Awareness of liquidity risk and cash management is the new arena to innovate in the hands of treasury practitioners. Effective liquidity management has become imperative to continuing operations and must be addressed through comprehensive processes, policies and programs. Companies and their treasuries have been focusing on gaining real-time visibility on global positions and improving cash forecasting processes, as bedrock to liquidity planning. They have been extending global cash concentration and pooling structures to access worldwide cash and take advantage of internal offsets. And they have been centralizing dealing and portfolio monitoring to guard against hidden risk-taking.
In the modern era of doing business of expansions, mergers& acquisitions, cross border payments and collections and investments across the globe; three risks are on priority to mitigate by every multi national.
- Credit and Interest Rate Risks
- Currency Volatility
- Country& Regulatory Risks
I have been enthusiastically studying a lot of product and service features by different banks and banking consultants on the new ways of doing Treasury Operations effectively and creating a win- win situation for every player in financial market.
To start with, I am taking multi currency pooling and the gamut of innovative ways it is being deployed by Treasuries to gain as much as possible. Companies have been focusing on gaining real-time visibility on global positions and improving cash forecasting processes, as bedrock to liquidity planning. They have been extending global cash concentration and pooling structures to access worldwide cash and take advantage of internal offsets. And they have been centralizing dealing and portfolio monitoring to guard against hidden risk-taking. The aim is to save on COSTS, INTEREST PAYMENTS and DEPARTMENTAL TIME and IMPROVE INTER- COMPANY SETTLEMENT while bringing even more of cash under central control.
Multi currency cash pools – as part of a global liquidity structure – are proving extremely popular among treasury fraternity as a means to gain liquidity and operational efficiencies, whilst also replacing or at least reducing the need for FX swaps. With a multi currency pool, it is possible to offset charges in certain low-yielding currencies by changing the mix of the company’s assets and increasing those currencies which have a wider spread. Furthermore, for the day-to-day operating business, rather than having to spend resources and investment dollars executing FX transactions, treasuries can effectively use the multi currency cash pool as an implicit way of executing their FX swap transactions.
This new innovation has
- Reduced the cost of FX swaps by eliminating the need to do FX trading
- Reduced the credit risk on counter parties
- Reduced the interest rate risks
- Reduced the risks because of currency volatility and geopolitical instabilities.
I will first explain the basic and fundamental concept of doing FX swap, and then will explain how a multi currency pool with Inter Company Lending can achieve the FX swaps internally.
Definition Purpose and Example of FX Swap
An FX swap agreement is a contract, in which one party simultaneously borrows one currency and lends another currency to a second party. The repayment obligation is used as collateral and the amount of repayment is fixed at the FX forward rate. FX swaps can be considered riskless collateralized borrowing/lending. The contract virtually allows you to utilize the funds you have in one currency to fund obligations denominated in a different currency, without incurring foreign exchange risk. Effectively the FX swap is two exchange contracts packed in one: a spot foreign exchange transaction, and a forward foreign exchange transaction.
The most common use of FX Swaps is for institutions to fund their foreign exchange balances. FX swaps are also used by importers and exporters, as well as institutional investors who wish to hedge their positions. They are also used for speculative trading.
The diagram below illustrates graphically the flow of funds in a typical EUR/USD contract. At the start of the contract company A gives company B EUR in the amount of X, which later receives in the same amount at maturity. Company B gives USD in the amount of X times S, the spot exchange rate to company A at the start. At maturity company A pays back company B USD in the amount of X times F, the forward rate.
Since the swap contract is virtually the difference between a forward and a spot contract, it is expressed as F – S (where F = forward, and S = spot)
F – S = S * [((1 + r1)/(1 + r2)) T – 1]
- r1 = simple interest rate in the term currency
- r2 = simple interest rate in the base currency
- T = tenor (periods of interest accrual)
In a multi-currency notional or inter-company loan cash pool structure, there is no need to convert or swap the different currency balances in the cash pool to a single currency. By means of a simple translation mechanism treasury determines the net-cash pool balance in a currency. In practice a treasury maintains the overlay structure of the accounts in different countries and currencies. A global header account is maintained in the country and currency of treasury choice. Henceforth, regional treasuries or companies can sweep funds among pool accounts and with the help of a simple inter company lending interest rate maintenance; they can charge the optimal rates for lending or hedging the currency risks.
To conclude, from negative interest rates to significant currency volatility and geopolitical risk, today’s treasurers are operating in largely uncharted territory. Exploring and exploiting this new liquidity landscape will require skillful navigation and an open mind. These kinds of innovations are only going to become more popular as people adjust to the new normal. And over the last five years, treasurers have already demonstrated great flexibility in their mind-sets, adjusting their investment comfort zones to include instruments such as secured lending, offshore securitization, centralizing, rationalizing and automating their liquidity management so thinking outside the box has almost become part of the job description for those at the top of the profession.
To be continued... with the next innovation in Treasury :-)
Thanks
Himanshu Sanguri
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