FX in a Covid-19 era

There are some things in life that are out of our control. The weather, for example, has the potential to make or break an event – a picnic, a harvest, a Wimbledon final – with very little input from its proponents.

The foreign exchange (FX) markets have this similar uncontrollable characteristic, which can also lead to the success or failure of a wide range of dealings.

For insurers, both the weather and FX play a vital role in their daily business operations – but only one can be managed with any real success.

FX markets are the world’s largest financial arena. In early 2020, LearnBonds research found daily trading volume had increased over the last decade by 40% to reach $6.6tn, dwarfing other sectors such as bonds and equities by a significant margin.

While FX markets are a magnet for speculators, who aim to make money betting on the direction one currency will move against another, much of this huge daily trade is on behalf of businesses, central banks and governments attempting to manage their global financial risk.

“It is next to impossible to predict where FX markets are going to go to make money,” says Richard Berry, managing director at Good Money Guide. “But it's very simple to hedge exposure to protect yourself from losing more money.”

With an increasingly global investment portfolio and a range of international clients, insurers have never been more exposed to movements in currency markets.

A survey of 156 insurance companies by asset manager Schroders found FX hedging to have moved up their agendas significantly over the past few years. While 43% considered it to be an important risk management tool in 2017, this number had increased to 51% by 2019. Behind risk budgeting, FX hedging was shown to be the tool that had gained the most favour in the last few years.

“If an insurance company has a big foreign currency transaction, coming up, it's very simple to protect their exposure for budgeting,” says Berry. “With currency forwards or currency options it's so simple to protect against losing money in the foreign exchange market.”

However, there are costs attached, which also need to be managed.

“A UK insurer with exposure to global equities might be using rolling FX forwards to hedge their exposure,” says William Gibbons, principal in Mercer’s insurance investment solutions business. “These rolling forwards are short dated, relatively cheap contracts.”

They are cheap because the relatively limited timescale doesn’t pose that much risk to the counterparty. Currencies jump around, but it’s the long-term movements that inflict the pain.

“If an insurer has long-dated bonds, however, it might use a cross-currency swap to hedge, which is expensive,” explains Gibbons. “Cross-currency swaps cost more because they are long term and match the cash flows of a bond against cash flows in your own currency.”

In 2019, instruments used to do this, known as FX swaps, made up 49% of the total market turnover, LearnBonds found.

If a UK insurer buys a dollar bond it will pay every time it receives a cash flow from it, under the swap to an investment bank, which will pay you a corresponding amount in pounds.

“It works as a transaction and you have predictability, but it’s expensive,” says Gibbons. “Insurers also need to consider the liquidity requirements arising from the need to post margin against cross-currency swaps, as currency moves, and the derivative moves into/out of the money.”

Despite the complexity and expense, for a chief financial officer, this might be the preferred approach.

“From a CFO's perspective, it is a line on the budget, and they want it to be static,” says Berry. “From the CIOs perspective, the temptation is there to try and make something from foreign exchange markets.”

This is possible, Berry explains, through the use of stop-losses, tools that kick in and cash out a trade or hedge when a certain level or trigger is hit. But in the current volatile environment, there is likely to be little appetite for such increased risk taking.

However, it is this prudence that may be hurting insurers. In a market built on basic supply and demand, surge pricing seems to be – at least anecdotally – in full effect.

“Fees can vary between a quarter of a basis point or one basis point,” says Berry. “In the foreign exchange market providers still aren't being transparent and businesses get very little protection from the regulators in terms of pricing.”

Berry, a former City broker, believes there are few in the market who understand how foreign exchange pricing works.

“Even people who are doing multi-million-pound transactions on a daily or a weekly basis,” he says. “It's very hard to calculate where the actual market is and how the day marked up, in particular when it comes to currency forwards, unless you have a Bloomberg terminal that can tell you emphatically what the forward rate is.”

It seems that to have the mechanisms to ensure you are getting a good deal means creating the staffing and infrastructure of a broker yourself.

But how can this be avoided?

It’s tricky, according to Gibbons, as insurers allocate globally because they can’t get enough investments in their own currency – which means they end up paying more in fees, taking more counterparty risk, and having to hold liquid collateral to post as margin.

“You might be able to cross some of the risk yourself if you’ve got international entities, but you will still be left using banks for most of it,” he says. “You could do an internal transaction, but then there will normally be some net risk and you have to trade the net risk anyway.”

On the claims side of the balance sheet, an increased scope of international clients also needs attention, which means potential extra cost, too.

For UK insurers, a post-Brexit reprieve from some of the more onerous aspects of Solvency II matching rules could allow them to use less strict and expensive instruments, but that seems like a long shot – and relying on it would be akin to leaving the house without an umbrella.