Today’s corporate treasuries often deal with problems that arise when their assets and liabilities are in different currencies. It can impact how they fund their operations, match their income with expenses and handle transactions between different areas of their firms. Managing transactions in multiple currencies is especially difficult for companies that operate globally and are closely linked, but lack a unified accounting system. The need for big investments in technology can make managing these currency issues even harder. This currency mismatch can take various forms, including:

Structural currency mismatches related to funding and global operations, for example, are an inherent aspect of international businesses that cannot be entirely eliminated. Many organizations effectively mitigate their impacts through strategic financial management techniques such as exposure netting, hedging or currency diversification. Tackling multicurrency intercompany transactions, however, continues to challenge many firms due to significant system, integration and operational complexities.

Navigating intercompany transactions: Mitigating the impact of currency fluctuations

The efficient management of multicurrency intercompany transactions in firms that operate across multiple jurisdictions isn’t easy. In some cases, up to 30% of a firm’s transactional activity could be between related parties, who are often on different accounting platforms that are not integrated. For a group treasury function to centralize visibility, clearing and net settlement normally requires significant spend in technology and treasury operations.

In addition, organizations having many multicurrency intercompany transactions are especially vulnerable to currency fluctuations, since the sourcing and distribution of goods and services span diverse markets. When cross-currency intercompany trade payables ultimately settle, absent a netting system, for many it is frequently between subsidiary’s bank accounts. This results in hidden transactional foreign exchange (FX) that adds expenses to costs of production.

Just as significantly, from an accounting perspective, the clearing and settlement of multicurrency intercompany transactions often results in realized FX gains or losses. When a company engages in transactions involving foreign currencies and the exchange rates change between the time the transaction is initiated and when it is settled, FX gains or losses are realized and must be reported in the income statement (typically under "Other Income" or "Other Expenses" depending on whether it is a gain or a loss). This can result in several potential adverse impacts:

Is it possible to avoid realized FX gains or losses from intercompany transactions, which can skew the perception of a company's financial performance?

The answer is yes—with the right systems and intercompany policies in place.

Multilateral netting is the main method available to organizations to address currency mismatches that result from multicurrency intercompany transactions.

While traditional netting solutions are instrumental in streamlining the settlement of intercompany transactions, they can present a limitation: They aggregate invoices to calculate obligations prior to executing settlement, whether through cash or cashlessly via intercompany ledgers. This invoice grouping requirement adds a time-delay factor into the intercompany trade payable cycle. So, while traditional netting mechanisms can help lower costs through net settlement, which itself introduces multiple invoices to single settlement reconciliation issues, they don't improve and actually reinforce realization of foreign exchange gains and losses.

The role of VAM in managing FX in intercompany transactions

A virtual netting solution, such as that offered by J.P. Morgan Virtual Account Management (VAM), is a mature banking solution; many are familiar with its use for enhancing reconciliation, rationalizing bank accounts or centralizing group settlements through payment factory structures. Recently a new application of virtual accounts has emerged, one that offers an alternative to traditional netting for managing multicurrency intercompany transactions.

“For a company with distribution centers in more than 70 countries, but manufacturing facilities in only a handful of countries, hundreds of thousands of intercompany invoices need to be generated yearly,” Ngoshi said. “In the absence of virtual accounts these invoice balances are settled through international wire transfers, which come at a cost. Virtual accounts help eliminate all these cross-border payments for all participating entities.”

With virtual netting, group companies settle their intercompany invoices one by one—without grouping—using a virtual account provided by the in-house bank (IHB) in each currency in which they have invoices. Then standard enterprise resource planning (ERP) payment-run operations are used to settle the open invoices, without using the banking system. This model eliminates invoice aggregation and the entire netting cycle, while maintaining streamlined reconciliation as the result of individual invoice payments.

An early adopter of virtual accounts for multicurrency netting: Wizz Air

Wizz Air Group a Hungarian ultra-low-cost carrier listed on the FTSE 250 index, was the first client to adopt virtual netting with J.P. Morgan as part of its journey to harness bank technologies and treasury expertise to enhance the overall value delivered to the firm.

One effective strategy to achieve this objective is through the implementation of the IHB treasury operating model. Among the various IHB technology enablers available, a VAM solution has emerged over the past decade as a leading option. VAM is increasingly being considered when assessing the costs and benefits of a bank-centric approach to managing risk and facilitating both external and internal group settlements.

Combining with a best-in-class treasury management system (TMS), the two solutions create a powerful model for treasury according to Gabor Bojtos, Head of Treasury at Wizz Air Group.

As other firms evaluate the business case for transitioning to IHB, several dimensions need to be considered, including:

• Comprehensive IHB capabilities: Beyond managing internal settlements, can the system provide a wider array of IHB services, such as intercompany loan administration and the centralization of external settlements on behalf of entities, including payment and collection factories?
• Accelerated return on investment: What is the timeframe required to realize financial benefits from capital expenditure in technology investments, encompassing system procurement, integration and maintenance?
• Cost savings: What is the extent of bank fee savings achieved by settling intercompany invoices without cash, eliminating netting cycles and implementing same-day processing where feasible? Additionally, what cost efficiencies are gained through account rationalization facilitated by payment and collection factories?
• Reduced operational costs: What will be the ongoing operational expenditure—either realized or foregone, depending on the solution choice—required to operate and administer the system?
• Technology efficiency: What are the integration cost savings between TMS and ERP systems when utilizing standard bank format virtual account numbers and reporting to facilitate IHB operations?
• Professional services: What are the professional expenditures—either realized or foregone—required based on whether a bank or vendor solution is selected?

Leveraging VAM to enhance financial performance

Effectively managing currency mismatch in intercompany transactions remains a pivotal challenge for global businesses, influencing both financial stability and operational efficiency. While traditional netting solutions offer some benefits, they often fall short in addressing the intricacies of realized FX gains and losses.

VAM emerges as a transformative alternative, eliminating the need for cash settlements and traditional netting cycles, thereby significantly reducing FX risks and associated costs. This innovative approach enhances visibility and control over funding requirements, empowering treasuries to centralize FX exposure management and leverage complementary tools like multicurrency notional pooling and strategic FX hedging. By carefully evaluating ROI and other critical factors, firms can build a compelling business case for adopting advanced banking solutions to optimize their treasury functions to achieve cost reductions and potentially improve financial performance in today's complex global economy.

J.P. Morgan can assist companies in mitigating risks by providing virtual account management solutions that contribute to eliminating the need for cash settlements and traditional netting cycles. By partnering with J.P. Morgan, companies can leverage virtual accounts to bypass capital expenditures on complex netting systems and transition to cashless clearing and settlement of internal transactions. Our expertise and technology can help companies optimize their treasury functions and realise savings.