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FX hedging and FX mis-selling: lessons learned

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The UK clearing banks were forced to get their houses in order following the March 2013 FCA review into the sale of Interest Rate Hedging Products (IRHPs) to SME clients. With the review concluding that a massive 90% of sales to UK SME’s between 2001 and 2012 did not comply with one or more regulatory requirements, it was clear there were significant problems in the sales processes at the UK banks. The negative publicity, lack of trust and expense of administering the FCA review and associated litigation resulted in all of the UK banks tightening up their procedures for the sale of interest rate derivatives. 
The MiFID II and FCA effect 
The introduction of MiFID II on 3 January 2018 requires banks to assess the suitability and appropriateness of hedging products for borrowers.  It will no longer be permissible for a bank to present all the possible product alternatives available. Instead, they must assess the needs of the client and provide information on only the specific products, which are suitable and appropriate for the client’s requirements and nothing else. As a result of the FCA review and implementation of MiFID II, the majority of UK clearers will no longer sell the riskier foreign exchange hedging products to SME clients.  In some cases, retail clients are already unable to purchase vanilla options and from January 2018, we anticipate they will no longer be able to trade any form of structured FX product with any of the UK clearing banks apart from by exception. 
FX Brokers fill void left by banks. 
As clearing banks back away from the sale of structured foreign exchange products to SME clients, FX brokerage firms have stepped in. A large percentage of the brokerage firms have set up separately capitalised companies, regulated by the FCA to provide designated investments such as currency derivative products. These subsidiary companies are staffed by salespersons who are CF30 registered, and while many of these firms have been extremely diligent in setting up compliance and on-boarding procedures similar to the banks, this approach has not been universal. It is not difficult to draw some parallels between the sales behaviour of some FX brokerage firms and the poor practices highlighted in the March 2013 FCA pilot review.
JCRA has been working with several UK SME importers and exporters in the capacity of an independent advisor to assess the conduct around the sale of their currency hedging strategies by brokers, and the (un)suitability and (in)appropriateness of the hedging. In some cases, the hedging is so convoluted that it has taken a number of days for us to reconstruct the component parts into our pricing models.  Many of the examples involve multiple restructures whereby the client has sold more and more optionality to the broker to ‘improve’ the headline rate - much like the doubling-up of gamblers in casinos where, of course, the house never loses. By selling optionality to the broker, the client moves beyond hedging and into the realm of speculation. The performance of their hedge is contingent on subsequent market movements over which they have no control. While the hedge may allow for ‘out-performance’, this is entirely dependent on the direction of foreign exchange markets and, in general, the risk/reward for such trades is poor.  
While gamblers are willing participants in casinos, the sale of foreign currency exchange derivative products is subject to regulation and “doubling-up” (or in a recent case, “tripling-up”) should not be happening under the current regulatory regime and certainly not under MiFID II.  
Combatting FX mis-selling 
The majority of currency hedges are relatively short-dated. The contracts are either concluded within the same financial year (which means the mark to market of the hedging will not be reflected in the statutory accounts) or will be less than two years in duration due to credit limits.  This means the ‘pain’ is relatively short-lived provided the company’s cashflow can support it (the losses and/or the cash collateral for the mark to market).  
JCRA believes that the short-dated nature of the problem is the only reason this issue is not higher up on the agenda of the FCA. After all, it took almost four years after the financial crisis for the Regulator to take action in relation to the sale of IRHPs despite the volume of complaints.   
While the introduction of MiFID II may well result in regulating these practices out of existence, we expect the volume of complaints and legal action in relation to FX mis-selling will only increase in the next two to three years. A much more critical review of practices in the regulated parts of FX brokerages is required by the FCA. 
How to get FX hedging right
Generally speaking, to get FX hedging right, you need to:
1. Identify the true underlying exposure(s)
2. Understand the hedging product in layman’s terms. If you can’t, don’t buy it
3. Take independent advice early in the process to ensure underlying exposures are suitable and appropriate hedging can be implemented.   
The old adage, 'There’s no such thing as a free lunch' is particularly apt for foreign exchange hedging.  In order to access a better-than-market headline rate, a client has to provide something of value to compensate the seller. The better the 'improvement' to the rate, the worse, and generally, more complicated the layers of options embedded into the product. Fundamentally, hedging should eliminate, or at least minimise known risks. The cost should not invole exchanging one known exposure for a series of unknown outcomes, dependent on future market moves. 
Our experience in mitigating poor FX hedging decisions

FCA review - poor sales practice identified:

FX sales - examples of poor practice

Poor disclosure of exit costs

JCRA is reviewing a case where the FX hedging was subject to a significant negative MTM due to the fall in the value of the GBP against EUR following the Brexit vote. The collateral requirement (variation margin) represented 18 months of the company’s average EBITDA.

The broker did not provide the exporter with a breakdown of the MTM across the component parts of the hedging strategy and made several miscalculations on the MTM value, resulting in changes to the variation margin.

Failure to ascertain the customer’s understanding of risk

The inclusion of ratio options (which, if triggered, will have the effect of doubling or even tripling the notional, subject to the FX hedging) reduces the ability for the company to hedge their transactional exposure.  It is not possible to foresee how much of their exposure will be subject to the hedging (as a market-driven event will determine this).  We have an example where a client thought he was entering into a 2x leveraged trade which transpired to be 3x leverage which impeded his ability to hedge his exposure to GBPEUR, leading to a sub-optimal outcome.

Non-advised sales straying into advice

Despite the Terms & Conditions stating that these entities are non-advisory sales, the company websites highlight their skills as advisors and currency forecasters.

Sample wording from the company websites includes: “Proactive advice, forecasting and analysis” and “Our dealers are invaluable in safeguarding your capital and providing expert guidance on the options that are best for you”

Over-hedging”, i.e. where the amounts and/or duration did not match the underlying loans

Ratio/leveraged and extendible options in FX structured products can lead to importers/exporters being obliged to buy or sell more than their required amount of currency exposure.   The client will then be in the position of continually rolling forward off-market hedges, perpetuating the losses across a longer time period.

Rewards and incentives being a driver of these practices

We are aware of practices where the FX brokerage firms have paid their staff commissions of 25% of any revenues made on structured products, increasing that to 50% for the first trade of each month.  The more complex a structure, the greater the opportunity for substantial margins to be charged as it is extremely difficult to get transparency on the pricing with so many layers of product.  Routinely, the spreads on structured products will be up to 10x the spreads charged on vanilla hedging solutions.




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