Digital disruption in the Treasury Management System space

There is a digital revolution going on in the treasury management system space, not that you would necessarily know.  For many there is still a stark choice – over-priced, over-complex and over-engineered treasury systems or good old Excel spreadsheets. But the world is changing and as with all things technology, it is happening at a rapid pace.

Globally, larger organisations are well catered for as far as treasury management systems are concerned, and in fact it is a crowded and mature market. The PwC Global Treasury Survey of 2014 showed that 80% of those companies surveyed were using some type of treasury management system. However, as with big ERP systems, the issue for the providers of large, expensive treasury systems is how to offer a cost-effective alternative to the massive SME market without detrimentally affecting their existing market. The challenge is to offer a slimmed down treasury management system without compromising the huge premium that they currently charge.

So where is the competition for these large, expensive systems coming from? The answer is the cloud app revolution which is sweeping the world. Platforms are being developed that aggregate a whole bunch of cloud apps, both financial and non-financial. The really clever bit is the integration of these different apps and bringing it all together through a variety of widgets and dashboards to give a complete, and often unique, view of a company’s position. It’s like a Fitbit for business.

Not only are these cloud app aggregators bringing leading edge technology to the SME market but they are doing so for small monthly fees. The apps cross the spectrum of business tools such as accounting systems, CRMs, social media tools and now treasury management systems. All of this for a few hundred dollars a month.

In the on-line accounting world, Xero is leading the charge in the digital disruption revolution with its New Zealand developed, $50 per month product. Treasury systems will need to follow suit with a much cheaper solution.

By leveraging cloud technology, treasury systems can be implemented for costs palatable to the underserviced SME market. There is an enormous amount of importers and exporters hedging their foreign cashflows with forward exchange contracts and possibly FX options. These companies probably aren’t hedge accounting, even if they are reporting under IFRS, but the impact of exchange rate movements is vitally important to their bottom line.

SMEs require the ability to record, report and value their transactions but just as importantly they want access to tools to help them make better hedging decisions. This is not too different from larger companies except SMEs are mostly using plain vanilla instruments. For a small monthly fee SMEs can benefit from a treasury management system with basic functionality, which integrates perfectly with other cloud based apps. So as we have seen with cloud based accounting systems, the power that was once reserved for large organisations can be put in the hands of a much larger group for a fraction of the cost.

Whether the current treasury management system providers have a solution for the SME market remains to be seen. It maybe that they do not care for this part of the market, however there are parallels with the large and expensive ERP systems which have successfully moved into the mid-market space and are now looking at the next tier down. The conundrum for treasury management system providers will be that SMEs will desire the core functionality of a larger system but without the price tag. The digital revolution for treasury management systems may only be in its infancy but it is set to have major ramifications regardless of the size of organisation.

First published on Treasury Insider (www.treasuryinsider.com)

PwC treasury survey reveals over-reliance on spreadsheets

PwC’s recently released “New Zealand treasury management survey” (http://pwc.to/1DCSdse) threw up some interesting results, especially in relation to treasury management systems.

It may come as no surprise to many, including us at Hedgebook, that there is a significant number of corporates who are still relying on good old spreadsheets to manage their treasury risks. In fact a whopping 73% of those surveyed still use spreadsheets, with only 13% using any type of treasury management system.

PwC Treasury Survey

Admittedly the 73% is mainly concentrated in small to medium sized organisations, however, the relative risks are the same for these business as they are for larger ones. The key difference is smaller businesses cannot afford, nor justify, the $50k plus price tag associated with these complex systems.

Therefore, it is not surprising that one of the main reasons for the high proportion of spreadsheet usage is price. However, as PwC pointed out in their survey, with low cost, cloud based systems entering the market, the excuse of treasury systems being too expensive is fast disappearing. We would also argue that a lower cost system does not have to mean loss of functionality.

Again as PwC’s survey showed “executives want detailed information in a timely, up-to-date, reliable and relevant manner.” This is becoming increasingly difficult to achieve with spreadsheets, as reporting requirements become more focused on information to make better decisions, as opposed to information for information sake.

Hedgebook certainly fits the bill of a low cost solution, not only providing the ability to better record, report and value treasury risks but also providing unique analysis combining cashflows, hedging and current market rates to help make better hedging decisions.

It will be interesting to see these same survey results this time next year. – we may start to see a significant change.

Why use an interest rate swap and how does it work?

It seems like only yesterday that I started my treasury career at one of NZ’s leading treasury advisory consultants, alas it was closer to 15 years ago. “We advise clients on managing their fx and interest rate exposures”, they said. “We use derivatives such as interest rate swaps to hedge risk”, they said. “Eh?”, I thought!

The financial markets have a lot of jargon but one quickly learns that many of the underlying concepts are quite simple. It is easy to assume people in the finance industry have a more in depth understanding of financial products than they actually do. There are plenty of examples of people who are exposed to interest rate swaps but whose understanding is rudimentary. Examples are young auditors who are coming across financial instruments rarely, or the back office clerk who is settling cashflows. Quite frankly there are also plenty of senior people who one might reasonably expect to have a greater level of understanding of these financial products than they actually do, such as senior auditors and CFOs.

In this article I attempt to explain in simple terms the purpose of an interest rate swap and how it works.

Why use an interest rate swap? When I was first learning about IRSs it was explained to me that they were simply an exchange of cashflows, either fixed for floating or floating for fixed, to hedge interest rate risk. Might as well have been in French for all it meant to me at the time. So I will try and take a step back. To my mind the best way to understand an IRS is by way of an example and the easiest example is that of a borrower who wishes to fix his interest rate exposure. Many of us borrow money from the bank in the form of a mortgage for our home and we choose to lock in the certainty of the interest rate payments by way of fixing the interest rate for a few years. A pretty simple concept. The corporate borrower has a few more options available to them to achieve certainty over interest costs on borrowings. They could borrow on a fixed rate basis very much akin to our residential mortgages. Alternatively, the corporate borrower could borrow from the bank on a floating rate basis and then enter a pay fixed interest rate swap to lock in the interest rate. The outcome is the same, however, the advantage of the IRS is the flexibility it allows the borrower in regards to the term he or she can fix and the flexibility to restructure. In terms of tenor, it is common for a borrower to fix through the IRS market out to ten years or longer. It is much harder, and expensive, to get the bank to fix interest rates long term as the bank needs to be compensated for tying up capital for such an extended period of time. It is also much harder, and expensive, to break debt that has been borrowed on a fixed rate basis, however, restructuring an IRS is a straightforward process and allows the corporate borrower to take advantage of prevailing interest rate market opportunities or “play the yield curve” to use financial market parlance.

How does an IRS work? Explaining how an IRS works requires us to understand the concept of exchanging cashflows. The diagram below represents the cashflows associated with a borrower using an IRS to fix interest costs:

IRS cashflow

 

1) The company borrows money from the bank, say $1 million for our example, on a floating rate basis. There are floating rate benchmarks for different currencies i.e. BKBM in NZ, BBSW in Australia, EURIBOR in Europe, etc. and this floating rate changes/sets every day. The bank will charge a margin on the money it lends, say 2.00%. The effect for the company is it borrows money at floating rate + 2.00%.

2) The company wishes to fix his interest cost and to achieve this enters a pay fixed / receive floating IRS with a bank (maybe the same bank as it has borrowed from, but not necessarily). We will assume the company wishes to fix the entire $1 million i.e. the swap is entered for $1 million. It could just as easily decide to fix only half i.e. $500,000. Herein lies some of the flexibility an IRS allows the company when considering its interest rate risk management profile. Under the terms of the pay fixed swap the borrower will pay the bank a fixed interest rate and receive floating interest from the bank i.e. exchange of cashflows. Note, there is no exchange of principal, only interest.

The floating rate received through the swap offsets the floating rate paid to the bank for the debt. The net impact to the borrower is paying a fixed rate (through the swap) plus the margin the bank charges for borrowing the money (2.00%).

There are some important factors to consider when entering an IRS to ensure the hedge is at its most optimal. The roll-dates of the IRS should match that of the debt i.e. if the floating rate on the debt sets every three months then so should the floating rate on the IRS, and on the same day. The underlying reference rate on the debt and the swap should also match i.e. BKBM, BBSW, EURIBOR, etc. Both of these things ensure there is no “basis risk” within the hedge as well as ensuring it passes muster from a hedge accounting perspective if it is designated into a hedge relationship.

The example above is designed to provide a basic understanding of the concept of an interest rate swap. We have used the floating rate borrower as an example. However, IRSs are used by an array of market participants for a multitude of uses including investors wishing to structure their income profiles or borrowers who have borrowed on a fixed term but wish to have exposure to floating interest rates. However, the underlying concepts are fairly straightforward.

 

IFRS 7 – Disclosure Requirements of Financial Instruments

A key pillar of Hedgebook’s ethos is to make life easier for corporates in managing and reporting their financial derivative exposures. This approach extends to aiding Treasurers and CFOs comply with the ever increasing compliance requirements of accounting standards. The most recent standard to create further onus on corporates is the CVA requirements of IFRS 13. We have discussed IFRS 13 on numerous occasions via this blog (and will continue to do so!)

However, the focus of this blog post is the disclosures required by IFRS 7 and specifically the quantitative disclosures in assessing the risks faced by an entity in regards to its financial instruments. Quantifying the risks is demonstrated via a sensitivity analysis.

The Hedgebook application allows a user to perform sensitivity analyses on foreign exchange and interest rate positions at the press of a button and in doing so helps achieve compliance to IFRS 7 as simply and efficiently as possible. These numbers can be included directly into the Notes to the Financial Statements.

Interest Rate Swaps

There is a report within the suite of Hedgebook interest rate reports called the IR Sensitivity Report. A user is able to run the sensitivity analysis in three easy steps:

–          select the appropriate interest rate swap portfolio or individual deals

–          select the valuation date and currency

–          run the IR Sensitivity Report

The Hedgebook app produces the fair value per instrument based on the valuation date zero curve and also the fair values following pre-defined shifts in the yield curve.

Using the 31 March 2014 AUD zero curve as an example, the chart below shows the actual zero curve plus the alternative yield curves that are applied to the swap portfolio:

Sensitivity analysis

The zero curve is flexed by a parallel shift of +/-50, +/-100 and +/-200 basis points. The output of the report is the hypothetical fair value of each transaction under the aforementioned yield curves. The analysis provides information about the extent to which the entity is exposed to risk. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Foreign exchange

Hedgebook’s sensitivity analysis for fx instruments follows a similar vein to interest rates. The fx curve (spot plus forwards) is flexed by a +/-1%, +/-5%, +/-10% and +/-20% to derive the hypothetical valuations. The subsequent Hedgebook report can be printed, copied into a document or downloaded to excel for inclusion in the Notes to the Financial Statements.

Summary

As regulatory and compliance requirements continue to increase it is important that corporates find ways to increase efficiency and find alternative ways to complete increasing workloads without increasing personnel. A low cost system such as Hedgebook allows senior members of the finance team to focus on added value tasks and not become encumbered by compliance requirements that can be automated such as sensitivity analyses for IFRS 7 disclosure requirements.

Mis-selling of swaps case dismissed

Further to our article posted last week, there has been more evidence to confirm that borrowers crying about “mis-selling” of swaps is not going to garner sympathy in the courts. A sophisticated borrower, or an entity with access to expert advice, cannot lay blame at the door of the banks for their own misjudgments for what have been in hindsight poor hedging decisions. http://bit.ly/1at7pk0

It’s risk management stupid

The bankrupted City of Detroit is locked in a legal battle over the purchase of interest rate swaps as are many other municipalities/local governments around the world. Detroit’s case is particularly high profile given the tragic demise of a once great city, and as with most bankruptcies not everyone appears to be treated equally or indeed fairly.

The numbers that relate to the interest rate swaps are enormous, which is no doubt why Detroit feels so aggrieved. These numbers are also, not surprisingly, losses, and indeed realised losses as the bankruptcy will result in the closing out of these swaps. But whose fault is it really, the banks for selling these swaps or the municipality for purchasing them?

Everyone likes to bash the banks and indeed they may not be blameless in this case. If the banks are withholding information or forcing the entity into purchasing the swaps as part of the underlying transaction then this doesn’t seem right. However, whether you are a large municipality in the US or a dairy farmer in New Zealand the onus is on the buyer of these products to understand the risks associated with them before they transact. It is difficult to believe that a finance team that is sophisticated enough to issue millions of dollars of bonds does not understand the mechanics of an interest rate swap.

Interest rate swaps are risk management tools. They can be used to give certainty of interest cashflows for entities that are perhaps highly geared and therefore cannot afford to pay any higher interest rates or can also be used as a proactive way of managing interest rates. Portfolio management dictates that a proportion of debt should be fixed either through fixed rate borrowing or interest rate swaps but the financial markets are not a one way bet, otherwise we would all be millionaires. There are risks attached to entering these transactions. As is often the case we hear of the cases where rates have gone against the swap owner but not so much when it has gone the other way.

Interest rate swaps are not toxic or necessarily dangerous. They should though be used by those who understand them. The various scenarios that can play out depending on movements in the financial markets should be modelled. Interest rate swaps also have the flexibility of being able to be closed out as part of the overall risk management strategy if necessary.

As with any purchase the buyer needs to know what they are buying. With swaps they need to form part of the overall risk management approach. We would all like the opportunity to try and renegotiate the whys and wherefores of entering into a financial instrument when the markets move against us. Swaps can be complicated but are also useful risk management tools that have a place in any borrowers or investors risk management strategy. Lack of understanding should not be a defense against decisions which in hindsight may not have been made.

IFRS 13: Fair value measurement – Credit Value Adjustment

The purpose of this blog is to examine IFRS 13 as it relates to the Credit Value Adjustment (CVA) of a financial instrument. In the post GFC environment, greater focus has been given to the impact of counterparty credit risk. IFRS 13 requires the valuation of counterparty credit risk to be quantified and separated from the risk-free valuation of the financial instrument. There are two broad methodologies that can be considered for calculating CVA: simple and complex. For a number of pragmatic reasons, when considering the appropriate methodology for corporates, the preference is for a simple methodology to be used, the rationale for which is set out below.

IFRS 13 objectives

Before considering CVA it is worthwhile re-capping the objectives of IFRS 13. The objectives are to provide:

–          greater clarity on the definition of fair value

–          the framework for measuring fair value

–          the disclosures required about fair value measurements.

Importantly, from a CVA perspective, IFRS 13 requires the fair value of a liability/asset to take into account the effect of credit risk, including an entity’s own credit risk. The notion of counterparty credit risk is defined by the risk that a party to a financial contract will fail to fulfil their side of the contractual agreement.

Factors that influence credit risk

When considering credit risk there are a number of factors that can influence the valuation including:

–          time: the longer to the maturity date the greater the risk of default

–          the instrument: a forward exchange contract or a vanilla interest rate swap will carry less credit risk than a cross currency swap due to the exchange of principal at maturity

–          collateral: if collateral is posted over the life of a financial instrument then counterparty credit risk is reduced

–          netting: if counterparty credit risk can be netted through a netting arrangement with the counterparty i.e. out-of-the money valuations are netted with in-the-money valuations overall exposure is reduced

CVA calculation: simple versus complex

There are two generally accepted methodologies when considering the calculation of CVA with each having advantages and disadvantages.

The simple methodology is a current exposure model whereby the Net Present Value (NPV) of the future cashflows of the financial instrument on a risk-free basis is compared to the NPV following the inclusion of a credit spread. The difference between the two NPVs is CVA.  The zero curve for discounting purposes is simply shifted by an appropriate credit spread such as that implied by observable credit default swaps.

Zero curve

To give a sense of materiality, a NZD10 million swap at a pay fixed rate of 4.00% with five years to maturity has a positive mark-to-market of +NZD250,215 based on the risk-free zero curve (swaps). Using a 200 basis point spread to represent the credit quality of the bank/counterparty the mark-to-market reduces to +NZD232,377. The difference of -NZD17,838 is the CVA adjustment. The difference expressed in annual basis point terms is approximately 3.5 bp i.e. relatively immaterial. In the example we have used an arbitrary +200 bp as the credit spread used to shift the zero curve. In reality the observable credit default swap market for the counterparty at valuation date would be used.

The advantages of the simple methodology is it is easy to calculate and easy to explain/demonstrate. The disadvantage of the simple methodology is takes no account of volatility or that a position can move between being an asset and a liability as determined by the outlook for interest rates/foreign exchange.

The complex methodology is a potential future exposure model and takes account of factors such as volatility (i.e. what the instrument may be worth in the future through Monte Carlo simulation), likelihood of counterparty defaulting (default probability) and how much may be recovered in the event of default (recovery rate). The models used under a complex methodology are by their nature harder to explain, harder to understand and less transparent (black box). Arguably the complex methodology is unnecessary for “less sophisticated” market participants such as corporate borrowers using vanilla products, but more appropriate for market participants such as banks.

Fit for purpose

An important consideration of the appropriate methodology is the nature of the reporting entity. For example, a small to medium sized corporate with a portfolio of vanilla interest rate swaps or Forward Exchange Contracts (FECs) should not require the same level of sophistication in calculating CVA as a large organisation that is funding in overseas markets and entering complex derivatives such as cross currency swaps. Cross currency swaps are a credit intensive instrument and as such the CVA component can be material.

Valuation techniques

Fair value measurement requires an entity to explain the appropriate valuation techniques used to measure fair value. The valuation techniques used should maximise the use of relevant observable inputs and minimise unobservable inputs. Those inputs should be consistent with the inputs a market participant would use when pricing the asset or liability. In other words, the reporting entity needs to be able to explain the models and inputs/assumptions used to calculate the fair value of a financial instrument including the CVA component. Explaining the valuations of derivatives including the CVA component is not a straightforward process, however, it is relatively easier under the simple methodology.

Summary

IFRS 13 requires financial instruments to be fair valued and provides much greater guidance on definitions, frameworks and disclosures. There is a requirement to calculate the credit component of a financial instrument and two generally accepted methodologies are available. For market participants such as banks, or sophisticated borrowers funding offshore and using cross currency swaps, there is a strong argument for applying the complex methodology. However, for the less sophisticated user of financial instruments such as borrowers using vanilla interest rate swaps or FECs then an easily explainable methodology that simply discounts future cashflows using a zero curve that is shifted by an appropriate margin that represents the counterparty’s credit should suffice.

Scope for Recovery by Australian Dollar Limited as Labor Suffers

The Reserve Bank of Australia cut its key benchmark interest rate to a record low 2.50% earlier this year, highlighting the central bank’s concerns over the sensitivity of the Australian economy to turmoil in emerging markets.

When discussing Australia at the turn of the year, we suggested that: “Now, with rates at all-time lows, it’s a good moment to reflect on why we’re in the current predicament. After all, dovish monetary policy is only implemented when worries of an economic slowdown persist.”

These concerns were well-informed, as the Australian labor market has only deteriorated over the course of the year, forcing the Reserve Bank of Australia to cut its main interest rate to a record low of 2.50% at its August policy meeting. This is a significant step lower from the 4.75% rate employed as recently as November 2011; an aggressive rate cut cycle the RBA has employed, indeed.

Nevertheless, it’s evident that concerns surrounding Australia will continue. The country’s most important sector, mining, continues to show signs of slowdown, and government advisors have reluctantly admitted that the global commodity supercycle – driven by rapidly growing emerging markets – may be finished.

We continue to believe that the changing economic climate of Australia will play a negative influence on the Australian Dollar. The labor market remains a primary concern, and has proven to be a major negative influence on the Australian Dollar in recent months:

AUDUSD_unemployment

Over the past two-plus years, after the AUDUSD peak near $1.1100 in the summer of 2011, the RBA’s aggressive easing cycle, in part to help soothe fears over the labor distress, has driven the AUDUSD down to its lowest exchange rate since September 2010, below $0.9000 in August.

Further pressure on the Australian labor market, and thus the Australian Dollar, seems likely. Whereas the AUDUSD was quite stable near $1.0500 for several months while labor markets deteriorated, it’s clear that reality has set in. Despite several rate cuts since November 2011, Australia’s unemployment rate has increased from 4.9% in April 2011 to 5.8% in August 2013, the highest rate since August 2009.

Scope for recovery in the labor market is limited at best as long as the commodity cycle slowdown persists. Data compiled by the RBA in August showed that base metals prices, perhaps most indicative of economic strength in the mining sector, sunk to their lowest level since late-2009 by midyear, an ominous sign considering the time before prices had reached that level it was on the way lower by another 30% amid the global financial crisis of 2008.

RBA CPI

Base metals prices continue to be the guiding light for Australia – and should they remain subdued going forward, we suspect that dovish guidance will remain in place at the RBA, serving as a consistent, bearish influence on the Aussie for the remainder of 2013.

Steel, iron ore and coking coal

European Growth Rebounds and Bolsters Euro Turnaround

This post will discuss the improving economic conditions that have started to emerge from the Euro-Zone. Policymakers have a difficult task of balancing a diverse regional economy marked by declining rates of production, consumption, inflation, and overall growth, all of which are exacerbated by a recently-strong Euro.

The Euro-Zone has backed away from the brink of collapse – for now. The recession that’s gripped the region since the 2Q’12 appears to be abating, with the contraction appeared to having bottomed in the first half of 2013.

Euro 10 yr bond spreads

The rebound, in its entirety, can be attributed to the European Central Bank’s efforts to reduce financial risk in the region in the summer of 2012, when it announced its outright monetary transactions (OMT) program, essentially an unlimited safety net for Euro-Zone countries facing high borrowing costs in trading markets.

Euro GDP

The Euro, with the tail-risk premium of a break up very-much diminished, has sparkled amid the turn in growth prospects. After bottoming just above $1.2000 against the US Dollar in July 2012, the Euro has spent much of 2013 trading above $1.3000, trading as high as $1.3832 on October 25. The resiliency of the Euro is commendable two-fold: first, not only due to warding off breakup threats; but also because the US yields have risen sharply thanks to the Fed’s upcoming reduction in QE3.

Euro PMI

The rebound in regional economic activity, of course underpinned by stability in peripheral bond markets, may continue through the remainder of 2013 and into early-2014, if incoming PMI data is accurate. In fact, the last time we discussed the Euro-Zone crisis, manufacturing and services PMI figures from across the region were struggling below 50, the demarcation between growth and contraction.

In February 2012, only German PMI Services showed growth, while the other seven gauges tracked (manufacturing and services for Germany, the Euro-Zone, France, and Italy, each) were contracting. Indeed, our last commentary was near the “bottom”; and now five of the eight PMI readings are in growth territory (see chart above). Further sustained signs of economic progress in the region will only further serve as a bullish catalyst for the Euro.

Going forward, political risk is what could undermine the Euro. Corruption in Spain and Italy threatens the governments (the latter especially), while record or near-record high unemployment rates across the Euro-Zone will only serve as a constant reminder as to how far the region needs to go before “recovery” can be declared. Depending on what the Fed does over the 4Q’13 – will it taper? by how much? in what increments? – the EURUSD is positioned for the time being to finish the year above $1.3300 so long as political pressures remain subdued and further signs of European ‘green shoots’ emerge.

Credit Value Adjustment

Credit Value Adjustment or CVA has been around for a long time, however, with the introduction of the accounting standard IFRS13, this year there is a requirement to understand it a bit better. The new standard requires the CVA component to be separately reported from the fair value of a financial instrument.

CVA is the difference between the risk-free portfolio value and the true portfolio value that takes into account the possibility of a counterparty’s default. In other words, CVA is the market value of counterparty credit risk.

The big question is whether it will be material enough for most organizations to worry about; given the potential complexity around its calculation, most would hope not.

There is no doubt if you have cross-currency swaps the impact of CVA is likely to be material. However most companies that use these instruments would normally have a sophisticated treasury management system that would do this calculation at the push of a button.

Most other organizations however will probably be relying on spreadsheets to capture and record their treasury transactions and will lack the ability to calculate financial instrument valuations let alone the more complex CVA.

Will you need to worry about CVA is the question? Most do not know there is a requirement, let alone how it will be calculated and this is true of the audit profession as much as the corporate world.

Whether it is material or not may be the question, however, it is likely that even if it is not material there may be a requirement to prove this. At the end of the day the audit profession will decide whether organizations will need to calculate CVA or not. In the meantime we are keeping a watching brief on both the banks’ ability to provide the CVA component and the audit firms as to whether they will force organizations to calculate it.

Watch this space.