What Is a Topping-Up Clause?
A topping-up clause is a contractual provision commonly found in loans involving more than one currency. It is intended to protect lenders and borrowers from the risk of foreign-currency devaluations.
Specifically, topping-up clauses require the borrower to make additional payments to the lender to cover any devaluation in the currency being borrowed. In exchange, the lender agrees to compensate the borrower if the borrowed currency appreciates during the life of the loan.
- A topping-up clause is a legal provision designed to protect the parties to a loan from the risk of currency devaluation.
- It is generally used as a risk-management measure rather than as a means of speculating on future currency values.
- Topping-up clauses will typically only come into effect once certain thresholds have been reached, such as when currency values deviate by more than a specified percentage.
Understanding Topping-Up Clauses
Topping-up clauses are a method used to reduce foreign-exchange (forex) risk. As such, they are especially useful when the value of the currencies involved in the loan are expected to fluctuate against one another during the term of the loan. Accordingly, the more volatile two currencies are with respect to each other, the more forex risk is involved with the loan.
Although topping-up clauses cannot reduce that underlying volatility, they can help to compensate the parties to that loan for the impact of that forex risk. For example, if one of the loaned currencies is devalued by 10%, the borrower would need to make additional payments equal to 10% of the loan's value in order to make up for that currency devaluation. Similarly, if the value of the loaned currency increases by 10%, then the lender would be required to reduce the outstanding balance of the loan by 10%.
Topping-up clauses do have their limitations, however. To begin with, they are typically only activated once the variance in exchange rates surpasses a certain level, such as 3% or more. Also, the additional payments required by the topping-up clause can lead to unwanted tax liabilities for the receiving party.
Risk Management vs. Speculation
Unlike derivative instruments, such as currency forwards, topping-up clauses are generally not used as a way to speculate on currency fluctuations. Instead, they are viewed mainly as a measure to reduce forex risks.
Real World Example of a Topping-Up Clause
In some countries, such as the United Kingdom, court judgments can sometimes require parties to render funds in currencies different from that of the court. In those situations, a topping-up clause is used to require the debtor to pay any additional amount needed to produce the amount in the expressed currency.
In other countries, however, bankruptcy laws require that foreign debts be expressed in the local currency. In those circumstances, topping-up clauses may be ignored, causing the debts to be effectively devalued if the local currency is worth less than the foreign currency. This is one of many risks which lenders must be aware of when extending loans to debtors in foreign countries.