ECU Group in London uses currency management to reduce clients' lending costs. As it starts pitching to corporates for the first time, Charles Romilly, ECU's head of corporate liability management, explains how it works

The idea of reducing debt by currency management is appealing. How does it work?
Think of the two sides of a balance sheet. In an environment of low interest rates, benign economic conditions and generally rising prices, investors focus on assets and go to great lengths to identify talented asset managers. However, in an environment of rising interest rates, declining economic output and stagnating or even falling valuations, liabilities assume greater relevance.

At ECU, we believe a unit of currency deserves skilful management regardless of whether it has a plus or a minus sign in front of it. In other words, why not manage both sides of a balance sheet with equal diligence? We focus on the often overlooked side - liabilities - and have two core objectives: reducing debt and improving cashflow. We do this by placing debt in currencies that fall in value relative to sterling and, where possible, are lower yielding than sterling.

We manage $1.5 billion at 15 different banks, where our clients have multi-currency loan facilities with individual currency accounts for sterling, US dollar, euro, Swiss franc, yen, Australian dollar and Canadian dollar. We can switch their debt from one currency to another by executing spot FX transactions which go to delivery. The bought leg of each transaction always repays the old debt currency and the sold leg becomes the new debt currency. If the debt currency falls 5% against sterling, the sterling value of the loan reduces by the same amount. Conversely, a 5% rise in the debt currency increases the sterling value of the loan.

How do you pick your positions, and how often do you trade?
We have an investment committee comprising a group of highly-respected analysts and strategists, and two full-time investment managers: Michael Petley, chairman of the investment committee and ECU's chief investment officer, who co-founded the firm in 1988, and Neil MacKinnon, chief currency strategist, who joined ECU's investment committee in 1998. He was previously chief currency strategist at Merrill Lynch and Citibank.

We employ a developed-economies foreign exchange trading programme. The programme is discretionary and aims to identify the medium-term direction and relative strength of the major currencies through both fundamental and technical analysis. The strategy is long sterling, directional, and incorporates a carry-trade bias (long high-yielding currencies and short low-yielding currencies). Positions are never leveraged and are only entered into when well-defined risk/reward parameters have been identified. As a result trading is relatively infrequent, typically 15-20 times a year.

Currency markets are notoriously risky. How did you fare during high-profile shocks such as sterling dropping out of the Exchange Rate Mechanism in 1992, or during the Asian currency crisis of 1998?
Fortunately on both those occasions we were short of sterling at the time. If sterling is deemed to be the weakest of the major currencies we will return all sterling-benchmarked debt to sterling. Over the last 10 years this has been the case about 25% of the time. However, as you say, there is always the risk that we will get the markets wrong. For this reason clients need to be able to tolerate an increase of 15% in the value of their loans, and the higher interest payments which would result. In the last 10 years no client has experienced such a loss. The period of worst performance increased client debt by 11.9% which we recovered in four months.

How do you mitigate the risk of sudden exchange rate movements against your positions?
As our funds under management have grown, we now have the type of risk management controls and procedures that you would expect of a $1.5 billion hedge fund. RBS is our FX prime broker and we are able to trade our entire debt book, 24 hours a day, with any one of a number of major FX banks, including Citigroup, Goldman Sachs, RBS and UBS.

We also offer a performance protection option for our clients via ABN Amro, which underwrites trading losses in excess of any interest rate saving over and above the initial value of the loan, in return for a premium. The option is specifically for companies that cannot or will not take currency risk. It could be because they are publicly quoted, highly geared or simply risk averse.

It works as follows: the client buys an at-the-money put option on our performance from ABN Amro with a strike price of the initial loan amount. If the loan increases (loan loss) the option goes in-the-money (option profit), and if the loan reduces (loan profit) the option goes out-of-the-money (option loss). The lending bank has a charge over the client's option account at ABN Amro, which provides additional security if a loan increases.

The client continues to pay sterling Libor interest, plus the bank's lending margin into a blocked sterling deposit account at the lending bank. The actual quarterly currency interest accruals are then debited from this blocked account. Interest is never added to a loan. If all goes well, a surplus starts to accrue in the blocked sterling deposit account and the sterling value of the currency loan capital accounts reduces.

However, let's assume the interest side of things goes to plan but sterling dips and the sterling value of the debt increases. In this scenario the intrinsic premium value of the ABN Amro option will increase by the amount of any loan increase, above its original balance, net of any interest savings in the blocked deposit account. For example, a £1.5 million interest rate saving (profit) in the blocked sterling deposit account and a £5 million increase (loss) in the sterling value of the original loan balance would generate a £3.5 million cash-in amount on the option.

How much does it cost, and how does that compare to asset management using similar methods?
We charge an annual management fee of 0.65% and a quarterly peak-to-peak performance fee of 20% on any net reduction in the debt and any interest saving. The cost of the ABN Amro option varies. Typically we suggest long-dated options to avoid excessive extrinsic premium decay in the early years. They are American-style options and can be sold at any time. A 25-year option currently costs 15.5% upfront or 0.95% per annum. Typically hedge funds - with no performance protection - charge 2% and 20%, whereas our multi-currency loan management, with ABN Amro's performance protection, costs 1.65% per annum with a 20% performance fee.

Currency volatility has been at record lows over the past year. What impact does that have on your performance?
We take the view that nothing lasts for ever and periods of low, or indeed high, volatility come to an end eventually. But the present climate is puzzling because nobody could possibly say the world is a more stable or safer place than it was even five years ago. In the past our clients would not have needed an ABN Amro performance protection option and all our models show that it would have acted as a drag on our performance, but times do change.

Putting all of this in context, since January 1, 1997, a £100 million multi-currency loan under our management would have reduced by £31 million and accrued £26 million of interest saving, a net return of 57%. The cost of the ABN Amro performance protection option would have reduced this to a net return of 47% (which does not include the interest that would have been earned in the blocked sterling deposit account). Either outcome would surely have been preferable to an unchanged £100 million loan after 10 years of making GBP interest payments.

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