The importance of being liquid
Much like a brooding teenager, cash has become a high maintenance asset class as a result of events over the last few years. Whether it is finding liquidity to put to work for new investment strategies (or, for that matter, support existing ones in terms of collateral management) or looking for ways to invest cash to improve investment yield, traditional approaches to liquidity management have become increasingly problematic.
This ‘liquidity conundrum’ has made it more important than ever that investors have solutions in place to find the right balance of how and where to invest cash. Northern Trust detailed this earlier this year in a white paper entitled, ‘Cash: An Asset In Adolescence’. The white paper outlines how investors can build a holistic picture of the liquidity landscape and develop an effective liquidity management strategy by considering five core tenets: security (ie, instrument or counterparty quality), liquidity, yield, operating efficiency and cost.
“Within different industries, different sectors and even within sub-sets of clients operating in the same sectors, their liquidity concerns are broadly driven by these five key tenets,” comments Steve Irwin (pictured), head of asset servicing liquidity solutions at Northern Trust.
As the white paper points out, one can attribute a number of market and regulatory factors as to why cash has become somewhat of a problem child. For example, centralised clearing of over-the-counter (OTC) trades has led to increased collateral demand. Furthermore, central bank intervention in the markets has driven bonds and interest rates to historic lows, penalising cash deposits. Regulatory impact, in the form of Basel III, has led banks to manage their balance sheets very differently, simultaneously reducing the amount they are willing to lend, and, in some instances, requiring them to introduce negative interest rates to hold cash on deposit.
“Holding more cash in portfolios can lead to a drag on fund performance in markets like Denmark, Sweden, Switzerland and the Eurozone, where negative interest rates persist. This is forcing clients to think about cash and liquidity in their portfolios very differently,” says Irwin.
According to the white paper, some institutions have had to increase their cash holdings from 1 or 2 per cent of their investment portfolios to 6 or 7 per cent. Institutions such as large European pension funds, for example, face pressure putting that cash to work to optimise returns, in light of current central bank monetary policies. Where can they comfortably allocate that cash, such that if they need to raise short-term liquidity they can do so without fear of getting locked in to illiquid positions?
CCPs and the move towards OTC clearing
Market regulation in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in the United States and European Market Infrastructure Regulation (EMIR) in Europe has led to a transformation in the derivatives markets. Fuelled by opacity and by fears that another systemic meltdown could occur following the ’08 global financial crash, regulators have taken pains to move the OTC market into a more transparent centrally cleared environment using central clearing counterparties (CCPs).
This has had quite an effect. As reported by the Bank for International Settlements (BIS)*, based on figures as at the end of June 2016, some 62 per cent of the USD544 trillion in notional amounts outstanding reported by dealers was centrally cleared.
A consequence of this is that investors are required to post initial and variation margin; and, crucially, variation margin for cleared trades must be posted in cash (or in cash and certain securities if bilaterally traded) – potentially multiple times a day.
This may not sound too burdensome. After all, fund managers have long managed margin calls to support derivatives. The issue, however, relates to the volume of cash that would be needed for collateral, were interest rates to change. If a 100 basis point move in interest rates took place, those holding interest rate swaps would find themselves in hock for posting huge amounts of variation margin.
Northern Trust acknowledges that even a modest 25 basis point increase in interest rates would lead European pension funds to post intraday margins of approximately EUR55 billion.
“Managers are looking to understand all the sources of cash they can have at hand to meet variation margin requirements when needed, and whether those sources of cash will be available to them, not just in benign markets but during periods of market stress. We see managers stress testing and shocking their portfolios to develop ‘What if’ scenarios and thinking more about investing not just on a risk/return-based budget, but on a liquidity-based budget.
“They have to consider the liquidity implications of pursuing investment strategies, rather than thinking purely in performance terms,” says Irwin.
This makes for a difficult trade-off. To what extent do investment managers put unencumbered assets to work to optimise yield, while at the same time ensuring they are well positioned to meet intraday margin calls?
“That is why we refer to it as the ‘liquidity conundrum’,” adds Irwin. “There is no perfect answer. It often comes down to finding a balance based on the five priorities I referred to earlier”.
“People have to come to their own conclusions on risk appetite, on investment strategies, on banking relationships and so on, to come up with their own defined liquidity policy that they need to operate under. Many clients are now re-assessing their cash and liquidity policies in their organisations through different lenses: for example with a particular eye on front office yield or back office compliance.”
Low interest rate environment
As Northern Trust writes, there is an estimated USD13 trillion of global negative-yielding debt, according to some reports. That compares with USD11 trillion before the Brexit vote and almost no negative yield debt in mid-2014*.
The unintended consequences of central banks’ propping up the markets and embarking on wholesale quantitative easing have been manifold. Their actions have had the desired effect of stabilising equity markets, which have gone from strength to strength, but there is now significantly increased volatility to contend with. Furthermore, the net result of central bank intervention has been to drive government bond yields to punishingly low levels.
Against that backdrop, knowing where best to allocate cash becomes tricky. As mentioned above, central clearing provisions mean that investors must have liquidity to hand at short notice. Yet, at the same time, they are being pushed to invest into higher yielding asset classes.
One only has to look at the burgeoning asset class that is infrastructure debt, not to mention private lending markets, to appreciate the appeal these asset classes offer. However, the reason they are appealing is because of the higher yields on offer due to their illiquidity premia. The problem is that by holding such assets, investors risk not having access to short-term liquidity when needed.
“What we have seen some clients start to do is forecast and segment cash. It doesn’t all have to be held in liquid assets overnight in say, money market funds. Some clients are determining what proportion of their cash they can do something more meaningful with over a longer duration, to avoid performance drag – exposure to longer-dated deposits with banks or short-dated cash funds for example. Anything that can offer some stability and avoid or reduce the impact of low and negative interest rates,” explains Irwin.
In other words, investors are segmenting their cash to more closely match their assets and liabilities. Northern Trust refers to this as a ‘liquidity ladder’. “We are trying to deliver solutions to help our clients navigate through these liquidity challenges”, says Irwin.
In terms of solutions at hand, Irwin describes how Northern Trust has recently developed its Evergreen Deposit, where clients can hold deposits with Northern Trust. “For ease of management, clients don’t have to worry about rolling over deposits when they are approaching maturity. It is, effectively, an open, perpetual deposit for clients seeking alternatives to traditional deposits.”
Another emerging cash investment option is trading repos/reverse repos with non-bank counterparties. This can best be thought of as an alternative to the banking model of taking deposits and issuing loans.
“We are seeing a couple of areas of development here, although they are yet to reach maturity. Long-term cash investors who are looking to lend cash can meet institutions looking to raise cash, and trade with each other – I think we will start to see this institutional peer-to-peer lending space evolve over the coming years,” says Irwin.
Solving the ‘conundrum’
As Irwin acknowledges, there is no ‘one-size-fits-all’ solution to the liquidity conundrum. But he offers a few thoughts as to how managers can get themselves on the front foot regarding their cash and liquidity management. “Firstly, getting into the practice of forecasting your liquidity needs and matching it with known cash flows is important,” he says, “as well as developing your thinking as to how you would source cash in times of market stress.”
Another is to consider whether any strategic moves on the horizon may affect your investment strategy and cash requirements – a merger or acquisition may be examples of this, he says, potentially requiring flexibility in terms of holding liquid assets.
“Managers should also model and stress test their asset liquidity profiles in order to better understand the benefits and funding costs of their investment strategies,” he says. “And it is also a good idea to identify any unusual sources of liquidity that could be called upon if needed”. Managers should explore all potential sources of liquidity and consider non-traditional counterparties as they look at ways to manage liquidity in this environment.
To read the Northern Trust white paper in full, please click on the following link:
* The Wall Street Journal, Black Hole of Negative Rates is Dragging Down Yields Everywhere, 11 July 2016.
About Northern Trust
Northern Trust Corporation (Nasdaq: NTRS) is a leading provider of wealth management, asset servicing, asset management and banking to corporations, institutions, affluent families and individuals. Founded in Chicago in 1889, Northern Trust has offices in the United States in 19 states and Washington, D.C., and 22 international locations in Canada, Europe, the Middle East and the Asia-Pacific region. As of March 31, 2017, Northern Trust had assets under custody of US$7.1 trillion, and assets under management of US$1 trillion. For more than 125 years, Northern Trust has earned distinction as an industry leader for exceptional service, financial expertise, integrity and innovation. Visit northerntrust.com or follow us on Twitter @NorthernTrust.
Northern Trust Corporation, Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A., incorporated with limited liability in the U.S. Global legal and regulatory information can be found at https://www.northerntrust.com/disclosures.