It’s not easy being green: why the FX market is lagging on ESG

Imagine a meeting of desk heads at a bank, to discuss progress on ESG transactions. The rates head describes an interest rate swap linked to climate metrics. The equity head talks about an index futures trade that tracks environmental benchmarks. Then it’s the turn of the foreign exchange head – and an awkward silence.

The FX market has slipped behind other asset classes in developing trades linked to environmental, social and governance factors. But banks are working to reverse this trend.

ING, for example, is nine months into a pilot programme to automatically link clients’ ESG behaviour to the pricing that the Dutch bank offers for electronic FX transactions. ING is now considering extending the programme to a wider client base.

“We’re really trying to embed ESG into the DNA of our pricing methodology and therefore, rather than specific FX transactions being linked to ESG targets, all of our electronic FX prices will be influenced by the overall ESG behaviour of our clients,” says Thomas Epple, head of financial markets, Germany and Austria at ING.

Financial institutions are under growing pressure from ethically minded clients to offer ESG products. Governments, too, are pushing lenders and investors to adopt sustainable ways of working, in line with high-level commitments such as reducing carbon emissions to net zero by 2050 or the United Nations sustainable development goals.

But the FX market’s ethical efforts have run up against a structural obstacle. Foreign exchange transactions are generally shorter dated than in other asset classes, with tenors often as brief as a single day. This hampers dealers in linking individual transactions to longer-term key performance indicators (KPIs).

The bulk of FX market volume comes from spot transactions, which simply don’t have the length of tenor to embed an ESG target into them
Patrick Kondarjian, HSBC

To get around this, more banks are taking a portfolio approach to ESG-linked transactions – where a client executes a number of FX transactions with a particular bank over a specified period of time and receives a one-off rebate payment from the bank at the end of the period if it meets pre-agreed ESG targets. Conversely, if the client misses its KPIs, it pays a fee to the bank.

The size of the client’s rebate or fee is usually linked to the number of FX transactions it executes, and the volumes involved. Banks often use third-party rating agencies, such as Sustainalytics or MSCI, to assess whether the client has met its targets.

But these transactions can have drawbacks. Calculating the potential rebate (or fee) a client might receive (or have to pay) can create complex accounting issues for both parties and how they document their profit and loss.

There are more fundamental challenges too. Members of the European Central Bank’s FX contact group highlight that there is still a lack of mutual understanding as to what constitutes adherence to ESG, even though various initiatives have tried to find common ground. As a result, the few ESG-linked FX transactions that have taken place within the market so far have been costly, with a high degree of manual handling making it difficult to push the agreements out at scale.

Holistic remedy

ING’s pilot programme of ESG-linked foreign exchange trades is currently limited to around 100 non-financial corporate clients in Frankfurt. The bank uses an in-house methodology to cluster clients into different pricing brackets, based upon publicly available ESG data. Clients with a better ranking for sustainability receive more competitive prices for their FX spot, swaps and forwards trades than clients that are ranked poorly.

ING conducts its analysis on a monthly basis to ensure that any changes in a client’s ESG behaviour are fully reflected in the price savings they receive.

Overall, the pricing incentives aren’t huge. Epple says that cash trades in the range of €5 million to €10 million would receive a pricing improvement amounting to “several hundred euros”. Epple says this pricing incentive is a “relevant difference” in the competitive FX market, and can be “obviously adjusted”.

The scheme differs from ESG-linked transactions in other asset classes, in that it doesn’t peg trades to a pre-agreed sustainability metric or KPI. Rather, clients are judged on their overall ESG profile.

“Clients are very enticed with this methodology as it makes them reconsider their ESG behaviour in a way that doesn’t require them to agree to specific KPIs or bilateral documentation with us – which can challenge entry within the ESG market,” says Epple.

He adds: “We’ve had positive feedback on the pilot, which is why we’re now looking into potentially rolling this out on a much bigger scale.”

Building a portfolio

For many banks, adopting a portfolio approach to transactions is one of the only ways to make ESG-linked trades work within the FX market.

“While options, futures and forwards typically see longer tenors – and therefore can work on a standalone basis – the bulk of FX market volume comes from spot transactions, which simply don’t have the length of tenor to embed an ESG target into them. So, this portfolio approach is a structure that works well for clients,” says Patrick Kondarjian, global head of sustainability, markets and securities services at HSBC. “That being said, it’s still a relatively nascent offering compared to the sheer scale of the overall FX market.”

Such a structure was used by UK-based power generator Drax in April 2021 when it signed two ESG-linked FX derivative agreements with Barclays and NatWest Markets.


The Drax power station near Selby in North Yorkhire provides 12% of the UK’s renewable power

The trades were built as an overlay to the firm’s International Swaps and Derivatives Association master agreements, and included a carbon intensity KPI – whereby Drax would receive a sustainability-linked premium payment if it reduced its carbon intensity below a pre-set threshold.

The premium was calculated based on transaction volume and tenor monitored throughout the year, with the ESG component tested at year-end. So long as Drax met its carbon intensity KPIs, the company would receive the amount that accrued throughout the 12-month period the following year.

Lisa Dukes, former director of corporate finance and derivatives at Drax and co-founder of risk management firm Dukes & King, believes portfolio trades such as these will become more popular within the FX market. But she admits such transactions can be complex for firms that are unfamiliar with setting ESG performance indicators.

Before entering its FX hedges with Barclays and NatWest, Drax had already entered into a £125 million ESG facility, where margin was adjusted based on Drax’s carbon emissions against an annual benchmark. As such, the company already had a set of company-wide ESG metrics it could easily extend to its FX transactions

“Since our early adoption of a multi-asset derivative portfolio approach, there appears to have been a growing number of participants following this path, which is encouraging. One of the key blockers to this becoming more widespread is surrounding the KPI methodology,” says Dukes.

Bodies such as Isda have proved helpful through their efforts to help standardise the process of setting sustainable KPIs for the derivatives market. Published in September 2021, Isda’s guidance states that in order for KPIs to be credible, market participants must ensure that they are specific, measurable, verifiable, transparent and suitable.

“Obviously everyone’s ESG KPIs will be highly bespoke but at least the market now has a clear framework to work from as a starting point, which will no doubt help adoption of ESG-linked derivative transactions – including within the FX market. Especially, for smaller size clients who don’t necessarily have a specialist legal team in-house to help them navigate the complexities of such transactions,” says HSBC’s Kondarjian.

Called to account

Yet questions remain for banks and clients in addressing the accounting challenges of ESG-linked trades. For example, banks may have difficulties including the future rebate aspect of the transaction when documenting their P&L.

“It’s quite hard to effectively calculate any potential rebate over a long period of time. From an accounting perspective, that starts to get very tricky for both banks and clients,” says the head of global FX sales at a European bank.

The head explains that banks can face queries from auditors on whether an ESG-linked transaction should be considered as an embedded derivative – whereby the derivative contract is hidden within a non-derivative contract that doesn’t pass through P&L accounting.

Under global IFRS accounting rules, embedded derivatives must be treated as part of the host derivative, with accounting treatment thus applying to the financial asset as a whole – unless the non-derivative host contract is a financial asset that does not fall into the scope of IFRS rules.

Meanwhile, under GAAP accounting rules – which are used in the US – the decision to treat the embedded derivative contract as a separate financial asset depends on the accounting treatment of the non-derivative host contract. That is, whether the embedded derivative can be treated independently to the host contract, and how closely the embedded derivative relates to the host contract.

“When you start to go down that path, accounting can become really complicated for both counterparties,” adds the FX sales head. “We’re talking about rebates that are typically quite small, but it’s definitely a challenge that people are really starting to consider within ESG transactions.”

ING’s Epple hopes his bank’s approach will help iron out any accounting wrinkles, since the sustainability element is set at the outset of a trade, in much the same way that banks automatically bake market volatility, counterparty risk, and various other XVAs into their FX prices today.

Editing by Alex Krohn

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