Brexit exposes the laggards in currency risk management

Over the first quarter of 2016, North American and European multinationals lost an estimated US$20bn to currency volatility. Moreover, that was before the UK referendum on its European Union (EU) membership on June 23 resulted in Brexit; the latest currency crisis to roil global markets and likely just the first of a series of dominoes that have and will continue to raise currency volatility around the world.

The FiREapps currency impact report on Q1 2016 posits that possibly in Q2 and most certainly in Q3, Brexit will create significant impacts on the income statements of companies that weren’t prepared for the result. It would be no surprise were we to see record-setting negative impacts totalling as much as US$35-40bn.

Impacts are not inevitable

In the wake of Brexit the author has had conversations with chief financial officers (CFOs) and treasurers at many multinational companies. A number of them – those that had robust currency risk management programmes in place – were able to deflect much if not all of the damage from Brexit. For example one CFO recounted how, in the hours after the vote was announced on June 24, his board was initially frazzled, apprehensive, and anxious for answers. They wanted to know exactly how the crisis affected/would affect the company moving forward. Once he had pulled four reports via our analytics and delivered them to his board in half an hour, “the mood shifted to a calm.”

Yet in some of the organisations I’ve spoken with, finance leaders seem to think that because Brexit has had such an outsized impact, they get a pass. More specifically, a few executives have been heard to express the sentiment that “we are all in the same boat with these impacts,” but unfortunately they are wrong. These leaders incorrectly assume that during their next board meeting, directors won’t press them with hard questions about how they were impacted by Brexit and why they didn’t mitigate the risk. Likewise, they wrongly expect that analysts will give them a pass in the next earnings call.

In fact, research shows that boards and analysts increasingly expect accurate and complete answers, in a timely fashion, about currency exposure on all lines of the income statement. To respond, finance leaders continue to invest in currency awareness. Earlier this year, FiREapps reported a trend emerging from its 2015 year-end analysis: North American corporates and their executives appeared to be increasingly currency aware.

There are three indications that the trend of increasing currency awareness is continuing:
• In Q1 2016, 40% of North American corporates reported a negative impact from currency headwinds, maintaining that trend for the third consecutive quarter.
• The share of corporates quantifying negative impact crossed above 50% for the first time in three quarters.
• In Q1, despite fewer and less sizable top line impacts, more corporates took the time to quantify in terms of earnings per share (EPS) impact than a year earlier. One would expect the opposite if there was not an underlying trend of greater awareness driving increased EPS disclosures.

Within organisations that haven’t had accurate, complete, and timely visibility into currency exposures, getting that is the first order of business. With that information, chief executive officers (CEOs), CFOs, and boards want to understand the risk/reward (cost) trade-offs of actually managing the risk. In low interest rate environments, the costs are likely minimal and it is likely that companies can actually have positive interest income – by no means the most important, but still a nice added benefit of managing currency risk.

Technology adoption is accelerating

The fact is that companies surprised by the impact of Brexit-induced volatility on the balance sheet are laggards in the adoption of currency risk management programs. Yet many of these same companies are otherwise among the most successful innovators on the planet: Apple, for example, has quite publicly struggled to come to terms with its currency exposure.

Figure 1

Tracking the Trends 2016 Corporate Currency Market Review Figure 1

As the anecdotal adoption curve shown above in Figure 1 sets out, adoption of balance sheet currency risk management technology began in 2008. The euro crisis served as a catalyst to accelerate adoption in late 2011 and early 2012. The development of cash flow currency risk management technology didn’t really begin until 2014, as companies became more comfortable managing cash flow risk – in many cases, volatility forced them to be more comfortable. As with the earlier euro crisis, record-high currency impacts in late 2015 and most recently Brexit have served as powerful catalysts to accelerate adoption of cash flow risk management technologies.

Today, as early adopters introduce these technologies, the companies that have not implemented balance sheet currency risk management since 2008 are the laggards. So when a company asserts “Sure we were hurt, but this is a huge crisis and this kind of volatility is impossible to manage” that claim is simply not true; the majority of multinationals have successfully implemented a balance sheet risk management programme.

In parallel with this adoption we have also seen senior management acknowledge that the 80/20 rule (protecting only 80% of your largest exposures) for managing currency risk simply no longer holds up. In fact, the unmanaged 20% can often present more risk than the 80% as these currencies are often the more volatile, higher risk currencies subject to rapid movement. For example, consider the rapid movements in Turkey, Russia, Argentina and Brazil – to name just a few – from the past eight quarters.

Now is the time

Before Brexit, we observed a baseline global negative currency impact to earnings of about US$4bn a quarter. Now, it’s clear that US$20bn has become the new baseline.

In the past nine quarters, there have been nine rapid-moving currency events – or crises – across eight major currencies with Brexit being the most recent. At this point, one quarter it’s the pound sterling (GBP), the next it’s the Japanese yen (JPY), the next it’s anyone’s guess, but we are clearly running at a rate of at least one major event per quarter.

Two types of teams emerged from Brexit. The first were those who were proactive and when we asked about Brexit responded “no crisis here, we were prepared; still monitoring though.” The second were those who were reactive and responded: “yes, it felt like a bit of a crisis -we were getting more questions than we had answers to; and we are still working to get some of them.”

This kind of environment demands a risk management technology stack that enables companies to operate proactively and react swiftly if necessary. It is also an environment that demands innovation.

The bottom line: If you are managing your global currency risk manually (spreadsheets, email, etc.) or operating with processes older than 2.5 years, you’re a laggard. What’s more, if Brexit felt like a crisis you should swiftly begin assessing how your current processes and technology are likely to respond to the next one.

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