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Hidden drivers of FX gain/loss: stranded balances

  • Scott Balta headshot

    Authors

    Scott Balta

    ChathamDirect

    Corporates | Kennett Square, PA

Summary

“Stranded” or “shadow” balances have become a common problem for corporates looking to minimize FX gain/loss noise due to remeasuring balances. In this article, we’ll give some background on what these balances are, how to manage existing ones, and how to prevent new ones from forming.

Key takeaways

  • Stranded balances occur when the settlement or clearing of an open transaction is booked in a currency different from the original balance, with no effort to close out or link to the original position, leaving it “stranded.”
  • If you have existing stranded balances, they likely inflate the sizes of your balance sheet exposures and contribute to FX gain/loss.
  • Preventing new stranded balances requires that those who are recording the settlement or clearing understand the need to link back and close the original transaction when clearing in a different currency.

Understanding stranded balances

Stranded or “shadow” balances occur when the settlement or clearing of an open transaction is booked in a currency different from the original balance, with no effort made to reconcile this discrepancy. This is particularly relevant for open-item managed accounts like payables and receivables, where you would expect to eventually book a settlement that closes out the outstanding balance. In this sense, stranded balances are largely due to user error by those recording the settlement bookings, but there are business factors that can make these mistakes more likely. For instance, if your company has an intercompany netting process that simplifies the number of currencies changing hands, this may cause a settlement to appear in a different currency than the original payable, without a clear connection between the two.

Identifying stranded balances

The level of difficulty in identifying stranded balances largely depends on whether accounting practitioners are aware of this challenge and have taken measures to keep things organized. In particular, if someone is booking a settlement in USD that is related to a EUR balance, it’s recommended that the settlement at least include some reference to the original balance, such as a document or invoice number. Without this, there may be no clear link between the two transactions, and because the amounts themselves will be different (one is in USD terms while the other is in EUR), it can be extremely difficult to connect large amounts of stranded balances after they’ve been created. One measure companies can take, even in the worst-case scenario described above, is to run an analysis of open-item managed accounts for balances that are still active long after their expected turnover. This can be a useful way to at least monitor how many balances are remaining active longer than expected, which could suggest that stranded balances are a significant problem.

Impact of existing stranded balances

Once a foreign-denominated balance in a monetary account is stranded, you can expect it to contribute to FX gain/loss on an ongoing basis as it will remeasure at each financial reporting date. For most companies with this issue, it’s likely that the stranded balance will appear in exposure datasets that drive balance sheet hedge amounts—meaning you are likely to hedge your stranded balances alongside other exposures. This can be a good thing, at least from a P&L noise perspective, because the stranded balance would impact FX gain/loss if left unhedged. However, there is still the underlying problem which is that the balance shouldn’t exist to begin with and a hedge may have been placed without there being any actual economic risk. Treasury teams can hedge it to limit the accounting noise, but on a deeper level, you’re hedging something that presents no real FX risk to your company.

Impact of resolving stranded balances

If you have some way to connect stranded balances with their settlements or clearings, like an invoice or document number (or through a manual reconciliation effort), there is still the question of how doing so will impact your P&L. One thing to consider is the impact of booking FX-related entries to reconcile between the original balances and clearings. For example, if a EUR payable was booked at a particular EUR-USD rate and then left stranded for several years, there may be situations where an FX G/L entry is required to true-up between the EUR payable with the USD clearing. In some cases, long delays in resolving these balances can lead to very large FX impacts when they are finally closed.

The bottom line

Stranded balances are a common issue, especially for larger companies where the volume of transactions makes it difficult to connect disparate open item balances with their respective settlements. In cases where existing stranded balances are difficult to resolve, there are often other measures you can take to improve your balance sheet hedging program at large or to minimize the appearance of new stranded balances going forward. Chatham often assists companies with exploring their balance sheet exposure profiles and taking a holistic look at drivers of FX gain/loss noise. Schedule a conversation with a Chatham advisor for support in exploring stranded balances or other balance sheet hedging challenges in more detail.

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Disclaimers

Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.

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