Capital Markets

Lack of Liquidity and Price Transparency Complicate Dollar Hedging

Many small and midsize companies need better access to Tier 1 FX liquidity and more information on hidden execution costs.
Eric HuttmanSeptember 13, 2022

The surging dollar has become one of the dominant macroeconomic trends. The Wall Street Journal Dollar Index, which measures the US dollar against a basket of 16 major currencies, has surged repeatedly this year and is near a 20-year high as of September 12 — up 10% since the beginning of 2022 and 13% from roughly a year ago. (See chart below.)

The rise of the greenback has wiped billions off the earnings of global companies consolidated in the United States by lowering the value of their international sales. 

IBM, for example, has warned that further strengthening of the dollar could reduce its earnings this year by $3.5 billion. Streaming giant Netflix is the latest big name whose earnings highlighted the need for an effective hedging strategy. It did not use foreign exchange (FX) derivatives to hedge volatility exposure in the second quarter. Revenues would have been about “$619 million higher” had exchange rates remained consistent with those of 2021, the streaming video company said.

With the strong dollar set to persist throughout 2022 and possibly beyond, now is the time to ask why the dollar has risen so sharply and examine the steps companies can take to hedge against heightened currency risk.

Why So Strong?

The surge in the dollar is primarily the result of the aggressive tightening of monetary policy by the Federal Reserve Open Market Committee. That has pushed real yields on U.S. government bonds into positive territory for the first time in years, making U.S treasuries more attractive to investors worldwide and thereby increasing the relative value of the dollar.

While the U.S. dollar’s surge has brought some perks for American travelers, its increase in value has had a negative impact on companies. A stronger dollar causes goods from U.S. firms to become more expensive, making them less competitive overseas. 

As a result, companies are closely reviewing their FX hedging strategies in the search for savings, with many who previously didn’t hedge now considering it.

Lacking Transparency

But corporate treasurers have found navigating FX risk challenging due to the market’s lack of transparency.

Most companies tend to work with only a small number of counterparties for their FX hedging due to the operational complexity of setting up multiple banking relationships. So, it is harder for treasurers to compare pricing among providers.

Moreover, banks and brokers reserve their most competitive rates for institutions that transact in the highest volumes. As a result, small and midsize organizations struggle to get the best possible deal. The European Central Bank produced a report in 2019 that found banks were overcharging their smaller corporate customers for FX services —  hedging rates were as much as 25 times higher than for larger clients.

Improve FX Strategies

Fortunately, there are several steps firms can take to improve their FX risk management infrastructure.

  • Use transaction cost analysis (TCA).TCA was created to highlight hidden costs. It enables firms to understand how much they are being charged for the execution of FX transactions. An ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance.

  • Compare the market. The ability to put trades up for competition is central to ensuring access to the best price — which is key to effective hedging. However, many treasurers are hampered by an inability to access Tier 1 FX liquidity (large global banks and some non-bank institutions), meaning they often rely on a single bank or broker to meet hedging requirements. A new generation of fintechs is tackling this problem, enabling treasurers to access rates from multiple banks while reducing the operational burden associated with that kind of market access.

  • Outsource – There is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities. Using the right partner can improve transparency and execution quality. Outsourcing can also let firms dedicate more time to core business matters, which is all the more important amid inflationary and market volatility pressures.

Moving away from the traditional single bank-based approach and seeking greater transparency and execution quality will help mitigate the risk and uncertainty brought by currency volatility.

Eric Huttman is CEO at FX-as-a-service provider MillTechFX.