Cross-border currency exposure
15 January 2022
David O'Neill explains how to minimise risk and maximise returns for creditors at a time when the markets are particularly uncertain.
If you've ever tried putting 'currency risk exposure in the UK restructuring and insolvency sector' into a search engine, you could be forgiven for assuming that it either doesn't exist or isn't an issue given the absence of articles on the topic.
As the various UK government business support schemes and protections come to an end it is highly likely that this will trigger a rapid increase in distressed and failing businesses. In our global and all too interconnected world, there is also bound to be a rise in cross-border insolvencies, exposing all manner of currency exchange positions that need to be worked out.
Where will we see such currency exposure come from and how can the risks be mitigated? It makes sense to look at this question by looking separately at the restructuring arena and for appointment holders on formal insolvency cases.
Restructuring assignments
Businesses will derive currency exposure from importing and exporting, overseas assets and liabilities in the form of offices, plant and employees, and possibly overseas currency denominated debt.
If we were to look at a distressed business that had currency exposure, the first step would be to understand how it manages it and see if it could be improved. To illustrate, let us use an example of a UK business importing parts from Asia (US dollar requirement) and see what both an effective and ineffective currency risk management strategy might look like.
Effective risk management
Effective currency risk management includes:
- clear visibility of currency requirements;
- an ability to achieve competitive pricing;
- hedging forward currency risk to create protection;
- ensuring best credit terms to safeguard cashflow;
- access to market intelligence to assist with budget and cost forecasts.
Impact
By 'locking-in' the exchange rate for forward-date deliveries in line with its import schedule the business eliminates any exposure to market volatility and has clear sight on future cash flows, while negotiating the best credit terms frees up cash for day-to-day operations. Creating a strategic hedging policy such as layering in its forward currency exposure could result in improved forward exchange rates and these savings could make the business a more viable concern.
Ineffective currency risk management
Ineffective currency risk management includes:
- no control over pricing. An example would be allowing a relationship bank to debit a Sterling account to convert to US dollar for an onward payment;
- no hedging policy. This leaves a business exposed to market uncertainty;
- too much cash flow tied up for collateral if forward contracts are in place;
- paying/receiving Sterling to/from overseas suppliers/clients as the business may not control agreed exchange rate and may achieve more favourable returns if managing the currency conversion on its own side.
Impact
Having no control over the exchange rate in this example while selling Sterling and buying US dollar could mean the business forfeiting significant returns on their currency transactions. By remaining exposed to market uncertainty and not hedging, the business has no sight on future cash requirements while also potentially experiencing losses if the Sterling exchange rate moves lower. If a UK importer had adopted this approach and had a requirement to buy US dollar in March 2020 they would have experienced a negative impact of approximately 10%* (at the time of the UK national lockdown announcement)!
An overseas payments provider could assist in administration cases by analysing any currency exposure and creating a currency risk management policy that fits the business, which in turn would allow the administrator to make the most informed decisions - mitigating risk and enhancing returns.
It is also worth noting that an effective strategy enhances the credit risk profile of a business in any funding discussions. Lenders will examine all areas of risk, so by highlighting its management of their currency risk it can help in negotiating facilities and improving servicing costs.
Formal insolvency appointments
A cross-border insolvency case may bring about additional responsibility for IPs and their colleagues in the finance team to ensure that the conversion of proceeds from overseas asset disposals is completed using the most competitive exchange rate and ensuring a smooth transfer of funds. To enable this, the finance team will need to have control over pricing and visibility during the fund transfer stages, if cross-border transactions have been traditionally left to filter through the relationship bank, then it is highly likely that there would have been no negotiation or awareness of the exchange rate and transfer fees applied. If this is truly the case, then creditors are losing out!
Currency risk can be managed
It is probably fair to say that IPs will not welcome the additional workload of managing or overseeing currency risk as they navigate a potentially very busy year in 2022. While the currency market uncertainty settled down somewhat in 2021, we still saw a high to low range for Sterling of around 7.5% versus the US Dollar (approximately 17% in 2020) and around 8.3% (13% in 2020) versus the Euro. To put those 2020 ranges into context around 10% of that range took place in the couple of weeks following the UK national lockdown in March 2020*. Therefore, any Sterling sellers having to go to the market at that point would have incurred a substantial loss. Of course, it must be mentioned that a Sterling buyer would have experienced a significant uplift at that moment, but for the purposes of this article we are looking at managing risk.
Currency risk cannot be eliminated totally but it can be managed to help mitigate risks and allow both businesses and IPs alike to make the most informed decisions.
*Data sourced from Reuters
David O'Neill is partnership sales manager at Lumon.
