Corporates should prioritize counterparty diversity when it comes to FX risk management

The collapse of Silicon Valley Bank (SVB), UBS’s takeover of Credit Suisse and the closure of Signature Bank has shone a light on banking industry vulnerabilities, particularly the risks associated with only having one or two banking partners. Eric Huttman, CEO at FX-as-a-Service provider MillTechFX, explains why there’s safety in numbers when it comes to FX counterparties and how firms can enhance their FX risk management in this uncertain climate.

On March 8th, shares in SVB fell sharply due to fears of the bank's solvency. Venture capital firms started advising their portfolio companies to withdraw money from SVB and by the end of March 9th, customers had withdrawn $42 billion. The next day, US regulators seized the bank, whilst SVB’s UK arm was sold to HSBC for £1.

Spooked by SVB’s collapse, customers at Signature Bank began to also withdraw deposits. As withdrawals reached over $10 billion, regulators took over Signature Bank in the third largest bank run in US history.

The collapse at SVB and Signature Bank was followed by crisis at Credit Suisse, which culminated in UBS agreeing to purchase the beleaguered firm. 

Whilst the banking sector has seemingly stabilised since the turmoil of the Spring, it’s important that senior finance decision-makers at corporates make sure they have the right systems in place to mitigate the impact of any future crises.

As corporates navigate this uncertain landscape, they should consider assessing their existing FX counterparties and using technology to get access to multiple liquidity providers to protect their business from further fallout.

The importance of thorough counterparty risk assessment

When selecting FX counterparties, many firms may prioritize prices and onboarding times as two major factors, but other execution factors are equally important.

Corporates should consider establishing a robust counterparty risk evaluation framework that considers many risk factors. These include monitoring realized and unrealized profit and loss for each counterparty, credit rating from reputable rating agencies, credit default swaps as well as regular counterparty review and monitoring activities.

Recent market events also highlight the importance of establishing a robust FX execution contingency plan that considers legal and operational complexities. If the counterparty becomes unavailable, the firm should be able to manage the existing FX trades and implement new FX trades as the business requires quickly and efficiently.

Having your eggs in multiple baskets

One of the big lessons for corporates is the importance of having access to multiple counterparties.

It is now widely known that a bank’s failure can cause serious short-term liquidity issues. Should a banking counterparty no longer be able to function as an FX provider, then this can affect vital expenditures such as payroll and supplier invoices, even if it’s only for a few days. 

Many CFOs are subsequently making changes for the better, with one in four (28%) planning to diversify their deposits across more banks.

In FX, reliance on one or two banking partners can be a problem. For corporates who trade FX for payment or hedging purposes, they may often transact in FX not because they ‘want to’, but because they ‘have to’. It is thus often operationally inefficient for them to set up and manage multi-bank relationships.

In some instances, regional tier two banks will offer smaller firms a ‘soft dollar’ arrangement whereby they provide a discount on other services if the corporate deals exclusively with them for FX, meaning they are often reliant on only one or two counterparties. This may leave them open to risk should another bank run occur and the loss of a major FX counterparty could render firms unable to trade, potentially impacting staff pay, supplier invoices and currency exposure.

Recent research from MillTechFX shows that corporates are taking this lesson onboard, with 88% now looking to diversify their FX counterparties.

This highlights that firms are taking positive action to diversify their counterparty base to avoid having all their eggs in one or two baskets. 

This can also have a positive impact on pricing as it can be difficult to compare prices without having access to multiple banks. Getting competitive quotes from multiple counterparties can enable corporates to compare the market to ensure they get the best rate and achieve best execution.

Looking beyond the traditional single bank-based approach

It’s clear from this debacle that cost and transparency issues aside, reliance on one or two counterparties can be extremely risky.

Fortunately, there are alternatives to the traditional single bank-based approach on which so many corporates have been forced to rely. Technology and the advent of electronic trading have enabled new entrants to offer an alternative way to transact in FX that addresses risks associated with a single point of failure.

They offer access to a greater pool of liquidity from a single interface, providing corporates with more options. This also has cost benefits as it enables them to compare live rates and execute at the best available price.

By expanding beyond traditional brokerage or banking relationships, corporates can get access to the kind of liquidity normally reserved for the largest trading institutions, along with associated cost savings. Vitally, they get the safety that comes with having multiple counterparties.