When trading in single currency margin, cost isn’t the only factor to consider – you should also take FX exposure into account. 

Many firms use Single Currency Margin to meet their margin requirements. This has many operational advantages, although there are also costs associated with it. Obviously, dealing with payments across multiple currencies can be both time consuming and costly, especially ensuring that sufficient liquidity is available across all the currencies involved. On the other hand, brokers will be keeping track of your running credits and debits, and charging interest (including a spread) on these balances. 

Firms need to be aware of the various costs involved and work out the optimum set up based on their business. This balance will depend on the specific characteristics of the firm, for example the number of currencies in which margin is calculated for their portfolio and the ability to transact FX trades.

But cost isn’t the only factor to consider. There is also the FX exposure to take into account. Using Single Currency Margin, balances in other currencies can build up over time. This leads to exposure to the FX market, compared with immediately taking any profit or paying any loss in the original currency.

Running these balances has the potential for unexpected losses. This can happen even for a simple position held with a single broker.  But if you had a box position across brokers, with profit held at one and loss at the other, then the effect would be even greater. This is not an uncommon scenario, for example a firm may be clearing ICE Stir positions at one broker and  Eurex Bonds at another.

The balances held in these trading currency accounts will be impacted over time by the broker charges; profits will get smaller and losses will get larger. The credits and debits in different currencies will no longer match. And this is without taking into account any changes in the FX rates between the currencies.  


How can FX movements affect profits on a given trade or strategy?

Example One

Assume you have a trade in which you make €100,000 profit. If you are paying your margin in Dollars then you will immediately lose some of this profit as it is converted into the margin currency. If at some point you decide to take this profit from your Dollar account you may find that the value has dropped significantly, based on the FX rate applied. Changes of 1% in FX rates leading to similar losses over a period of time as short as a month is not unexpected.

Example Two

This loss could be even greater in the scenario where the original profit is $100,000 and the margin is being paid in Euros. This is because of the current interest rate regime, whereby holdings in Dollars will be paid interest, whereas those in Euros will potentially not. This means that any expected increase in value based on interest rates will not occur, at the same time as FX rates reduce the value of the profit. 

The combination of potentially larger changes in FX rates and the increased loss of interest, means that even over a relatively short period of time the losses can build up. In this scenario it is very easy to lose more than 10% of the profit within 6 months even during periods of low volatility.

Example Three

Taking the profit from a strategy held across two brokers can greatly increase the impact on profits from these small variations in FX rates. As an example, assume a profit of $100,000 has been made on a spread between Stirs at ICE and Bonds at Eurex. These are cleared through different brokers resulting in a profit of €200,000 at Broker 1 and a loss of €100,000 at Broker 2.

Conducting the same analysis, taking into account the spread in FX rates applied between buys and sells, then these losses can easily rise to over 15%. 

All this analysis was based on relatively small spreads in FX and interest rates, and a period of low volatility in the FX markets. If brokers choose to apply larger spreads and the markets become more volatile, then potential losses of over 25% can quickly build up. And this is without taking into account broker fees for providing Single Currency Margin.


Conclusion

The use of Single Currency Margin in combination with movements in FX rates can have a significant impact on profits even in low volatility markets. This can be exacerbated by the differences in the interest paid or charged based on the currency.

However, it should be noted that just as FX rates can go both up and down, it is possible that the use of Single Currency Margin may result in an increase in profit because of the exposure to the FX markets.

In the same way that firms monitor the risk on their traded positions, they need to ensure that they are properly monitoring their single currency balances to ensure that they are effectively managing their FX exposure. This means having systems and processes in place that are able to provide the information and perform the analysis required to make sure that the use of Single Currency Margin doesn’t result in large FX losses.

Find out more on Single Currency Margining in our latest blog – “Is there a cost to single currency margining?. 

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