The FX and payments market: A sub-sector with positive recovery potential and a focus on technology

What can small and midcap investors expect with exposure to the FX dealing, currency management and international payments sector? Our latest sector research shows the FX dealing and international payments sector offers a number of interesting listed opportunities for investors to get exposure to both positive underlying market drivers as well as company-specific plays on technological innovation and business model transitions. Like most sectors, COVID had a significant impact, specifically on FX orders, global trade and payments, but we believe the opportunity for a strong recovery is apparent, given the underlying quality of companies in this space.

The FX dealing and international payments sector offers a number of interesting listed opportunities for investors to get exposure to both positive underlying market drivers as well as company-specific plays on technological innovation and business model transitions.

Like most sectors, COVID had a significant impact, specifically on FX orders, global trade and payments, but we believe the opportunity for a strong recovery is apparent, given the underlying quality of companies in this space.

Prominent player Alpha FX ranked highly as part of the Ambition Nation Listed 50 last year, and this year features once again. Watch our interview with Alpha FX CEO Morgan Tillbrook here.

Find out more about the Ambition Nation Listed 50

Corporates require commercial FX and payments services, an offering that, depending on the size of any given client, has traditionally been delivered by small payment platforms, SME brokers, high street banks and large international investment banks/prime brokers. Banks are the largest players, with c.85% of market share built up from existing relationships with corporates via traditional banking services. Companies, however, are increasingly using specialist providers that can offer tailored levels of client service and in-depth knowledge of the client and its needs, onboarding new companies with speed and efficiency, an element of the journey where traditional full-scale banks often fail. The requirement to be a market leader in this regard is a company’s ability to recruit knowledgeable front office sales teams who are able to pry corporates away from ‘integrated’ banking services (though in reality large banks offer little in the way of a unified approach to banking and additional service provision).

The sector is characterised by a product-based offering increasingly delivered on a unified platform basis, which is a model offering scale-up and cross-selling opportunities while capturing sticky clients over the long term. FX revenue represents commissions and spreads, with risk managed through the matching of client contracts against concurrent counterparty contracts between the FX business and its banking partners (often high street banks). Cash on the balance sheet is ring-fenced as collateral for such contracts, controlling the level of forward FX contracts that can be entered into given the amount of collateral held on the balance sheet.

Typical FX products

While complexity can increase markedly for more sophisticated clients, for example the large financial institutions served by Record Plc, the basic mechanics of the products offered by the other players are simple, meaning investors do not have to get bogged down in assessing complex underlying exposures. Although some corporates engage in accidental speculation when formal hedging strategies are not applied consistently, services offered by listed players are based on underlying business needs and the FX business itself does not engage in speculation on its own book.

• Spot contracts are used to purchase currency for immediate delivery with settlement ranging from 1-3 days.
• Forward contracts fix the exchange rate for a pre-determined period of time with typical flexibility being structured around:
  • Fixed forward contracts to purchase a fixed amount of currency for a fixed exchange rate and future date;
  • Window forward contracts to take delivery of a fixed amount of currency at a fixed exchange rate within a specified window; and
  • Open forward contracts, enabling clients to take delivery at any time between the date the contract is booked and the final settlement date.
  • Bad debts can occur when forward positions are ‘out the money’ and the client is unable to provide sufficient collateral, suggesting risk appetite of a firm can still play a part in performance, despite FX trades being market neutral.

Market opportunity

The currency market offers depth of USD6.6trn traded per day, with London as a leading hub, even after the Brexit vote in 2016. The UK’s market share for FX trading increased to 43.1% in April 2019, compared to 36.9% in 2016. In terms of import and export activities involving FX, the market is upwards of £500bn, although the market is likely much larger when considering corporate repatriation of profits, expatriating payroll, overseas investments and hedging by financial institutions. The market opportunity for small and midcap participants is therefore substantial, both in terms of the new business gleaned as a percentage of the total market size in addition to wins from the traditional banking sector.

The importance for decision makers within corporate finance and treasury departments to avoid speculating in FX is paramount, given the potential for poor decision making to negatively affect the consistency of cash flow and profits. Speculative activities enter a corporate’s financial statements through the back door unless a defined hedging strategy is drawn up and implemented. Having such a strategy suggests two positive drivers: clients become sticky due to the understanding needed between corporate and FX broker and the work needed to re-educate another FX provider should a switch occur; and revenues reoccur since decisions are no longer based on taking a forward view on FX markets and whether to hedge or not, instead being based on a formal hedging arrangement that provides fluidity around the underlying market.

How sector participants must differentiate themselves

Client service

While product pricing is important, it is perhaps secondary to concerns about client service, an area where traditional players have failed, either because front office teams are too small and are unable to deal offer the capacity for service alongside growth, or the FX provision is tacked onto traditional banking services with little in the way of resources.

This has long been a problem in private banking and wealth management, where client accounts below a certain threshold receive little attention. The opportunity for sector participants is therefore to offer a focussed, tailored approach that is bespoke. The cost of this bespoke-style provision can be offset by the FX firms dealing with clients that have similar underlying needs, for example retail companies with overseas sales channels.

Staff recruitment and culture

With client service at the centre of what can be a sophisticated financial services offering, the importance of recruitment cannot be underestimated. There has been some movement of hires between competitors, but strong company specific cultures mitigate such brain drain. Alpha FX particularly is known for its strong, identifiable culture. In fact, the company puts ‘cultural density’ ahead of operational agility and client centricity in its stated strategy.

Technology

Management of risk, volatility measurement, reporting, payments, cash flow modelling and compliance are examples of features important to clients using companies to facilitate FX management. Firms in the sector largely build proprietary systems in order to gain a potential competitive edge, with the operational element of the technology being needed to connect the various FX and payment systems throughout a customer’s lifecycle.

Increased use of technology is perhaps most apparent at Alpha FX, and the valuation reflects this. Equals too is focussing on technological innovation, although the shares do not yet reflect the progress being made, presenting an opportunity for investors wishing to get exposure to a recovery/transition style play in the sector.