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SUSTAINABLE DERIVATIVES: THE “GIVING TREE”

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Jennifer Kafcas, Lauren Blaber, Alvino Van Schalkwyk and Harry Polan

 

Momentum continues to gather pace towards building a sustainable economy, especially since the start of the pandemic. As a result, financial markets have seen a considerable increase in the focus on, and deal volume with respect to, sustainability-linked loans and bonds.  It has been a logical progression that the sustainability tree sprouts a new leaf with the development of environmental, social and governance (ESG) linked derivatives.  These products enable, among other things, firms and companies to hedge risks associated with sustainable investments including project risk, interest rate and currency risks.  This will be all the more important given the need to hedge risks from any underlying loan and its related sustainability criteria.

While ISDA has outlined the broad range of derivatives in sustainable finance, furthering the development of this product type (including, among others, sustainability-linked derivatives, ESG-related credit default swaps, exchange-traded derivatives on listed ESG-related equity indices, emissions trading derivatives, renewable energy and renewable fuels derivatives, and catastrophe and weather derivatives), this article focuses on more conventional derivatives transactions, such as interest rate swaps (IRS) and Foreign Exchange (FX) transactions used by market participants to hedge the risk arising from green bonds and loans. Though these transactions are no different conceptually from a product standpoint than any other IRS or FX transaction, it is important to understand the inherent structural and deal term differences.

 

Finance-linked sustainable derivatives (OTC)

A number of sustainability-linked derivatives have been issued in recent years, which add an ESG pricing component to conventional IRS and FX hedging instruments. The table below provides examples of recently issued sustainability-linked derivatives. As this is a developing market, the transaction volume has been very low, but uptake is expected to increase over coming years.

 

Parties Deal Information
BNP Paribas & Siemens Gamesa €174 million FX forward, under which Siemens Gamesa will pay a premium on their forward if they do not meet certain ESG targets. If paid, that premium shall be used to finance local reforestation projects in Spain. The premium shall be calculated using a metric assigned by a third-party sustainable finance specialist.
Société Générale & Enel Cross currency swap, by which Enel hedged their euro-dollar exchange rate and interest rate risk under a $1.5 billion sustainability-linked bond. If Enel does not meet certain renewable energy targets, the swap will be re-priced to their detriment.
New World Development (NWD) & DBS Hong Kong Interest rate swap linked to the United Nations Sustainable Development Goals, hedging interest rate risk under NWD’s HK$1 billion sustainability-linked loan. If NWD generates at least eight business-to-business opportunities that contribute to the Sustainable Development Goals, DBS will sponsor certain NWD social innovation projects.

 

As evidenced above, ESG-linked derivatives can take on a number of characteristics and structures, including:

  • Derivative pricing. One counterparty having a number of prescribed ESG targets which, if met, will lead to a downwards ratchet in the pricing of the derivative (with such pricing often increasing if the targets are not met).
  • Fixed payments. If ESG targets are not met by the corporate, a fixed payment can be required to the issuing bank, which will be put towards a green project.
  • Triggers linked to a company’s ESG rating. If the ESG rating of the corporate increases, a benefit can be awarded to them (e.g. interest rate discount).
  • Both parties having ESG targets papered into their derivatives contracts. Corporates can receive a discount on the interest rate under the derivative if they meet their ESG targets, with that discount increasing if the issuing bank fails to meet its own ESG targets.
  • Charitable giving requirements. A failure by the corporate to comply with its ESG targets can lead to it being required to make contributions to non-profit organisations, with the bank having to make such contributions if the corporate’s ESG targets are met.

As sustainability-linked products gain traction, a degree of care will be required to ensure ESG targets are finely balanced and verifiable. Verification is essential for market transparency, for ESG products to be considered credible and for lenders and corporates alike to avoid reputational risks. Furthermore, the ability of a corporate to verify reliable compliance with ESG targets could provide a significantly smoother path through their lender’s credit approval process and in turn the lender’s ability to verify will enable it to better monitor the performance matrix set by the underlying loan or bond.

 

Renewable Energy and Renewable Fuels

In addition to the above OTCs, renewable energy hedging transactions (including power hedge transactions) are important for market participants to hedge the risk associated with fluctuations in renewable energy production, and in doing so, encourage more capital to be contributed to renewable energy projects.

Typical documentation with respect to the above type of trades are Power Purchase Agreements (PPAs) which document the purchase of power and associated renewable energy certificates between a renewable energy generator (the seller) and a purchaser of renewable electricity (the buyer). PPAs do not require companies to contribute directly to enhanced ESG standards, however they can help catalyse a shift to clean energy sources as they reduce market price volatility for buyers, and reassure sellers that a buyer will purchase power generated from renewable energy assets, thus encouraging the financing of such projects.  In an ESG-linked transaction, these types of arrangements can be replicated by covering the credit risk element in the intercreditor terms.  As an alternative the market may develop such that in lieu of these structures the underlying risk with respect to market price volatility is documented under an ISDA and secured under the financing and intercreditor documentation. This structure is fast approaching.

 

Expected developments in 2021

Climate change and, therefore, a sustainable economy remain front and centre for governments and regulators worldwide.  In 2020,countries like Japan, China, South Korea, Hong Kong and the UK set net carbon neutrality objectives and most recently the USA, following the inauguration of President Biden, announced plans to spend $2 trillion over four years to aid in the fight against climate change, all following the commitment already set by the EU.

Whilst the need for banks and corporates to develop and consider bespoke products to promote true progress in ESG compliance may hinder any radical uplift in ESG-linked derivatives volumes over the course of 2021, we anticipate that as banks and corporates continue to familiarise themselves with the requirements of such products, integrating ESG elements into derivatives trades will begin to be common practice.

In view of this, derivatives market participants will be eager to continue to drive ESG-linked derivatives volumes and to develop new and innovative ESG products facilitating the mobilisation of capital towards sustainable investments to ensure that they continue to significantly improve ESG standards, and to strengthen their contribution to the green finance drive.

 

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FINTECH COMPANY PAYEN CHOOSES AQILLA FOR ITS LIMITLESS SCALABILITY AND SUPERIOR MULTI-CURRENCY FEATURES

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Payen is a fast-growing FinTech company that provides gateway Payment and FX services to online merchants. Having launched in 2010, the business has grown steadily, winning three UK high-growth awards in 2019 and now has an annual revenue of over £14 million. As a global payments company, Payen deals with huge volumes of complex multi-currency transactions on a daily basis. Their accounting system needs to be able to scale effortlessly to these volumes as well as handle the unique nuances of multi-currency and foreign exchange.

 

Payen’s vision is to provide innovative solutions with a personal touch. As such they’ve continuously improved their 100% proprietary technology to enhance the process at every step in the payment value chain. Most recently, this includes extending their global options for alternative payment methods, as well as offering business bank accounts and forex services. As a cloud-based service, Aqilla effortlessly scales to handle Payen’s growing number of currencies and transactions.

 

Global payment transactions involve numerous touchpoints. As a payment gateway, Payen sits in the middle of this process, but Aqilla has the flexibility to handle this. Payen also offers foreign exchange services, so multi-currency is key to their finance function. Aqilla features simple but sophisticated handling of multi-currency transactions with extensive multi-currency capabilities throughout its ledgers.

 

Hugh Scantlebury, Aqilla’s CEO and Founder, explains further: “Aqilla’s reporting system features an easy to use report editor and query builder that lets you create custom reports that can easily be extended across multiple companies and currencies. Aqilla’s API also allows it to connect to other business apps, which Payen plans to use in the future to consolidate reports for its two UK-based entities.”

 

Payen’s Head of Finance Hannah James endorses Aqilla as an adaptable and easy to use accounting solution to support Payen as it grows: “As a fast-growing business, we need lean processes that can scale. Aqilla has continued to deliver this, even as we’ve added more services, currencies, and transactions. We’ve had no issues with the volume of transactions, and Aqilla’s support team has always been prompt and helpful. On the whole, we don’t notice any problems because Aqilla just works. And we know it has the features and flexibility in place to keep up with our evolving requirements,” she explained.

 

Hannah continues: “Aqilla meets all of our reporting needs. I particularly find the ability to drill into accounting categories very useful, avoiding the need to manipulate data outside of the system, downloading it every time. I can see the detail I need through simple navigation. We hope to continue to build on the reporting capabilities in Aqilla by creating a more automated method of consolidation using Sharperlight, however, we already have a good level of business intelligence and the information is easy to extract.”

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NEW RESEARCH REVEALS KEY ROLE OF KYC COMPLIANCE IN DRIVING CUSTOMER LOYALTY, ADVOCACY AND NEW BUSINESS

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The impact of financial crime for institutions goes beyond crippling fines

 

A piece of original research conducted by RegTech Associates on behalf of PassFort, the SaaS RegTech provider, whose platform automates financial crime and compliance processes, has revealed that customers who reported a better than expected compliance onboarding experience in the last 12 months were much more likely to remain loyal, advocate for their brands and acquire more products than those whose experience was worse than expected. These results underline the importance of delivering outstanding service along the whole customer lifecycle.

The survey was conducted in July and August 2021 and addressed a representative sample of 500 UK financial services consumers who had acquired a new financial product in the past twelve months. Products had been acquired from a mix of high street banks, challenger banks, mobile and digital banks and building societies. Those who had a worse than expected compliance onboarding experience[1] were much more likely than their peers to believe their providers did little to protect them from financial crime[2]. They were also much more likely to underestimate the penalties facing providers, with one-third (32 percent) assuming they would get no more than a “slap on the wrist”[3].

Announced today to coincide with Donald Gillies’, CEO, PassFort, panel discussion at Money 20/20, the research highlights consumer attitudes towards their providers and the outcomes they drive, as well as digging more broadly into their perceptions of risk, their experiences of fraud and views on the current UK debate around digital identity.

Regulatory technology that supports know your customer (KYC) compliance in financial institutions has historically been viewed as a cost burden. However, the findings revealed today clearly show a positive trend for those providers who execute well. The case for business benefit or value-add can clearly be seen in the correlation between consumer attitudes towards positive compliance onboarding experiences and a likelihood to go on to purchase additional products.

 

In fact, as a result of their interactions, those customers who received a better than expected experience of compliance onboarding described themselves as:

  • more likely to recommend their provider (77 percent, which was more than double the rate of 32 percent for those whose experience had been worse than expected)
  • more likely to buy more products (60 percent, which was almost 3.0x the rate of 21 percent for those whose experience had been worse than expected)
  • less likely to make a complaint (50 percent, versus only 14 percent for those whose experience had been worse than expected)
  • less likely to switch providers (49 percent, more than 2.5x the rate of 18 percent for those whose experience had been worse than expected)

“The complex compliance landscape has been under even more pressure with the impact of the pandemic. There were more than 1,330 pieces of covid related regulation introduced by August 2020 alone. Couple this with the enforced financial pressures on consumers and a global increase in fraud and financial crime and we have to understand that the perceptions and demands of consumers have shifted,” said Dr Christine Bailey, CMO, PassFort. “The compliance onboarding process shouldn’t be seen as a cost burden to financial institutions. Instead, what this research starkly demonstrates is the importance of onboarding at the beginning of the customer lifecycle in terms of how it influences customer loyalty, advocacy and future buying decisions.”

Far from being an unseen element of the customer journey, KYC at onboarding can be a differentiator for financial institutions. As financial crime increasingly dominates our headlines, the public are becoming aware of the value and vulnerability of their digital identity. One of the many legacies of Covid is that consumers are demanding more from the organisations they engage with across the board and trust ranks highly on that list of expectations.

“A stand-out result from the survey is the clear connection between the ability of leaders to exceed the customer’s expectations of what their compliance journey should look like, and the positive outcomes that follow. For example, in 90 percent of cases, customers who received a better than expected compliance journey would describe their provider as “trustworthy”, while 88 percent would say their provider was “efficient”. In contrast, for those whose experiences undershot expectations, the figures drop sharply, to 64 percent and 39 percent respectively,” commented Rob Stubbs, Head of Research at RegTech Associates. “Despite many customers telling us their experience was ‘as expected’ it’s clearly important that providers don’t rest on their laurels.”

“Against this backdrop, firms cannot afford to view satisfactory delivery as being good enough. There is a very real opportunity for engaging valuable revenue streams and enhancing reputation for those who step up,” continued Dr Bailey. “The regulatory landscape is ever changing and incredibly complex, yet we still see an ad hoc approach to regulatory technology across the industry with many firms still relying on heavily manual processes.  In the same way we have seen marketing automation revolutionise the marketing function, it’s time to digitise compliance and streamline the entire customer journey.”

 

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