Dealers warn of capital squeeze from increased FX hedging

Sharp rise in uncollateralised buy-side hedges could restrict banks’ ability to take on positions

Key points Summary Q&A

• Dealers say a surge in uncollateralised FX forwards hedging from buy‑side clients could put bank balance sheets under pressure.
• The SA‑CCR rules, introduced in 2022, have raised capital charges on uncollateralised FX swaps and forwards and penalise directional risk.
• Banks must choose to absorb higher costs or widen spreads, and some are asking clients to collateralise or internalise trades.
• UBS said a 5% rise in hedge ratios, mostly through FX forwards, would add about $1.4 trillion of flows for banks to risk manage.
• Trading concentrated around month‑end and IMM dates also raises operational and settlement risk if there is a spike in volumes.

These summaries are generated by an LLM, but edited by humans.

A surge in uncollateralised foreign exchange forwards hedging from buy-side clients could put bank balance sheets under pressure, dealers warn.

FX hedge ratios at asset managers and pension funds have not materially increased in 2025, despite the selloff in the US dollar in the second quarter. This may change, though, as narrowing interest rate differentials could reduce costs for foreign investors hedging their US assets through FX forwards.

FX forwards and swaps trades between dealers and clients are largely uncollateralised, meaning banks incur a higher capital charge to warehouse these trades on their balance sheet. 

We have had a lot of conversations [with clients] around capital and liquidity. It has been top of mind

Chris Pizzotti, State Street

Speaking at the Federal Reserve Bank of New York’s FX market structure conference on December 17, Adrian Boehler, global head of macro sales at UBS, said dealers may be restricted in how much they can take on if there is a sharp rise in FX forwards hedging. 

“If we project forward into a scenario whereby trading activity were to increase substantially, I’m actually less concerned about day-to-day liquidity than I am about some of the market structure implications,” he said. “Other capital constraints come more into focus in the event there is a large increase in hedge ratios.”

FX forwards and swaps trading has become one of the main capital burdens for banks since the standardised approach to counterparty credit risk (SA-CCR) was introduced in 2022.

Under the previous capital measure, known as the current exposure method, short-dated FX trades largely fell out of scope and added no risk-weighted assets, but SA-CCR captured them for the first time. It also included penalties for uncollateralised or non-cash-collateralised trades and penalised directional risk, which make up a large proportion of the FX swaps and forwards market.

Dealers faced the tough choice of either swallowing the higher capital costs to trade uncollateralised FX swaps or widening spreads to uncompetitive levels.

$1.4 trillion

The additional flows that banks would need to risk-manage arising from a 5% uptick in hedge ratios, according to UBS.

Some have had discussions with clients about voluntarily collateralising their deliverable FX forwards and swaps positions in return for cheaper spreads. But in the event of a surge in hedging in response to changing macroeconomic conditions and volatility, clients may have less incentive to do so.

“If we’re talking about a materially larger quantum of outstanding hedges, then with the cost of balance sheet for dealers going up because of regulatory capital requirements, I wonder if there’s a scenario whereby the willingness or the ability to keep warehousing uncollateralised hedging activity continues,” said Boehler.

Boehler highlighted that a 5% uptick in hedge ratios would equate to an additional $1.4 trillion of flows for banks to risk-manage.

Speaking on the same panel, Chris Pizzotti, global head of FX sales and trading at State Street, agreed with Boehler’s sentiment and noted that it could become a growing concern if hedge rates rise.

“We have had a lot of conversations [with clients] around capital and liquidity. It has been top of mind, especially when you start to see an increase in hedging activity in uncollateralised forwards that puts a lot of stress on balance sheet and liquidity consumption,” said Pizzotti.

“That could change over time, but the conversations around collateralised forwards and [internalising] more to continue to scale with clients are the main points.”

Optimisation

Panellists also said potential market structure issues could be exacerbated by the timing of FX forwards trading activity.

Volumes from asset managers and pension funds are typically concentrated around month-end rolls or International Monetary Market dates, resulting in a large number of transactions being processed and settled within a brief window of time. A major surge in trading, said Boehler, particularly in the case of market dislocations, would increase the chances of operational and settlement risk.

Related

Has US dollar hedging hype faded? 

SA-CCR proves a bitter pill for US banks to swallow 

US banks eye collateralisation to tackle SA-CCR costs 

In the meantime, he said, conversations with clients around balance sheet optimisation and resilience have become more common.

“It is a very welcome discussion because it makes the ecosystem that we’re all participating in much more sustainable and resilient. But the industry needs to spend more time thinking about what that looks like, should we see a material increase in the quantum of hedging,” said Boehler.

Another panel at the conference flagged how SA-CCR was a major cost consideration and that it is encouraging dealers to turn to optimisation tools to reduce counterparty credit risk.

“SA-CCR definitely changed the game a little bit for us, given that it was a notional base and a lot of our trades are short term/high notional,” said Gregory Emmanuelidis, a senior FX forwards trader at JP Morgan. “But we have evolved quite well, and now we are very active in collapsing trades with our other interbank counterparties and running compressions all the time.”

The issue of uncollateralised trading was also raised in November’s minutes from the Australia Foreign Exchange Committee, which highlighted the contrast between margined interbank trading and unmargined dealer-to-client trading for FX swaps and forwards.

A member from the Commonwealth Bank of Australia noted: “In a scenario where there was a material decline in the Australian dollar, this may put pressure on how a dealer bank manages its liquidity (with super funds initially shielded from liquidity effects due to the absence of variation margining).”

The minutes said members noted that so-called super funds may have to consider alternative liquidity management arrangements and other fund sources, such as repo.

Editing by Joe Parsons