New ways of thinking about liquidity have emerged over the past few years, encouraged by the need to protect cash from erosion by low interest rates. Fiona Rintoul examines the latest thinking.
You may be a twenty-to-thirtysomething trying to save a deposit for a house, or you may be one of the world’s largest pension funds. Either way, you face a dilemma when holding cash: how can you keep it safe and achieve a return – or at least not lose money in real terms?
The unconventional monetary policy that followed the financial crisis may have been good for asset owners; it has not been good to owners of cash. In fact, liquidity management has become one of the foremost challenges facing the investment industry, according to the Northern Trust white paper ‘Cash: an asset in adolescence’, which won the 2017 Funds Europe Award for thought leadership.
In the white paper, Northern Trust identifies a pernicious cash conundrum. At a time when, for a variety of reasons, many institutional investors must hold more cash than they might have had to previously, it is becoming ever harder in a low-return environment to squeeze returns from cash. Thus, cash has become the investment industry’s problem teenager: it takes and takes, and gives nothing back.
“It just sits there and grunts,” says Steven Irwin, head of liquidity solutions product management at Northern Trust and co-author of the white paper.
The loudest grunts can be heard in the eurozone, where the European Central Bank’s (ECB) deposit rates have been negative 40 basis points since March 16, 2016.
“All the main instruments for portfolio managers are negative,” says Philippe Renaudin, chief investment officer, money markets, at BNP Paribas Asset Management (BNPP AM).
Interestingly, that does not mean that they are shunned by investors. Far from it. Renaudin reports increased inflows to money market funds since the beginning of the year. “All our clients want to use money market funds for liquidity management,” he says. “It’s down to the fact that corporates raise money by using commercial paper. They are happy with negative rates because the balance is equal.”
Just the same, with institutional investors typically holding more cash, cash drag can be a troublesome issue. The starting point for the Northern Trust white paper was a ‘quick and dirty’ survey of some of its clients, reports co-author Mark Austin, of Northern Trust’s institutional investor group. This revealed that some pension schemes were holding as much 5%-6% cash. Speaking to 14 large clients, the firm found that cash was seen as a problem.
“There was a significant negative drag in terms of return but also a significant headache in terms of counterparty risk,” says Austin. “Cash is now a risky asset.”
How did that happen? Many of the problems that institutional investors now face in managing liquidity are the result of regulatory changes, says Irwin. These “make sense in isolation and are well founded but have unintended consequences”.
An example is Basel III. Its principal aim was to ensure that banks were well capitalised to guard against their future collapse. An unintended consequence is a change in banks’ appetite for certain deposits and in the extent to which – and the price at which – they will lend to clients.
“The relationships investors have with their banks have changed following Basel III and similar accords,” says Kathleen Hughes, global head of liquidity solutions at Goldman Sachs Asset Management. “No longer are there plentiful reserves of cash and unlimited balance sheets to access.”
Other factors compound the problem, particularly for defined benefit (DB) pension funds, which, Northern Trust says, are arguably “coming under the greatest amount of pressure”. For example, the trend towards holding illiquid assets such as private equity and infrastructure creates a greater need for liquidity at a time when many pension funds have more members in the decumulation than in the accumulation phase, and may be receiving requests to transfer out.
“There is an ever more diverse set of reasons to hold cash,” says Austin.
Start by thinking
So much for the problem. What is the solution? The starting point, in Northern Trust’s view, is for institutional investors to think more deeply about their liquidity requirements than they may have done before. Such deep thought may reveal both that one portion of liquidity could serve multiple needs that are unlikely to occur simultaneously and that not all of the liquid portfolio needs to be available overnight. For some investors, other forms of detailed interrogation have also become important because of liquidity challenges.
“We see asset managers making a deeper analysis of their shareholder structure to get a real understanding of the nature and sensitivity of investors,” says Etienne Deniau, head of strategic marketing at Societe Generale Securities Services. “They then try to match the shareholder structure with liquidity.”
Having interrogated their liquidity portfolio, investors can segment cash holdings into a bucket for immediate needs, and other buckets they are confident they won’t need immediately and which can be used more strategically, says Andy Burgess, fixed income investment specialist at Insight Investment. These latter portions can then be deployed in longer-term investments that provide return.
“You can balance these in what we call the liquidity waterfall,” he says.
Custodians performing securities lending for clients also encourage them to segment their portfolios. According to Jamila Jeffcoate, head of agency lending, Emea at State Street, counterparties to repurchase agreements (repos) increasingly want to trade on a fixed-term basis, with the term typically running to 30 days plus. “There are very few opportunities in overnight. We encourage clients to keep a buffer in overnight and think about what portion of their cash they can take up to 30 days.”
A complete understanding of their own liquidity needs is the sine qua non for institutional investors. In its white paper, Northern Trust discusses a “liquidity ladder” to forecast needs and match them with known cash flows, suggesting that investors should think as far in advance as one year.
For Salman Ahmed, chief investment strategist at Lombard Odier Investment Managers, this exercise involves precision engineering of investors’ liquidity portfolio. Above all, investors must know what they want. “The definition of liquidity is changing,” he says. “The difference between the old and new regime is that in the old regime, you didn’t need to be so precise. Now you have to be very specific about how you define liquidity.”
Having defined liquidity and segmented their portfolio, institutional investors must decide where to invest each segment. Diversification is the name of the game, and the range of products on offer is increasing.
In the current environment, where interest rates are normalising in the USA and there is more issuance than buys by the European Central Bank – even if an interest rate rise is still a distant prospect – some investors are turning to bond futures, says Patrick Barbe, CIO of European sovereign and aggregate bonds at BNPP AM. “More and more insurers are buying forward bonds,” he says. “They are taking advantage of the yield curve steepening.”
Lombard Odier IM also recommends futures for immediate liquidity needs, combined in a barbell structure with higher-yielding products. “We have more confidence in futures to give liquidity,” says Ahmed.
Meanwhile, the Northern Trust white paper highlights the possibilities offered by the repo market.
“It is a large market that has shrunk over time, driven by Basel III and banks looking to deleverage and shrink their balance sheets,” says Irwin. “If banks are not willing to take that trade, who might you trade your repo with?”
To exploit this opportunity, Northern Trust is looking at ways of bringing its clients together with non-bank repo counterparties. “We are exploring this at the moment in terms of product solutions,” says Irwin.
Insight Investment’s Burgess also extols the virtues of repos, in particular reverse repos. In what is essentially a form of secured lending, Insight does reverse repos only where the collateral is provided by UK gilts.
“It’s an opportunity for cash investors to disintermediate banks,” says Burgess. “UK DB pension funds among Insight Investment’s clients are looking to do these trades with UK gilts they hold. Historically, if you did a reverse repo you would get a low return, but now, by cutting out the banks, you can get a higher return.”
Such solutions offer the additional benefit of diversifying counterparty risk. The need to do this is another driver of change in liquidity management. One result is that French money market funds are finding clients in markets such as Italy and Germany. “They would also like to buy our funds to diversify counterparty risk,” says Barbe.
At the same time, Deniau observes a “Europeanisation” of the way people are managing cash as liquidity management strategies become more sophisticated. Where once you could predict how much cash a fund would hold according to its country of origin, this is no longer the case.
“It’s driven by shareholder structure, which was not the case before,” he says.
Sophistication is the watchword in this evolving area of the investment industry, which will shortly have to deal with the EU money market fund regulation. Coming into effect in January 2019, the regulation is expected to be a significant shake-up for this €1.2 trillion sector.
“Investors today are keen to plan for upcoming changes and learn the impact to their portfolio,” says Hughes at Goldman Sachs. “To be effective, investors cannot be complacent.
“The environment is constantly evolving and a cash strategy needs to reflect this dynamism.”
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