Banking on foreign exchange
BANKING ON FOREIGN EXCHANGE
By Steve Fox, Head of Treasury,
Fairbairn Private Bank
18 September 2008
As we edge towards winter after another
grey, wet summer, more and more individuals will be tempted to take
late holidays or even contemplate emigrating to sunnier and warmer
climes. In our increasingly globalised economy, travel, employment
and business commitments can often evolve into assignments or
contracts around the world, potentially leading to foreign
investment opportunities, overseas property purchase, overseas
educational or other family needs. Fortunately, the increased
accessibility of international financial markets now means that
individuals can regularly transact in currencies other than their
domestic currency.
Offshore banks based in jurisdictions such
as the Isle of Man and Jersey are ideally placed to cater for this
internationally mobile population and can deliver a full range of
multi-currency banking facilities. In fact, the above scenarios are
increasingly contributing to the global nature and growth in the
customer base of many offshore banks.
Financial institutions operating within the
offshore arena are very familiar with the needs of international
clients and are well-versed in the requirements and regulations of
international banking, which allows them to deliver a range of
services to suit the most basic client needs right through to more
sophisticated demands.
When operating in more than one currency,
the key concern is managing exposure to foreign exchange
fluctuations. The ability of an offshore bank to hold multiple
currency accounts within one location and provide a wide range of
services can be indispensable for international clients,
particularly with regards to cross currency transactions and
foreign currency risk management.
Most offshore banks provide a comprehensive
range of foreign exchange facilities, making use of highly
sophisticated price and market information systems within their
treasury operations, to enable their client relationship managers
to instantly quote foreign exchange rates for all major currencies
pairs. Some organisations will provide an advisory service to
their clients with respect to market views and aniticipated
exchange rate movements, however, the discretionary management of a
client’s foreign exchange risk is uncommon in the offshore
arena.
Undoubtedly, the ability to instantly execute
a foreign exchange transaction is far more efficient, cost
effective and lower risk than moving funds from one institution to
another to effect the same transaction. Transacting between
institutions may require the provision of written instruction for
transfer, may incur transfer charges and delays, and, as a
consequence, may leave a client exposed to substantial foreign
exchange rate movements.
This last point is particularly pertinent
given the volatility experienced in the foreign exchange markets
during 2008, where the exchange rates of major currency pairs have
moved by almost 15%, with some very substantial intra-day movements
occurring along the way.
Typically, a multi-currency account is
structured like an umbrella bank account, with a single account
number, under which any number of sub-accounts can be maintained in
different currencies according to a client’s specific needs.
The multi-currency structure allows a client to receive an income
in one currency, such as US dollars, and then offers the means to
make payments from the account in different currencies, such as
sterling or euro. If clients are based abroad for a
pre-determined period, one of these sub-accounts will usually be
denominated in their domestic currency. Alternatively,
clients planning to move or retire abroad in the future may wish to
accumulate assets in the currency of their future residence.
Within a multi-currency account structure,
account types can range from instant access deposit accounts
through multi-currency borrowing facilities to more sophisticated
structured deposit accounts, which offer clients the potential to
enhance their income.
Instant access deposit facilities
Commonly available in various major
currencies, these allow clients immediate access to their funds,
whilst also providing a gross, competitive interest rate. It is
important to note that if the client is an individual resident
within the EU, interest may be subject to a retention tax
charge.
Cheque guarantee, credit / debit card and
international transfer facilities are widely available in
conjunction with these accounts, often ensuring no foreign exchange
charges when withdrawing money in the currency of the card.
Fixed term deposit facilities
Commonly available in various major
currencies, these allow clients to receive a set rate of interest
for a defined period of time, usually ranging from overnight
through to twelve months, although longer maturity tenors can be
obtained.
These deposit facilities can be one of the
lowest risk, yet most useful, elements of a well-structured
portfolio as they allow clients to know exactly how much interest
is being earned and when the capital will be repaid.
Multi-currency borrowing facilities
Subject to each lender’s particular
criteria, finance in a range of currencies can often be secured
against a variety of assets, including investment holdings and
property, and is usually tailored to suit the needs of the
individual client.
More sophisticated clients may use these
facilities to reduce the interest they are paying by borrowing in a
low interest rate currency, or attempt to reduce their outstanding
capital borrowings by switching between currencies.
Structured deposit facilities
Over recent years structured deposit
accounts denominated in many currencies have become far more
accessible for private clients through offshore banks. Structured
deposits may offer the potential to obtain an enhanced yield,
whilst maintaining the comfort that capital is protected.
These products are suitable for clients who,
whilst limiting risk to the capital they have deposited, are
prepared to sacrifice all or part of the interest they could
earn with a conventional deposit account in return for the
potential to earn an increased yield.
For more sophisticated clients with a higher
appetite for risk, additional enhanced yield deposit accounts are
also available where the capital may not necessarily be 100%
protected.
Clients may wish to seek an offshore
institution that does not charge a commission for foreign exchange
transactions but provides a competitive foreign exchange rate quote
based on the size of the underlying transaction. Clients can
also make use of various financial instruments to take advantage of
prevailing exchange rates for either speculative purposes or for
reducing their own foreign currency exposures.
The rate most commonly quoted is the ‘spot
rate’: this is the rate offered by a bank for an immediate exchange
of one currency for another. However, spot trades are generally
‘settled’ two business days after the transaction date.
Clients can manage future exchange rate movements by using ‘forward
outright’ transactions, where the money actually changes hands at
some agreed date in the future. This allows the client and the bank
to fix an exchange rate for an agreed amount of money at a
specified future date, regardless of the market rate on that
day. Quite simply, it enables a client to guarantee an
exchange rate for a payment due to be made or received in the
future. The duration of these trades can be a few days, months or
years.
Currency speculation can be tempting,
particularly with the current volatility in financial
markets, however, trading currency involves serious risks. If
a client wishes to speculate, it is vital they have a sound
understanding of why currencies behave in the way they do. Currency
movements cannot be reliably forecast as they are influenced by
such a wide range of macro-economic and geopolitical issues.
Foreign exchange risk is directly related to the volatility of the
domestic currency and this can affect the value of a client’s
assets and liabilities accordingly.
Speculation aside, managing exposure to
foreign exchange fluctuations and mitigating foreign exchange risk
are still key issues for the increasing number of clients operating
internationally. The foreign exchange services offered by
offshore banks can be used to support investment decisions in any
of the world's major currencies and with the multi-currency banking
options generally available even the requirements of the most
complex portfolio should be supported.