The recent focus within the UK has been upon interest rate hedging products (IRHPs) with the UK’s largest banks having remediation enforced by the FCA (s. 166 review), specifically covering SME customers. There are many direct parallels with the sales of IRHPs for interest rate hedging and currency derivatives for currency hedging.
The interaction of the factors impacting currency exchange rates and Foreign Exchange Products (FX), is highly unpredictable and volatile, thus making it extremely difficult for a business to foresee what its potential exposure would be.
What is a Foreign Exchange (FX) Product?
Companies that trade overseas and require foreign currency for their business have often sought to protect themselves against adverse currency movements by entering into some form of hedging arrangement with their bank. A common example being forward contracts, so that there are fixed currency exchange rates (costs) over the coming months or years. Yet some banks have sold companies extremely complex currency products, which are potentially inappropriate for SMEs. Often, instead of helping the company to protect itself from currency exchange risk, these contracts are speculative in nature, and have the potential of exposing the company to enormous liabilities.
These products often include the following characteristics:
- Significant downside risks, which rapidly escalate when exchange rates move the wrong way
- Little upside benefits, if the trades are “Knocked-out” companies may have to purchase currency at or significantly outside of current spot rates
- Lock in period; companies may be bound to contracts lasting considerable periods of time, where they are unaware of the substantial break costs to terminate
- Complex structures, such as “Knock-out” or “Knock-in” or barrier options, if a predetermined target is exceeded or triggered. Examples include Target Redemption Forwards (TARFs) and Ratio Forwards, if the exchange rate reaches certain trigger points the company may find themselves having to buy double the currency they require
- Other common bank products include loan facilities structured to take advantage of comparatively low overseas interest rates, such as Yen Mortgages; however, when UK Base Rates fell the currency risk became apparent potentially doubling the company’s debt, and therefore doubling the interest payable. These substantial risks were seldom explained by the bank.
With GBP sterling at a five year high against the US dollar, and the Yen at its strongest (as at November 2014), many companies are now suffering from exchange rates that are far worse than market rates, trapped in financial products they do not understand. As a result many find themselves seriously out of pocket, only now realising they were completely unaware of the magnitude of the financial risks they were taking on, with these foreign currency derivative products.
To date the FCA has declined to comment on these products.
Obligations of the Adviser or Sales Person for FX Products
- In good time, the Bank provides the Customer with appropriate, comprehensive, fair, clear and not misleading information on the features, benefits, risks associated with the FX products.
- In good time, the Bank provides the Customer with appropriate, comprehensible, fair, clear and not misleading disclosure of potential break costs of the FX product.
- The Bank had due regard to the information needs of the Customer and provided comprehensible, fair, clear and not misleading information about the features, benefits and risks of relevant alternative FX hedging products.
- In relation to a non-advised sale, the Bank took reasonable steps to ensure that the Customer understands the nature of the risks involved and provided the Customer with relevant Risk Warning Notice or assessed whether entering into the FX product was appropriate for the Customer by determining whether the Customer had the necessary knowledge and experience to understand the risks involved. The Bank has obtained information regarding the Customers level of education, profession or former profession and the relevant past experience of FX hedging products.
The FX Market background
The FX market is one of the largest and most liquid markets in the world with a daily average turnover of $5.3 trillion, 40% of which takes place in London – so you can see why the UK regulator is particularly concerned with this issue.
Part of the FX market is the spot FX market that uses “fixes” or benchmarks to establish the relative value of two currencies (spot FX). These fixes are used by a range of (and numerous) financial and non-financial companies (located and operating across the globe) for a variety of purposes such as managing currency risk or valuing assets and liabilities – so when you hear the regulator talk about “systemic issues”, “integrity” and “undermining of confidence in the UK financial system”, you can see why this is a pretty serious issue.
Finally, G10 currencies are the most widely-used and liquid currencies – so we are not talking niche, contained or immaterial here either.
How was this service mis-sold?
FX products were sold on the basis of protecting customers from future interest rate rises; however there were many associated risks that were not fully explained to the customers leading to the possible mis-selling of these products.
- Customers were not made fully aware of what the financial impact would be when interest rates fell
- There were high exit fees associated with any cancellation of the product by the customer
The mis-selling of FX products shares many similarities with those of standalone IRHPs; such as:
- Failure to ensure the customer/s fully understood the risk
- Failure to fully inform the customer/s of the associated exit costs
- Allowing “over-hedging” to occur, i.e. when the amounts and/or duration did not marry up with the underlying loans
- Allowing non-advised sales processes to turn into advice being given to the customer/s
- Allowing the rewards/incentives to be a key driver in the above ‘failing’ sales practices.
Currently, there is no clear and definite redress programme for FX products or associated timeframes; however the FCA has outlined a basic ‘Principles of Redress’ for customers of ‘non-compliant’ sales of some FX products. The redress awarded needs to put the customer back in the position they would have been in had the breach in the regulatory requirement not taken place. The types of redress that can be expected are:
- Full redress—putting the customer back to the original position had the sale of the FX product not taken place. The redress needs to include all payments made by the customer, any ‘break costs’ paid and an exit from the FX product free together with Compensatory Interest of 8%.