate on the basis that this expression is true – and are selling a product that is entirely inappropriate and unsuitable for their clients’ hedging needs.

No free lunches

In a previous article, we discussed the concept of “free lunches” – in that no such thing exists, particularly not in foreign exchange markets where the seller needs to make a return in exchange for taking on risk. However, FX and other structured products continue to be sold to SME and corporate clients on the basis that they are providing “free lunches” and the risk disclosures of the resultant indigestion and other potential after-effects are simply inadequate. At JCRA we believe that hedging with FX structured products can be appropriate as long as they provide 100% protection and do not involve extensions or leverage, which is where the dangers lurk.

One of the main factors cited by Poundworld in its recent administration was pricing inelasticity exacerbated by the fall in GBP (the majority of items for sale in Poundworld stores were imported from the Far East and paid for in USD).  Poundworld is far from the only casualty of GBP weakness.

Another UK corporate caught on the wrong side of GBPUSD following Brexit fell for the ‘free lunch’ on offer via so-called TARFs; Target Redemption Forwards. These are structured products which – on the face of it – will deliver an improved headline exchange rate. However, this improved rate is not guaranteed and the corporate may be locked in to a disadvantageous rate for an extended period on a larger notional amount, than the hedging required (due to the inclusion of leverage and extendible options).

The corporate considered the chances of the TARF being triggered as so low, that this outcome was disregarded. FX markets had different ideas – the range on GBPUSD over the last 24 months has been 19%, and the company had significant costs in unwinding the position (which left them over-hedged over a long period of time at an off-market rate).  This is not only painful to deal with internally but also allows competitors, who have benefitted from using more appropriate hedging tools, to take advantage of more competitive budget levels. FX structured products have the tendency to backfire when the underlying business is not performing, creating additional liquidity burden.

These products are not FX hedges in any way, shape or form. They are speculative instruments, and the many layers of complexity make their pricing opaque, therefore giving banks and brokers the ability to charge significant undisclosed spreads  (regularly upwards of 1% of the notional amount of the trade).

Structured notes

Wells Fargo bank has recently paid the SEC $4.1m in connection with the sale of structured notes to clients. While no admission of guilt was made, the SEC believes these products suffer from “high fees and lack of transparency”. The most basic structured note will be a capital-guarantee product; the investor will receive at maturity 100% of initial capital invested and a coupon linked to the performance of an external index (such as an equity index, a FX index such as DXY).  In these cases, the bank will use a fraction of the money they would otherwise pay out in interest to purchase equity or FX options to cover the potential payment due under the structured note and charge a sales commission (regularly undisclosed) to further enhance their income.

One investor paid $900k in commissions and fees over a three-year period to 2012 on such structured notes, and made a $300k return on investment.  Wells Fargo had little risk on those trades but still made three times more than their client. By any measure, a very poor return on equity.

Fee disclosure - just what are you paying for?

If these fees and spreads are not disclosed – and even with the introduction of MiFID II, full transparency has not been adopted by all market participants – it is very difficult to measure ‘success’ or otherwise of the hedging or investment product.

The asymmetry of information provision – highly skewed in favour of enhanced returns and/or improved headline FX rates, with little emphasis on potential downside outcomes – impairs the ability to properly assess the merits (or otherwise) of the proposed transactions.  Coupled with corporate FD’s KPI’s, which focus on achieving  budget rates, it is easy to see the attraction of TARFs and other structured FX products that ‘promise’ to provide improved headline rates.

There can be stark differences in charges on ‘vanilla’ and ‘structured’ products; banks and brokers may charge a multiple (of up to 10 times) on structured products compared to standard forward contracts.  With many brokers (and some banks) continuing to pay sales people commission on revenue (sometimes as much as 30% of the revenue!), this will drive behaviours to sell structured products, even where these may be inappropriate for their client’s needs, to make 10x the income.

Barnum knew that people would find it exciting to watch the circus and see unbelievable tricks and stunts.  The audience is willing to participate – they have bought tickets and understand that there will be sleight-of-hand and illusions.   While a running commentary describing how this ‘magic’ works would ruin the show, it is clear that the conduct of some FX sales teams requires significant oversight, with enforced disclosure of spreads and margins at the very least.  And if they won’t tell you – don’t buy it. At the very least take advantage of independent advice from experts that can give you the necessary insight to the tricks of the trade!

 

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