This article is provided by Alt21 Limited, trading as Alt21, an FCA authorised payments and FX provider and is intended for UK businesses considering FX hedging as part of their treasury activity. All examples provided are illustrative only and not a current or guaranteed rate. Comments from Tom Vooght, Head of Sales at Alt21, and Chris Canning, Vice President of Sales & Trading at Alt21 are contained within the article. As Alt21 employees, their comments reflect their own experience working with Alt21’s clients and describe Alt21’s own products and approach, rather than independent market commentary. Please read the full disclaimer at the bottom of the page.
When you enter into a Forward Contract, the exchange rate isn’t the only number worth looking at. Your provider may also ask you to provide collateral, sometimes described as a deposit or margin, which can affect how much cash you need to set aside while the contract remains open.
Understanding FX collateral currency helps you see what that money is doing, why your provider might ask for it and how the arrangement could affect your cash flow.
It also gives you another way to assess a forward quote. A competitive-looking rate can tell you one thing about a contract. The collateral requirements, flexibility, pricing and settlement terms tell you much more.
What is FX collateral currency?
FX collateral currency is the currency in which collateral is held against an FX position or contract.
In its broadest sense, collateral is an asset or cash balance used to support an obligation. The exact mechanics depend on the type of FX product and provider you’re using.
For a business entering into a Forward Contract, you may encounter this as a deposit or margin requirement. (An FX Forward Contract is an agreement to exchange one currency for another at an agreed rate on a future date.)
Be aware that if you cannot meet a request for the deposit or additional margin, your provider may end the contract and settle it at the prevailing market rate. This could result in a loss to your business, as well as additional costs.
Rather than paying the full value of the future currency transaction when you book it, you agree to exchange currencies at a later date. Your provider is therefore taking on exposure to you until the contract is settled.
Collateral can help the provider manage that counterparty exposure.
The currency used for collateral doesn’t necessarily have to be the same as the currencies involved in the underlying position. Some financial platforms, for example, allow eligible collateral currencies to differ from the trading pair itself. The currencies accepted, and the way they’re valued, will depend on the provider and product.
For a business using Forward Contracts, the more useful question is:
What does providing collateral mean for my cash?
Why do FX brokers ask for a deposit?
If you’ve wondered why FX brokers ask for a deposit, it helps to look at what happens after you book a forward.
Imagine you agree today to buy €500,000 in six months at an agreed forward rate.
You haven’t exchanged the €500,000 yet. But you’ve entered into a contract that will change in market value as exchange rates move.
If the market moves significantly between the trade date and settlement date, the value of that outstanding contract can move with it. That creates counterparty exposure for the FX provider.
Research from Russell Investments, originally published in 2010, discusses this counterparty exposure in relation to FX forwards and the mechanisms financial institutions use to manage it.
For a business customer, this can appear in a few different ways depending on your provider and agreement:
- An initial deposit when you book the Forward Contract
- A requirement to maintain collateral while the contract is open
- Additional margin if the market moves significantly
- A credit facility that allows you to trade without providing the full deposit upfront
These aren’t interchangeable arrangements, and providers may structure their requirements differently.
That’s why it’s worth understanding the terms before you focus on the forward rate alone.
Is a forward deposit an extra FX fee?
Not necessarily.
A deposit or collateral requirement and the cost of the FX transaction are different things.
If you’re required to place collateral against a forward, the cash may remain yours but be unavailable for other purposes while it’s being held. The exact treatment will depend on your agreement with the provider.
Here’s another example:
A £20,000 collateral requirement isn’t necessarily the same as paying a £20,000 fee. But if that £20,000 is unavailable for payroll, inventory, supplier payments or another part of your business for several months, there can still be a working-capital impact.
When you’re comparing Forward Contracts, ask your provider what happens to the collateral, as well as how much you’re expected to provide.
You might be interested in our article, “No Fee FX: What Does Fee Free Hedging Really Cost”
What determines how much collateral you’re asked for?
There’s no single deposit percentage that applies to every Forward Contract.
Requirements can depend on factors including:
- The size of your Forward Contract
- How long the contract will remain open
- The currencies involved
- Market conditions
- Your provider’s credit assessment
- Your existing relationship and trading history
- The provider’s own credit and collateral policies
- Whether you’ve been given a credit facility
- Changes in the market value of your open contract
A provider may ask two businesses entering similar Forward Contracts for different collateral arrangements. That doesn’t automatically make one arrangement unfair. But you should be able to understand the terms you’re agreeing to.
Ask whether the initial deposit is fixed, whether additional margin could be requested and what would trigger that request.
Most importantly, don’t wait until the market has moved to find out.
Can you negotiate an FX deposit?
Some elements of your collateral arrangement may depend on your provider’s credit assessment and commercial terms.
That makes a conversation worth having.
Rather than treating the deposit as a fixed feature of every forward, ask your provider how the requirement was determined. You can also ask whether other credit arrangements are available and what circumstances could cause the amount to change.
Additional questions include:
- Why am I being asked for this amount?
- Which currency can I provide as collateral?
- When will the collateral be returned or released?
- Could you ask me for additional margin?
- What would trigger a margin call?
- Do you offer credit facilities for Forward Contracts?
- How would a credit facility change my collateral requirements?
- What happens if I can’t meet an additional margin request?
The wider point is to understand the terms around your Forward Contract, rather than treating the initial quote as the whole product.
As Chris Canning, VP Sales & Trading at Alt21, explains:
“It’s worth sense-checking that the amount of cover you’re taking out is sufficient, but also that it gives you the terms that you want and need.”
That includes understanding what happens while the contract is open, what you’re committed to at settlement and what flexibility you have if your circumstances change.
You may also be interested in our article on FX charges.
Is my broker’s FX rate fair?
If you’re asking “is my broker’s FX rate fair?”, comparing quotes can give you a useful reference point. But a Forward Contract shouldn’t be judged on the exchange rate alone.
“With forwards and hedging, it’s just making sure that the product fits the client’s business needs. I think that’s the most important part,” says Tom Vooght, Head of Sales at Alt21.
That means looking at what you’re getting for the price.
Start with the purpose of the hedge.
Does the amount you’re covering reflect your expected exposure?
Hedging 10% of a highly predictable exposure may not give you the level of cover you intended. Committing to 99% of a highly uncertain forecast could create a different problem.
Then consider how the contract will work alongside your actual cash flows. As Chris explains:
“Is it flexible? Can they draw down in the period that they expect to draw down? Have they checked with the counterparty that they can draw down and that it is flexible?”
It’s also worth understanding what happens at the end of the contract.
Are you committed to settling on a particular date?
If your plans change, can the forward be extended or rolled, and on what terms?
Price still matters. But assessing whether a quote is fair means understanding what you’re getting in return: a contract with a particular rate, level of cover, flexibility, collateral requirement and set of settlement terms.
A slightly different rate attached to a contract that better reflects your cash flows, timing and operational requirements may therefore be a very different proposition from a rate viewed in isolation.
How to sense-check your forward quote
You don’t need to accept a forward quote as a single unexplained number.
Start by asking what you’re actually being charged.
Depending on how your provider presents pricing, you may be able to see the exchange rate, the FX margin or spread applied and the resulting monetary cost of the transaction. If that information isn’t visible, ask for it.
You should also be able to ask how your provider arrived at the price you’ve been given.
At Alt21, Chris says that information is available to customers:
“If they want all the details on transparency, they can have them. If they’re going through the dealing desk and request them, we’ll give them our exact markup and what that costs in pounds and pence to them.”
That gives you something more useful than a headline rate. You can see what the provider is charging and assess that alongside the collateral requirements, flexibility and service attached to the contract.
Then look beyond pricing.
Check:
The amount you’re hedging
Does it reflect the exposure you’re actually trying to manage?
The settlement period
Does the contract line up with when you expect to need the currency?
Drawdown flexibility
Can you use portions of the forward as payments become due, if that’s important to your business?
What happens at maturity
Understand what you’re committed to doing when the contract ends and what options may be available if your circumstances change.
Collateral requirements
Know how much cash you’ll need to provide initially and whether further margin could be requested.
The total commercial arrangement
Technology, reporting, support, execution, and the ability to manage your FX independently can all form part of what you’re paying for.
Clear pricing also makes it easier to understand whether the way you’re being charged remains consistent over time.
A very competitive first quote doesn’t necessarily tell you what future transactions will cost, which is another reason to look at the pricing model rather than judging a provider on one trade.
Remember, a fair quote isn’t necessarily the lowest number you can find; it’s one you can understand.
Read more about the spot rate vs forward rate.
Look beyond the headline rate
Forward Contracts can help some businesses plan future currency costs with greater certainty, depending on their cash flows, exposure and objectives. The important part is knowing what you’re agreeing to, including what it could mean for your cash, your flexibility and your obligations while the contract is open.
Your FX collateral currency, initial deposit, potential margin requirements, flexibility and pricing can all affect how the contract works in practice.
That’s why understanding your forward matters more than simply collecting quotes until you find the highest rate.
At Alt21, we believe you should be able to see what you’re paying and understand the terms you’re agreeing to. Our currency management platform gives you visibility over pricing, self-service tools to manage your FX, and support when you need it.
Before entering into any FX product, it’s worth understanding the risks, costs and obligations involved – hedging products are not suitable for every business.
Want to see what managing your FX with Alt21 looks like? Create an account and explore the platform.
ALT21 Limited is authorised and regulated by the Financial Conduct Authority (FRN: 783837) and is a company registered in England and Wales (number 10723112). The registered address is 45 Eagle Street, London WC1R 4FS, United Kingdom. This article has been produced by ALT21 Limited for information purposes only. It does not constitute financial advice or an offer to sell or the solicitation of an offer to buy any products referenced. Hedging products are not suitable for every business. Before entering into any FX product, you should consider whether it is appropriate for your needs and circumstances. ALT21 Limited assumes no liability for errors, inaccuracies or omissions. Eligibility criteria and terms and conditions apply to all products and services offered by ALT21 Limited. Not all applications will be accepted.
1. https://russellinvestments.com/-/media/files/au/insights/collateral-managementaligning-fx-risks-with-the-right-risk-management.pdf
