Sitting at the crossroads of financial markets and the real economy, FX risks remain elevated despite the tariff reprieve, writes Mattias Palm, head of triReduce FX and commodities at OSTTRA. 
After the April tariff shock that saw margin calls surge, markets have returned to a business-as-usual mindset. Though not every country reached a trade deal with the US as the 90-day tariff pause ended, market reaction to their reimplementation was muted. Traders seem to have priced in the risk.
While US equities have shrugged off the April trading frenzy, other asset classes like foreign exchange (FX) are seeing lasting impacts.
FX is now facing a confluence of factors that are increasing known risks and creating new ones. Uncertainty over the role of the dollar is top of mind.
FX risk models have traditionally held the dollar as a safe haven during market stress. Such is its status, that it is not uncommon for some asset managers to forgo hedging dollar risk, though that is quickly changing.
FX markets have continued to see bouts of volatility, with major swings in the Taiwanese dollar in May and several interventions in the Hong Kong dollar through the summer.
Sitting at the intersection where financial markets meet the real-economy, FX is one of the most exposed asset classes to tariff-induced volatility. It’s not only impacted by the flow of physical goods, but also through the gyrations in US capital markets.
FX markets are diverse. The spot market – for a variety of reasons – is largely unregulated. Some FX derivatives are subject to uncleared margin rules while others are not, and a select few contracts are voluntarily cleared. Taken together, firms who trade in the FX market need to more carefully manage their risks compared to other asset classes that have more market-wide guardrails.
FX traders have, however, adopted industry-led approaches and standards to help minimise the risks in FX trading. Payment vs payment settlement, matching and allocation are increasingly being utilised to reduce settlement, counterparty and credit risk.
A rise in crosses?
The weakened confidence in the greenback has made de-dollarisation a hot topic. Though it remains a distant and remote possibility, de-dollarisation could lead to an increase in crosses – trades that don’t involve the dollar on any side – but would also increase certain FX risks.
A diversification to other liquid currencies like the euro, yen or pound could add more counterparties compared to a portfolio that is primarily priced in dollars. While settlement risk remains minimal in these currencies, each pair would have its own capital and margin requirements. Firms could also be taking on more market risk if exposed to a larger set of currency pairs.
If traders start to diversify their FX portfolios, increased interest in capital optimisation would be one of the first signs of a sea change to non-dollar trading.
A firm that is serious about trading in other G10 currencies may need to consider netting down the exposure of a more diversified portfolio. Portfolio optimisation may become more important given the greater number of currency pairs, as will trade compression and counterparty risk optimisation, due to the extra transactions and counterparties a more diversified FX portfolio will be exposed to. Bilateral payment vs payment would be a key facilitator in addressing settlement risk as well as optimising credit and liquidity in less liquid currencies.
Trading desks will need to take the initiative to ensure their own operations are ready to address risks that could arise in a less dollar-centric market.
But regardless of what happens with the dollar, the continued ambiguity of tariffs and volatility is reason enough for FX desks to carefully consider every option to minimise risk.