GFXD Publishes Paper on ESG in FX: Sees FX Global Code Adoption Helping

With ESG investing high on the public agenda, the Global Foreign Exchange Division (GFXD), part of the Global Financial Markets Association (GFMA), has published a paper looking at where Environmental impact, Social goals, and Governance quality can have an impact in the FX markets.

The paper voices GFXD’s support for global efforts to standardise taxonomies, disclosures and metrics, which it believes will help set the underpinnings for driving good ESG practices in the global FX market, it also includes what the association terms a “call to action”, particularly for the buy side to commit to the FX Global Code as part of its collective ESG commitments. Commitment to the Code, GFXD says, “will demonstrate social responsibility and good governance in the context of ESG”.

While the ESG focus in other asset classes has largely been on the environmental aspect of ESG, the paper observes that buy side adoption of the Code is “inconsistent” and that greater uptake is an “obvious mechanism by which wholesale FX market participants can demonstrate good governance and control practices in their FX activities”.

The paper adds that Code adherence can help boost a firm’s reputation as a good market citizen, It also observes that it can help further the UN’s Sustainable Development Goals, given the latter’s focus on fair and regulated financial markets, as well as the UN-supported Principles for Responsible Investing.

“In light of the above, the GFXD makes a call to action for wholesale FX market participants who have not yet adhered to the Code to do so, on the basis that Code adherence can evidence a showing of support for ESG goals as well as be an indicator of action towards developing good ESG credentials,” it states in the paper.

Highlighting the many regulator-driven initiatives to increase disclosures and improve metrics around ESG policies (which is also being driven by end investors), the paper points out that the GFMA along with Boston Consulting Group has published a paper issued Global Guiding Principles for Developing Climate Finance Taxonomies. It explains that these principles may be relevant for the FX community, since they recommend that all existing and new taxonomies should be assessed against these global principles for climate finance taxonomies as well as the conclusions factored into shaping future enhancements and development of new taxonomies.

An FX business will likely be assessed not only on its own ESG commitments and adherence, but also on the ESG practices of its client/customer base, as well as, that of market infrastructures and vendors with which it has relationships

GFMA stresses the five principles are by design high level and not prescriptive for applications that are based on regional or nationally defined contributions, climate targets and policies, and sector-specific transition pathways.  It also notes that individual institutions will decide what the appropriate ESG targets are for their organisation.

The regulatory focus and emphasis on climate change issues in particular, but also ESG more broadly, is likely to continue in 2021 and beyond, the paper argues. Depending on the scope and application of a particular policy, law, regulation or best practice, ESG taxonomies, disclosure or reporting mandates, and metrics, likely could have at least an indirect impact on FX. As an example, it suggests that ESG disclosures at a financial institution’s corporate level could impact how all business lines and operations within that institution, including the firm’s FX business, are viewed and assessed by investors, trade counterparties and clients.

“Though likely there will be some regulatory and/or jurisdictional differences in approach, rather than one single global unified framework, the GFXD supports the efforts being devoted to ESG taxonomies, disclosures and metrics and the goal of establishing more consistent ESG measures to provide better transparency for evaluation of an entity or product’s performance against those measures,” it says. “This could be key in the context of FX product innovation and review, to ensure clarity as to new products’ alignment with ESG criteria and avoid the risk of greenwashing or mis-selling, which can lead to litigation risk.”

ESG-related FX products are on the increase, in October 2019, Siemens Gamesa and BNP Paribas traded sustainable FX contracts, while a year later in 2020 Deutsche Bank created what it said was the world’s first ESG FX derivative framework. More recently NatWest Markets and Enel entered into sustainability-driven FX trades and HSBC executed an FX hedge based upon MSCI’s ESG Index.  GFXD predicts an increase in this, predicting that discussions between FX liquidity providers and their counterparties and clients about ESG performance will likely become more commonplace going forward.

The paper also notes that in the trading and markets arena it is expected that ESG review will form part of the selection process for liquidity providers and trading counterparties, as well as for the selection of ancillary service providers. “This could be directly relevant to FX in terms of FX end-users seeking out ESG “good-performers” to trade with (and vice versa, with liquidity providers assessing their counterparties and clients with FX needs),” the paper states. “FX market infrastructure providers and vendors may also be expected to evidence favourable ESG practices and performance to those using their services.

“In light of this, in terms of knock-on impacts it is worth noting that a financial institution or FX business will likely be assessed not only on its own ESG commitments and adherence but also on the ESG practices of its client/customer base, as well as, potentially, that of market infrastructures and vendors with which the financial institution or FX business has relationships,” it adds.

Away from firm-specific goals, on a broader note, the paper suggests that country-level ESG data could be integrated into asset allocation processes as well as in thinking about a currency’s long-term performance. With emerging markets investing on the rise, this could become a bigger factor in FX as well, indeed the paper notes that FX derivatives can be used to efficiently manage currency risk from pro-ESG projects in these markets.

The paper accepts that linking currency allocation and performance to environment factors can be “challenging”, however it uses as an example, some currencies’ links to commodities. “Environmental rankings could therefore be used to help firms identify how currencies are exposed to commodity price developments,” it states. “Social factors may drive moves in the FX markets, for example GDP, indicators of prospects for future wealth in a country, and political influence over economic policy. Governance factors could be used to assess risk premia for currencies.”

The paper highlights different products that could be used to build ESG goals into FX contracts, several of which have already been trialled by the banks mentioned above, and GFXD says that given financial firms’ strong interest in helping clients embed ESG into their investments and activities, including FX, “no doubt firms will increasingly design and develop more FX financial products that are linked to sustainability targets”.