Hedging Currency To Avoid Costly Mistakes #23

Hedging Currency To Avoid Costly Mistakes With Barry Mccarthy | Assure Hedge #23

If your company is exporting, selling goods or services abroad, you’ll almost certainly be quoting and getting paid in a different currency to your own. And even if you’re not doing that now, you’ll certainly be aware from the daily news that there’s a lot of volatility in exchange rates. So, for example, if your own currency is Euros or Sterling, but you’re selling to the USA, you’ll probably be quoting in Dollars. You’ll work out the price you need to charge today, when you send out the quote or sign the contract. But you might not get paid for months – and by that time, the exchange rate could be very different. Maybe in your favour, but if Murphy’s Law strikes, you could easily lose out. In fact, your entire profit margin risks being wiped out.

There’s a potential solution to that, currency hedging. But what’s that all about? And isn’t it something that only huge multinationals can do?

In this podcast, our host Oliver Dowson talks with Barry McCarthy, an expert in currency hedging who has developed solutions that even SMEs can take advantage of. Barry’s been trading in financial markets for over 15 years in Dublin, London, Chicago and Singapore. He then founded Assure Hedge in Dublin before then setting up in London as well. If your business ever needs to deal in two or more currencies, you’ll find their conversation quite enlightening.

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Contact details and Links

Website: https://assurehedge.com/

Twitter: @AssureHedge

Facebook: https://www.facebook.com/assurehedge/

LinkedIn: https://www.linkedin.com/company/assurehedge/

Transcript

OLIVER: Today I’m talking to Barry McCarthy the founder of Assure Hedge. Barry, welcome to the ‘Grow Through International Expansion’ podcast.

BARRY: Hi Oliver, thanks very much for having me.

OLIVER: So, Assure Hedge, it’s Assure as in assurance and Hedge but not a privet bush, correct?

BARRY: Yes, that’s right. I actually wanted to use the word insurance but we realised we needed to be regulated for that. I certainly don’t want to be regulated as an insurance company. So, we’ve settled on Assure Hedge.

OLIVER: Can you sort of give us a brief explanation of what hedging is, for those of our listeners who aren’t familiar with it?

BARRY: Hedging is one of these terms that in a financial sense confuses a lot of people. Some people think it’s to do with hedge funds and investments, which it can be. But when I talk about hedging, I talk about financial instruments that you can get access to that will reduce or eliminate risk that you might have as a person or in a corporate entity. For example, if you export products from the United Kingdom to the USA, and you don’t get paid for three months into the future, you have a lot of risk in the sense that the dollar could fall dramatically in that time. You’d get a lot less in pounds sterling when you actually convert 3 months later. So, there are financial instruments that you can you can purchase that will eliminate that risk. Obviously there’s no such thing as a free lunch, so all hedging comes at a cost, but you can think of it in terms of being somewhat like an insurance policy against risk.

OLIVER: OK. So basically, you’re paying a premium for certainty of what you’ll get in your own currency in the end?

BARRY: Yes exactly, that’s a very good way of looking at it. There are very liquid and deep financial markets for this type of product, but what we found, as I did in my career as a financial markets trader for 15 years, are that most of the people using these instruments are very large corporates and big banks and government institutions. Very rarely do you see smaller businesses and medium businesses getting the benefits of these hedging instruments.

OLIVER: I would guess that a lot of our listeners are related to a much smaller businesses, so can hedging work for them too?

BARRY: It depends on a lot of things. If they are working with traditional banks, what we’ve found is that the process can be quite cumbersome. It’s very much an antiquated process in the sense that they usually have to ring around to find the right person, and the product is often quite restrictive and can be hard to understand. Some of the newer FinTechs and brokers are probably a little easier to deal with. There are better, more suitable products there. That was basically the main motivation I had to come out of trading financial markets for myself into building a product that is easy to use. The whole point of everything we built is to provide a really simple to use go-generator. So, it’s as easy to use as buying travel insurance, and everything is automated, online and instant.

OLIVER: And you don’t have to be a big company to do that?

BARRY: No in fact the opposite, I mean we we’ve got one of the only hedging products that you can use to hedge for as little as £10,000 worth of risk. In fact, we actually want to get that lower. So, the cost of a hedge and £10,000 worth of risk might only be £50 to £200, and then that would give you protection against that amount of currency. So typically, with a bank, it would be rare to find a hedging provider for less than £100,000, and even that’s not really interesting to a bank. The economics that they have are very different from a technology company in the sense that a lot of processes are not yet automated. What I have built is a fully automated product from end to end that allows us to serve much smaller customers.

OLIVER: Let’s go back to your example of an exporter that’s going to be paid in dollars in three months’ time. Are you effectively estimating what the exchange rate is most likely to be or predicting what the exchange rate is likely to be in three months’ time and then adding a premium onto that, or is it based upon the exchange rate today?

BARRY: It’s up to the customer to decide that. I mean if you want to protect today’s exchange rates in full, that’s going to be more expensive than if you set a worst-case exchange rate lower than today’s rate. The way I think about it is that when you get any type of insurance, you can sometimes say I’ll take an excess on that. So, I will take the first £1,000 of any claim myself, and then that will reduce the cost of the insurance. It works a little bit like that in hedging a currency position that you might have. If I were to say that I will take the first 5% or the first 3% of any currency loss, then I am fully protected below that, and the hedging cost comes way down. It’s a lot cheaper. So, it’s really about the preferences of the customer, how risk averse they are or how much security they demand and how much certainty they demand in terms of a hedge.

OLIVER: OK, but the exchange rate can be very volatile these days, certainly thinking of anything against Sterling. It’s been very volatile for the last one or two ,years and it’s difficult to get a prediction of where it will actually be. If one goes in for hedging, I guess you’re getting an element of security. Can you actually find what it’s going to be in advance? So, if I was an exporter and I knew that I was only going to get paid in three months’ time, could I find out what the rate would be, so that I can control the enthusiasm of my sales team and give them an exchange rate to work with?

BARRY: Absolutely, that’s what hedging is all about. Generally what you see is the better managed businesses will have a higher propensity to have a hedging policy and actively hedge, and the reason for that is that current currencies can be extremely volatile. As you’ve mentioned with the pound sterling volatility recently. It could get a lot more volatile in the weeks ahead and people underestimate how dangerous this is to their business. We speak to businesses all over Ireland, the UK and beyond and it’s incredible how little people perceive the risk to be in this. I’ll give you an example, the Swiss franc in 2015 moved 30% in one day because of pegging to the euro and from the Swiss National Bank.

OLIVER: I think I remember.

BARRY: I remember it well because I was trading the market at the time and it was incredibly scary. I can only imagine what it would be like if you were exposed to that type of a move. That has the potential to put you out of business overnight. What we’ve found in a lot of studies and surveys that point to this is that upwards of 70 percent of small and medium businesses that operate internationally don’t do anything at all. They have no hedging plan. They don’t cover this risk in any way. and that’s quite shocking when you consider how hard a business person negotiates to get costs down, the fact that they will insure w every other part of their business against fire, against theft, against public liability, but then this whole huge risk of currency is just left totally open ended. But there is a solution there. I’m not claiming we’re reinventing anything. We’re using technology to give a business owner access to products that are already there. They’re already available, they’re generally considered to be forward contracts or options.

OLIVER: So why do you think that business people are not actually hedging up to now, is it that they just don’t know about it, or don’t know where to go, or they’re generally have pushback against the premium they have to pay?

BARRY: It’s a mixture of all of those things and more. I personally believe that a lot of business people are so busy running their business on a day to day basis that they just don’t find the time or energy to learn about hedging and to actually look into it properly. It’s seen as something like going to the dentist and they put it off. It’s only when you get toothache that it actually becomes a problem. Usually when they come and talk to us is after they’ve already suffered a bad loss. The other reasons we’ve seen beyond just being busy and lack of motivation is confusion. People are generally left completely confused about currency and currency hedging and so the default action is to just ignore it and see it as a cost of doing business. Some years they win, some years they lose. It’s sort of an attitude, and it balances out over time. That’s actually true to an extent mathematically, but the problem is when you get a sudden 30% move that could kill your cash flow and destroy your business overnight. This is when it becomes a real problem. The final reason I think people don’t hedge is the products on the market are really confusing, and that’s a real ordeal. It can take months to open an account and there’s a lot of conversations over the phone. Stuff isn’t explained properly, so the customer is generally left feeling pretty confused and without a really accessible solution for what they need.

OLIVER: I can see two other considerations. One is of course the exchange rates can work both ways. So, you could find that you fixed exchange rate now, but in fact you’d have been much better off waiting three months, crystal balls not being as reliable as they are in children’s literature. What happens if you find you could get a better exchange rate, can you actually walk away from a hedging deal?

BARRY: It depends on what products you choose. Typically, when we when we speak of currency hedging the two products are an “option” or a “forward”. So, a “forward” simply means that you agree a price to exchange your currency in the future. So, it might be that in three months’ time I will change euros to dollars at a certain rate, and you must follow through on that. So, as that is eliminating the uncertainty completely, you must execute that contract with whoever sold you that hedge. The benefit is that you get a certainty on your price. But as you’ve pointed out, there is a disadvantage in that, if the market were to go your way in the next three months as in a favourable gain, you forego that, because you’ve now agreed potentially at a worse price than it ends up in three months’ time. So, there is a cost there of missing out on potential gain. The other main way to hedge is with an Option. An Option is a simple payment up front that gives you the option to change currency if it makes sense to. So in other words, if you buy this option at a certain rate in three months’ time and the market goes against where you are you, will activate the option and change it at a better rate that you agreed, but if the market moves favourably for you, you will discard the hedging product and just trade on the market on the day at the better price. So, Options give you the upside potential but that comes with a little cost upfront, a premium cost. The Forward fixes the rate into the future, but you must follow through on that transaction so it’s a lot less flexible and you forego any possibility of a gain.

OLIVER: Understood. I also guess that specially in smaller businesses there’d be some hesitation with the Forward, the fixed option, because although, for example, I say, “OK we know this client will pay us in three months’ time or should pay us in three months’ time”, there are lots of cases of course where they don’t pay in 90 days, they pay in 92 or 93 or longer and they don’t have the money. I guess that means that they usually will have to buy the foreign exchange at whatever rate it is the time in order to change it?

BARRY: Yes. Well it depends. I mean there’s varying degrees of restrictiveness around a forward depending on the provider. Some providers will give you a break clause, somewhere along the line that if you don’t follow through, there is a repercussion. So, there’s dangers there. There’s another danger with a forward that people often overlook. Because the forward has an unrealized profit and loss effect before it settles, a lot of providers, in fact almost all of them will ask for what’s called a margin payment. That’s a sort of a down payment to say that you will make good on delivering the currency at the rate that you agreed. Because if the rate went against you, you could just rip the contract up and say no, I don’t want to do it, but then the provider that sold you that would be out of pocket for whatever unrealised loss that is to them. The margin payment could be 3, 5, 7 percent of the nominal value of the risk, but the problem then is that if, before you get your actual currency, the position moves substantially against for the provider, they will ask for more and more payments. So your cash flow could be eaten up. If you imagine the 30% move that we explained with the Swiss franc, potentially the provider would look for 30% of the nominal amount you’ve hedged against. This is something that people often overlook.

You don’t have that problem with an Option – you just pay the premium and that’s it. You never have to pay anything else unless you want to do the currency exchange at the end. So, it’s a lot more secure on cash flows. There are other benefits with the option, for example if you no longer need to hedge you can sell the option back. So, it’s like your car insurance. If you buy it for a year, and after two months you sell your car, you don’t need it. The insurance company will give you a high percentage back, because there’s value there. It works the same with an Option.

An Option could also be useful in terms of just using it to settle the profit and loss difference in your hedge. So that doesn’t involve necessarily changing currency at the end unless you want to. For example you could just set it up so that if there’s a 10% loss for you in the nominal you will get a 10% payment to you as settlement. There’s a lot of flexibility with an option.

The last thing with an option that I’d say is really good is that if you enter into tenders overseas and potentially M&A activity, where there’s a reasonable amount of uncertainty about the currency risk, the option can be tailor made to hedge you to some degree. So, you might say 5 percent or worse and it can end up being a half a percent of the risk or even a quarter of a percent. So, it can be quite low cost versus the dangers of a forward.

OLIVER: That’s really interesting. So, does this work for any currency pair or is it only restricted to say dollars and euros?

BARRY: It works for most currency pairs. It again depends on which provider you use. For Assure Hedge we can offer most currency pairs for an option. They are they are very liquid markets. Firms like ourselves connect right into the wholesale markets to give a full range of currency pairs.

OLIVER: What’s the exchange rate like compared to buying currency from your bank or
from a foreign currency provider at the time? Are they not only paying a premium but also signing into a worse exchange rate, would you say?

BARRY: Well the beauty of the option and the forward is you know upfront what exchange rate you’re dealing with, so you can compare that against the rate on any website that gives you the interbank rate like xe.com or Yahoo finance where you can see the interbank rate in real time. The hedge can be struck at that rate, which means that when it comes to settle, when you actually change one currency for another, you’ll get that at the Interbank Rate. You know you’re gaining massively there because you’re locking in today’s best possible rate into the future. What people often forget as well is multi-currency bank accounting. So many businesses just hold a sterling account. A lot of businesses have dollars paid into the pound account, and then the bank will charge anything from 2 to 3%. A huge number of businesses that do this. But it’s really easy to get a multi-currency account open, yet so many businesses don’t do it. Can you imagine – 2 to 3% of your income is mega. It’s such an easy thing to set up multi-currency bank accounts. So that’s another that’s thing I think people should be aware of.

OLIVER: Absolutely, it’s something I’ve always done myself in business and I’ve always been surprised how many people don’t do it, or don’t even think it’s possible to do it. It’s a very important thing, plus it gives you the flexibility to find the best possible exchange rate and the best possible place to exchange. As you say the standard bank rates are crippling, and if you get say a dollar transaction paid into a sterling account, there’s nothing you can do about the rate, the money arrives and its automatically converted so you know nothing about it until you actually see the bank balance.

BARRY: Yes. Another thing to point out is the average, the average charges by a bank are in the region of 1 to 2% but they can very easily be haggled down by just asking the bank. Most banks out there now are being very accommodative, but customers just don’t ask. So that’s what people should do, simply ask the bank to give you better rates and start checking them, and that could produce a lot of extra income for people. In my own company, I thought was very important that we give multi-currency accounts to all of our customers. So any customers we have can send or receive foreign currency balances on our platform. We had to get regulated from the FCA for client money to do that. So that complements are our regulation to create the derivative products that we use for hedging. But certainly the multi-currency accounts, there’s literally hundreds of thousands of business people out there operating internationally and they’re not doing this. So that would be a big takeaway from today as well.

OLIVER: What about security? If it was with your platform or some other in hedging, maybe people are going to say ‘I don’t feel like my money is going to be as safe as it would be with one of the big clearing banks’?

BARRY: Yes, well we can’t convince people if they’re if they’re dogmatic that banks are safe. What people fail to realise is that a company like my own is regulated by the Financial Conduct Authority, and that involves a huge amount of diligence, a lot of minimum reserves. All of our partners that we use are ‘A’ rated institutions. So, all client funds are held with ‘A’ rated institutions. A lot of people don’t realise that almost all high street banks are not ‘A’ rated banks. They have very poor credit ratings. So, their funds are actually at greater risk with a typical high street bank than they are with a company like ours that only uses ‘A’ rated entities and has complete segregation of client funds. So, it’s all about perception of risk. That’s something that I find a little bit odd from people sometimes.

OLIVER: I can understand that, and I think it’s actually a message to entrepreneurs listening to us that they need to sort of really check up on the security of any funds they’ve got within the banks they work with, and maybe spread their risk around as well.

BARRY: Yes, and people forget as well that it’s risky in the sense that when you leave money on deposit with a high street bank, there’s always a risk of a bail in if there’s another financial crisis. That’s a possibility. There are provisions there for banks to just literally take funds and put them towards a bailout package for other financial entities. So there’s a lot of risk in the system that people overlook. The high street banks aren’t necessarily as safe as people perceive them to be from my experience.

OLIVER: So, to recap, listeners who are interested in knowing more about what Assure Hedge does and hedging in general can obviously read up the supporting article on growinternational.org – we encourage all our listeners to always do that, of course, and you can find links to Barry’s company there with more details. But to recap on one thing, if you’re trading internationally and expecting future funds, what’s the sort of minimum figure for looking at to make this viable?

BARRY: In terms of in terms of actually hedging?

OLIVER: In terms of hedging. I think you said that you’re looking at £10,000 as the new minimum figure and aiming to get it down from there. Is that correct?

BARRY: Yes. I think it’s never too early to start thinking about this, because if you build it into the way you think about business from Day One, it’s a great thing. Rather than waiting till the business grows to be quite large, suffers a huge loss and then starts to think about this type of stuff. So, I would encourage anybody, no matter how small to learn as much as they can about hedging, have it as part of their day to day operational mandate to have a hedging policy, to implement it and to know who is responsible for it. Talk about it at board level, and of course contact us. We can handle hedges from £10,000 and up, which is not a huge amount, and that’ll probably be the entry level I would say. Any less than that, I wouldn’t think is going to be that relevant for most people. From 10,000 dollars or 10,000 euros of risk and up, we can work with you, and there are even online, automated products, at really low cost. We would love to work with your listeners.

OLIVER: Excellent, so even relatively small exporters should be thinking about this now and getting into it early so they may create a business discipline of hedging, right?

BARRY: Exactly. It’s all about a business discipline. People who do this can operate internationally with a lot more confidence than people who are leaving things to chance and gamble.

OLIVER: Barry, thank you very much for talking to me.

Photo by Christine Roy

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