Eliminating currency risk for international SME lenders

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Eliminating currency risk for international SME lenders

Project Summary
Elevator Pitch

Concise Summary: Help us pitch this solution! Provide an explanation within 3-4 short sentences.

MFX uses a proven approach, pioneered in the microfinance industry, to provide international lenders with currency hedging in markets where it is currently unavailable or unaffordable. This allows them to make local currency loans to SMEs in underserved, volatile markets without incurring the risk of a devaluation.

About Project

Solution: What is the proposed solution? Please be specific!

MFX has developed a proven, scalable way to catalyze lending in underserved developing markets by adapting standard currency hedging tools (swaps, forwards, options) to the SME market. By mitigating devaluation risk, MFX allows intermediaries to provide the local currency financing SMEs need without assuming devaluation risk. This eliminates a major barrier to lending in volatile markets. Standard hedging tools have generally not been unavailable to micro-SME intermediaries because they lend in countries with no swap or forward markets, have small transaction sizes and represent an unfamiliar credit risk. The need to set aside cash collateral also imposes a significant opportunity cost that can make hedging unaffordable. MFX’s model takes advantage of several innovations to eliminate these barriers: • A diversification approach that allows MFX to offer hedging in a wide range of exotic currencies unavailable from commercial hedging providers • A public sector credit guarantee to eliminate the need for cash collateral from SME lenders • Education for borrowers to support more sustainable borrowing practices MFX has successfully pioneered this approach in the microfinance market where it has hedged $30M in loans in its first nine months of operation, with current capacity to hedge up to $400M. MFX can achieve similar scale for the SME market with limited additional public sector support. In the long term, MFX can scale further and evolve to a fully commercial model.
Impact: How does it Work

Example: Walk us through a specific example(s) of how this solution makes a difference; include its primary activities.

The real measure of better currency risk management is how it affects the SME entrepreneur. MFX's mission is to convert what would have been hard currency loans to local currency and what would have been loans unmade because of market risk into loans actually made. One way MFX measures social impact is to compare the geographical distribution of the loans we hedge with that of the industry at large. Though not an exact barometer, it indicates whether hedging is catalyzing loans to underserved markets where social impact is greatest. So far this appears to be the case for MFX’s hedging for the microfinance industry. For example, MFX’s microfinance portfolio is skewed much more to Africa than is the overall industry (25% vs 8%). MFX can also help disadvantaged borrowers get better access to funding. Without a way to deliver local currency, intermediaries have the incentive to favor SMEs that produce an export product that generates foreign currency revenue or SMEs that operate in more dollarized sectors. By altering that market incentive, MFX can improve prospects for SMEs that serve local markets in more unstable, poorer economies. In some cases these can be more labor-intensive service businesses that generate more jobs than a typical SME in the same market.
About You
MFX Solutions
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Your Organization

MFX Solutions


, DC

About Your Organization
Organization Name

MFX Solutions

Organization Phone

202 527 9947

Organization Address

1050 17th Street NW, Washington DC 20007

Organization Country

, DC

Organization Type

Private Institution

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Your solution
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Region(s) your solution focuses on:

East Asia and the Pacific, Europe and Central Asia, Latin America and the Caribbean, Middle East and North Africa, South Asia.

Range of turnover in your target firms, in USD

$1-5 Million, $6-10 Million, $11-20 Million, $21-50 Million, More than 50 Million.

Average turnover in USD of your target firm

10 million

Number of employees in your target firms

25-49, 50-74, 75-99, 100-150, More than 150.

Average number of employees of your target firm


Specify the size, average and range of expected loans or investments in each target firm

MFX can provide hedging for loans of between $100,000-$10 Million. The average loan size will depend on demand from the intermediaries we serve but we estimate average loan size in the range of $500,000- $1 million.

What stage is your solution in?

Operating for 1‐5 years

How does your proposed innovation leverage public intervention in catalyzing private SME finance?

By working with public sector institutions, MFX’s model maximizes its impact on local currency lending to SMEs while minimizing required capital. MFX’s current model leverages public sector support in three ways to make currency hedging accessible to micro/SME lenders:

First, to be able to hedge in exotic currencies, MFX partners with a first-of-its-kind currency hedging facility --The Currency Exchange Fund (TCX), that functions primarily as a cooperative of DFIs, IFIs and governments. TCX offers its investors hedging in a wide range of exotic currencies because of its unique approach that manages currency risk through global diversification. As an investor in TCX, MFX has access to TCX’s $2.5 billion of hedging capacity. This allows MFX to provide swaps and forwards to the micro and SME communities while covering its risk on a matched basis. MFX therefore currently has the capacity it needs to scale hedging services to SMEs.

Second, MFX uses public sector guarantees to make it a strong, creditworthy counterparty and to mitigate the costs of collateral for its clients. MFX uses a guarantee from the Overseas Private Development Corporation (OPIC) to insure against default by clients on hedge contracts. This allows MFX to operate without charging collateral to its clients, eliminating another major cost. MFX can leverage its guarantee approximately 10:1, meaning that a $40 million guarantee allows MFX to hedge $400 million of loans. Because its current guarantee is restricted to microfinance, MFX would need a parallel public sector guarantee to cover SME clients.

Finally, MFX would need $10-15 million of new paid-in capital to scale its SME hedging to a level of $400-$500M. This would keep MFX safely within its current Basel capital adequacy requirement. The additional capitalization could come from clients, private social investors or public sector entities, and would not be needed immediately.

What barriers does your proposed solution address?

High transaction costs for financial intermediaries to serve SMEs, Lack of competition / incentives for financial intermediaries to serve SMEs, Underdeveloped local capital markets (term local currency funding, exit options for SME equity).

If you checked any of these barriers, describe how your solution addresses them

In high risk markets -- which also tend to have the least developed local financial infrastructure and the entrepreneurs most starved for capital - currency risk can be an insurmountable barrier for international intermediaries. MFX found in studying the microfinance market that many foreign lenders only began to consider higher risk markets when currency risk is taken out of the equation.

Lending in hard currency pushes market risk onto the borrower which raises credit risk. When the SME’s debts are in hard currency but its revenues in local currency, any devaluation makes it harder to repay those debts. Studies show that lending in hard vs local currency increases credit risk by 2-4 S&P notches and much more for very volatile currencies. But lending in local currency without hedging requires the lender to assume the risk itself. This can be a non-starter for many SME funds which are allowed only to lend in their funding currency (generally dollars or euros). Even if allowed to make local currency loans, the prospect of adding devaluation risk to the other business risks the lender faces can make lending in high volatility countries prohibitive.

This is a problem that in the developed world is solved using standard, commercial currency derivatives such as swaps, forward and option contracts. But in many developing countries there are no commercial options for hedging currency risk and SME intermediaries can’t access those that do exist. By making these standard tools accessible to SME intermediaries, MFX can eliminate a key risk that disproportionately affects SME’s in high volatility markets. This lowers transaction costs for intermediaries and allows them to focus on their core expertise – assessing the viability of the businesses they lend to.

Swaps and forwards are used primarily to hedge debt. MFX can also provide currency options which reduce risk for equity investments when the timing of exit is not certain. Given the challenges faced by SME investors to exit their investments, eliminating the threat that returns will be wiped out by a devaluation can be an important factor in improving the risk/return profile.

MFX’s hedging service also can improve competition in local markets by facilitating a new channel of local currency funding for SMEs other than local banks. For example, introducing an external source of longer tenured local currency loans creates incentives for local players to compete by extending the tenure of their loans. Giving SMEs more local currency loan options increases their bargaining power with both their international and local lenders.

Provide empirical evidence of your proposed solution's success/impact at present. If your project is in the idea phase, please provide evidence that speaks to its potential impact

MFX has proven its model over the last year as the first hedging facility dedicated to serving the microfinance market. After nine months of operation, MFX has a growing portfolio of $30 million in hedged loans to microfinance lenders with an average loan size of around $1.5M. Hedges provided so far cover most geographical regions – Africa, East Asia, Eastern Europe/Caucasus, Central and South America, and Central Asia. Assuming an average loan size of $500 for MFIs benefiting from loans hedged by MFX, MFX has helped deliver funding to 60,000 micro-entrepreneurs in its first year.

MFX operates as a cooperative, so its clients, primarily microfinance funds, are its investors. MFX began operations with ten client/investors. With expanded demand, MFX recently concluded a second round of investment where it is adding 30 new funds. MFX’s client/investor base now represents over $3 billion of assets under management and a majority of non-governmental funds lending to microfinance. The willingness of microfinance funds to invest in MFX, provides concrete evidence of the value of its services, in particular to open up markets that were seen as too risky without hedging. As one of our clients stated in their annual report “the partnership [with MFX] will be particularly significant in sub-Saharan African, a developmentally crucial region targeted by BlueOrchard [the client] as a key growth area now that local currency financing is available.” MFX can help level the playing field for SMEs in high risk markets in the same way it is doing for microfinance.

MFX can also help international SME lenders avoid some of the mistakes of the microfinance industry. The SME intermediary infrastructure is in some ways where microfinance was 10 years ago, before its rapid growth phase. According to the Aspen Network of Development Entrepreneurs (ANDE), non-governmental SME funds currently have roughly $850M in existing loan portfolio, but anticipate growth to over $7 billion in the next four years. In microfinance, with little access to affordable hedging options, the growth phase took place largely in hard currency. This resulted in a build-up of an estimated $4 billion in currency mismatch by the time of the 2008 crisis, which in turn led to major currency losses for MFIs when emerging market currencies fell. By introducing hedging to SME intermediaries at an earlier stage in the industry’s development, MFX can help avoid similar hardship for SME borrowers in the future.

How many firms do you expect to reach?

The MFX model has the potential to scale exponentially. Assuming an average loan size of $500,000, MFX would expect to reach 800-1000 SMEs based on its initial target of having $500M of hedging capacity dedicated to SMEs.

What is the volume of private SME finance you aim to catalyze?

Initially $500M with scale-up from there.

What time frame will be required to reach these targets?

3-4 years for the initial $500M

Does your solution seek to have an impact on public policy?


What would prevent your solution from being a success?

MFX exists to enhance the efficiency and viability of intermediaries. If the growth of SME intermediaries does not take place, then MFX’s model would not see the anticipated ramp-up. On the other hand, by reducing risk for intermediaries, MFX can help accelerate their growth by expanding their potential market and potential for sustainable returns. In that sense, the G-20 challenge itself, to the extent it succeeds in catalyzing new international flows to SMEs, will create the environment for the success of MFX, and vice versa.

Market conditions can also affect the up-take of the product. The larger the spread between U.S. or Euro interest rates (LIBOR/Euribor) and local benchmarks (interbank or T-Bill) the higher the perceived “cost” of hedging. Though this simply represents the market’s perception of the currency’s devaluation risk, if SMEs are unwilling to adjust their rate expectations to changes in local rates, they may not be willing to pay a rate that swaps to an acceptable hard currency rate for the lender. This could mean that in some markets hedging would not immediately open up new lending opportunities.

List all the funding sources that are required for the sustainability of this solution

• $10-$15 million equity capital: This would be required beginning in year 3 and could come from public or private sources.
• $40 million credit guarantee: This would come from a government-backed AAA institution and could be one of MFX’s existing guarantors. Could be disbursed in stages.
• $1million in grants to expand MFX’s training program to help SME borrowers improve their liability planning (optional)
• Small grant to develop new credit evaluation system for assessing MFX’s counterparty risk from intermediaries. Could come from guarantor.

Demonstrate how your proposed solution has the capacity to graduate from dependence on public finance. What is the time frame?

MFX’s model currently depends on two sources of public sector support, its partnership with TCX and its guarantee from OPIC.

Since TCX is the only fund currently able to provide the exotic currency hedging MFX needs, to fully graduate from dependence would require TCX to transfer to private ownership or for other private funds to appear offering similar products. With large enough scale, MFX itself could also potentially use a strategy similar to TCX’s to internally manage its own currency risk through a diversification model. TCX has a medium-term goal of transferring to private ownership via IPO or a strategic investor.

MFX uses its public sector guarantee to improve its creditworthiness with market counterparties and to eliminate the need to charge collateral to its clients. Once MFX reaches a portfolio of several hundred million, it plans to seek an independent rating which would reduce the need for external credit support. If and when MFX’s portfolio of hedges outgrows its guarantee capacity, its model can evolve to managing credit risk through a more standard cash collateral arrangement. This could happen first with larger more liquid funds and then continue as intermediaries become more well-established. MFX could also potentially substitute private foundation guarantees for its public sector ones.

Finally, if MFX raises equity capital from public sector investors in order to jump-start an expansion into the SME market, I it expects to be able to replace it with private capital from new investor/clients over time.

Demonstrate how your proposed solution will survive a potential loss of its largest private funding source

MFX has a diversified funding structure with over 20 separate investors. Its largest investor is a foundation representing around 40% of capital. MFX investors all agree to a three year lock up period and MFX can limit redemptions through 2017. Because MFX is a cooperative company, as its client base grows so does its investor base. Therefore, over time, its exposure to a single source of investment will dwindle.

Currently MFX has capital well above that needed to meet its Basel requirements. If, however, a major investor were to divest an amount that would create a capital shortfall, the loss would need to be replaced with new capital. MFX’s first option would be to go to its existing investor base. There would be strong incentive for this group to contribute to a recapitalization since if MFX were unable to operate it would force an unwind of all existing hedges. This would leave existing client investors with unhedged local currency loans.

Given the relatively small amounts of capital MFX’s model requires relative to portfolio size and the broad investor base, we do not expect to face serious disruption due to funding.

Please tell us what kind of partnerships, if any, could be critical to the greater success and sustainability of your innovation

MFX would need to develop new partnerships with:

• SME intermediaries which would be its primary clients. We see the G-20 challenge process as an ideal way to begin building these connections particularly to the extent other initiatives lead to invigorated or new SME intermediaries.

• IFIs or DFIs that could provide a credit guarantee and equity capital for the first stage of the project.

• Foundations or social investors interested in promoting SMEs’ access to local currency who could act as anchor investors to fund the capital required for MFX to service SME funds.

• Experts in SME credit who could help MFX assess the credit risk of intermediaries. MFX currently outsources its credit due diligence to a leading microfinance rating agency. We would want to find a similar partner in the SME space.

Are there non-financial issues that could threaten the sustainability of your proposed solution?

New U.S. financial services legislation will have an impact on the broader derivatives market. MFX’s current analysis is that it will not affect MFX’s model. However, if it turns out that the model requires any regulatory exemptions, which are allowed under the bill, MFX would seek them with the support of its public sector, microfinance and SME industry stakeholders.

Please tell us if your proposed solution aims to scale up through a high growth sector, expand immediately to multiple sectors, and/or scale up geographically

Since MFX supports intermediaries, its geographical and sector reach will be determined by its clients. Based on experience in the microfinance sector, geographical scope would be achieved quickly. Given the need for intermediaries to diversify their credit risk, we would also expect that hedged loans would support a wide variety of business sectors.