It’s not easy being green: why the FX market is lagging on ESG

Imagine a meeting of desk heads at a bank, to discuss progress on ESG transactions. The rates head describes an interest rate swap linked to climate metrics. The equity head talks about an index futures trade that tracks environmental benchmarks. Then it’s the turn of the foreign exchange head – and an awkward silence.

The FX market has slipped behind other asset classes in developing trades linked to environmental, social and governance factors. But banks are working to reverse this trend.

ING, for example, is nine months into a pilot programme to automatically link clients’ ESG behaviour to the pricing that the Dutch bank offers for electronic FX transactions. ING is now considering extending the programme to a wider client base.

“We’re really trying to embed ESG into the DNA of our pricing methodology and therefore, rather than specific FX transactions being linked to ESG targets, all of our electronic FX prices will be influenced by the overall ESG behaviour of our clients,” says Thomas Epple, head of financial markets, Germany and Austria at ING.

Financial institutions are under growing pressure from ethically minded clients to offer ESG products. Governments, too, are pushing lenders and investors to adopt sustainable ways of working, in line with high-level commitments such as reducing carbon emissions to net zero by 2050 or the United Nations sustainable development goals.

But the FX market’s ethical efforts have run up against a structural obstacle. Foreign exchange transactions are generally shorter dated than in other asset classes, with tenors often as brief as a single day. This hampers dealers in linking individual transactions to longer-term key performance indicators (KPIs).

The bulk of FX market volume comes from spot transactions, which simply don’t have the length of tenor to embed an ESG target into them

Patrick Kondarjian, HSBC

To get around this, more banks are taking a portfolio approach to ESG-linked transactions – where a client executes a number of FX transactions with a particular bank over a specified period of time and receives a one-off rebate payment from the bank at the end of the period if it meets pre-agreed ESG targets. Conversely, if the client misses its KPIs, it pays a fee to the bank.

The size of the client’s rebate or fee is usually linked to the number of FX transactions it executes, and the volumes involved. Banks often use third-party rating agencies, such as Sustainalytics or MSCI, to assess whether the client has met its targets.

But these transactions can have drawbacks. Calculating the potential rebate (or fee) a client might receive (or have to pay) can create complex accounting issues for both parties and how they document their profit and loss.

There are more fundamental challenges too. Members of the European Central Bank’s FX contact group highlight that there is still a lack of mutual understanding as to what constitutes adherence to ESG, even though various initiatives have tried to find common ground. As a result, the few ESG-linked FX transactions that have taken place within the market so far have been costly, with a high degree of manual handling making it difficult to push the agreements out at scale.

Holistic remedy

ING’s pilot programme of ESG-linked foreign exchange trades is currently limited to around 100 non-financial corporate clients in Frankfurt. The bank uses an in-house methodology to cluster clients into different pricing brackets, based upon publicly available ESG data. Clients with a better ranking for sustainability receive more competitive prices for their FX spot, swaps and forwards trades than clients that are ranked poorly.

ING conducts its analysis on a monthly basis to ensure that any changes in a client’s ESG behaviour are fully reflected in the price savings they receive.

Overall, the pricing incentives aren’t huge. Epple says that cash trades in the range of €5 million to €10 million would receive a pricing improvement amounting to “several hundred euros”. Epple says this pricing incentive is a “relevant difference” in the competitive FX market, and can be “obviously adjusted”.

The scheme differs from ESG-linked transactions in other asset classes, in that it doesn’t peg trades to a pre-agreed sustainability metric or KPI. Rather, clients are judged on their overall ESG profile.

“Clients are very enticed with this methodology as it makes them reconsider their ESG behaviour in a way that doesn’t require them to agree to specific KPIs or bilateral documentation with us – which can challenge entry within the ESG market,” says Epple.

He adds: “We’ve had positive feedback on the pilot, which is why we’re now looking into potentially rolling this out on a much bigger scale.”

Building a portfolio

For many banks, adopting a portfolio approach to transactions is one of the only ways to make ESG-linked trades work within the FX market.

“While options, futures and forwards typically see longer tenors – and therefore can work on a standalone basis – the bulk of FX market volume comes from spot transactions, which simply don’t have the length of tenor to embed an ESG target into them. So, this portfolio approach is a structure that works well for clients,” says Patrick Kondarjian, global head of sustainability, markets and securities services at HSBC. “That being said, it’s still a relatively nascent offering compared to the sheer scale of the overall FX market.”

Such a structure was used by UK-based…