Should small businesses lock into fixed exchange rates to protect against the wavering pound?

Posted on the 19th April 2017

Last month, hours after Theresa May triggered Article 50 and Britain's withdrawal from the EU, sterling fell against the euro from €1.151 to €1.145 in early trading, before recovering.

It also dropped 0.49 per cent against the US dollar to $1.239. In January, it was at a 30-year low as May indicated the country could opt for a 'hard' Brexit.

Two weeks later, the pound is back on the up. Yesterday it was trading at €1.1792 and £1.2542.

Fluctuating exchange rates have been a challenge for many of Britain's businesses since the referendum result back in June last year. 

Theresa May triggered Article 50 this week, starting two years of Brexit negotiations.

Many source raw materials, services and products from Europe, the US and further afield and have seen their profits suffer as the pound has lost value. 

Others employ people outside the UK, pay salaries in other currencies or sell most of their produce or services abroad. 

With Brexit negotiations beginning and the pound wavering, small businesses may be wondering whether to lock in their costs to provide some certainty - at least for the immediate future.

Daniel Webber, of currency comparison site FXCompared, says: 'Brexit has shown us a consistently volatile pound. Simple currency hedging products, such as a forward contract, can be used to lock in a fixed exchange rate, removing the need to predict the future movement of the pound.

'As such, currency hedging products should be used primarily by SMEs as a budget planning tool.'

If your company knows they have future international financial transactions, a forward contract can be taken out days, weeks, or even months in advance, allowing your financial decision makers the ability to know exactly what exchange rate they will be paying. 

Webber adds: 'The future uncertainty is removed and the price of a good or service they are buying or selling is then fixed and can be applied to a company's budget in advance.' 

Hamish Anderson, of Money Mover - a firm which allows SMEs to 'fix' exchange rates on payments, says smaller firms that make invoice payments, pay salaries and manage their treasury accounts overseas could benefit.

'Britain’s small businesses are facing unprecedented levels of uncertainty in light of the UK’s vote to leave the European Union,' he says. 

'Our aim is to empower SMEs to make informed decisions about currency exchange and global payments by giving full and upfront information about the cost of a transaction.

'We want to help SMEs free up capital set aside to cover uncertainty, and ultimately help them expand their businesses, employ more people, and deliver greater value to the economy.'

But is this too good to be true?

Emma Jones MBE, founder of small business support group Enterprise Nation, explains the risks and potential rewards of taking a punt on the path of exchange rates.

Emma Jones MBE, founder of small business support group Enterprise Nation, explains the risks and potential rewards of taking a punt on the path of exchange rates.

Should businesses lock into future exchange rates?

The short answer to this is it depends – one of the issues for some of the small businesses we speak to is that those buying raw materials, products or services from Europe, for example, have already seen a 20 per cent dip in margin because of the exchange rate. 

This is unless they had the foresight to hedge long-term last year or are enjoying increased exports due to the drop in sterling.

The pound has fluctuated in value against the Euro significantly since June last year.

Many smaller firms are not experiencing the latter because they are not yet well-established in overseas markets – for these firms, growth plans will have to be reviewed. 

The implication for very small companies is that their ability to use cash flow to invest in vital business-building including exports and currency hedging is going to be more limited going forward. 

The reality is that they are having to go back to suppliers and renegotiate deals to save money that way – and that takes precious time out from the business. 

While many could look to raise more capital to invest in hedging, many have already benefited from investment earlier in the pipeline and would find it prohibitively expensive to do so again at this point. The net effect is that they will likely buy smaller quantities and for example have smaller production runs more frequently.

In what circumstances can it work well?

If a business has a well-established customer base in the US or China which operates using dollars, hedging is an excellent idea because this is where the real rewards lie. 

If a firm is seeing a constant or even an upturn in demand for its products from overseas because of the price drop due to the fall in sterling, then hedging for the long-term can sometimes be a no-brainer and maximise profits in a time of uncertainty.

Hedging has its own inherent drawbacks just like any form of betting
What are the drawbacks?

Hedging has its own inherent drawbacks just like any form of betting – it could go the wrong way. In this instance, a rise in sterling any time soon seems unlikely, but can never be ruled out.  

The other drawback is that it means upfront payments and tying up capital, which, for the reasons already mentioned, is an issue particularly for smaller firms that rely on cash flow and may not be already established in overseas markets. 

If a firm is taking on board finance to hedge, this could wipe out any gains and so would need very careful consideration and advice from a financial expert.

How do you do it? Is there more than one way?

I would say take some financial advice on this, but here are some of the ways you can hedge.

Using a hedging agency or bureau is a very simple way to hedge and probably the most common way small firms do this. Obviously it’s important to shop around to get the best deal for your business. 

Quite often there will be an ability to make agreed monthly payments over the course of a year, which works well for small firms or you can use them to make one-off international transfers, which can be an efficient way of doing things. Firms like OFX and Caxton FX are particularly SME friendly.

Another way is to do it via a bank. Major banks offer currency forward contracts, but this is an option that only makes sense for larger firms with bigger volumes. Each contract would be linked with a specific transaction.

Futures contracts are a way to invest in currency at a future date at an agreed rate. This would need to be done via a reputable exchange such as the London International Financial Future Exchange.

Open a foreign bank account and purchase goods or services in the currency. This would only be effective if the sterling is sent into the bank account when it is strong against that currency.

Are there other ways to shelter your business from exchange rate risk?

Getting paid in the currency you most use and raising finance in that currency is one way to do it.

For example, one of our members is running a crowdfunding campaign in dollars. 

Whilst being British-based, its products are developed here and made in China, so all its payments are made in US dollars. It makes financial sense for them to make all transactions in US dollars.

Finally, sourcing and producing as much as possible in this country is obviously the best way to avoid having to lose money due to currency fluctuation.

It's impossible to predict the future and just because something has happened in the past does not mean it will happen again. 

Hedging for future changes in the value of the pound can be helpful but these are highly complex products and it's important, if you're thinking of doing it, that you get advice. 

Double check this advice with someone independent - an accountant or independent financial adviser who really understands the risk you're taking on. 

It might sound like a great idea, but with potential reward comes inevitable risk. 

The banks also have form for mis-selling complicated hedging products to small businesses. The former financial watchdog ordered Barclays, HSBC, Lloyds and RBS to compensate small businesses mis-sold complex interest rate hedging products back in 2012. 

So do your homework before you commit.