Cash: An Asset In Adolescence
Aug 31 2017 | 3:34pm ET
Cash: An Asset In Adolescence
by Steve Irwin, Head of Asset Servicing Liquidity Solutions, Northern Trust
If the investment industry has a rebellious teenager in the house today, that teenager would be cash: it costs you more, is more challenging and offers little in return. Since the 2008 crisis, liquidity’s growing pains have become an increasingly critical issue for asset managers and institutional investors alike. So everyone is asking the question: how to effectively manage liquidity requirements in this difficult environment?
The answer is that – unfortunately – there isn’t a single solution for this “liquidity conundrum.” To balance the demands of liquidity, security, yield, operating efficiency and cost, a comprehensive understanding of factors making up today’s liquidity picture landscape is required.
How Liquidity Has Become The Industry's Problem Child
Cash Drag
Holding cash has become a challenge for many market participants. In the past, cash could earn a return of 2% to 3%. But in today’s low interest rate environment, a zero or low rate of return can become negative after inflation. Cash has gone from being a benign by-product of investing to arguably the essential facet of many investment strategies.
This situation presents other challenges such as counterparty risk. If you’re holding more cash than in the past, you may struggle to find a bank with the capacity to take the assets on their balance sheet or to provide a positive yield. As a result, investors may have to place their assets with a less ideal counterparty: perhaps a bank with a lower credit rating or one in need of funds itself. Holding cash, therefore, becomes a material risk instead of an “invest and forget” option.
Central Clearing Reforms
Part of the liquidity crunch is driven by regulatory developments such as EMIR and Dodd-Frank, which have had unintended consequences. Alongside the requirement to centrally clear certain derivatives, these regulations also:
- Mandate the posting of initial variation margin (VM) for OTC derivatives
- Requires initial margin to aim to cover the potential future exposure to a counterparty default
- Requires VM to aim to fully collateralize the mark-to-market exposure at any given time
Because VM must be posted in cash, the last point is the most challenging.
For example, an independent report published by Europe Economics and Bourse Consult for the European Commission estimated that if European pension funds were required to clear their derivatives trades and post cash as VM, the total cash collateral needed by them to support a 100 basis points (1%) move in interest rates would range from €205 billion to €255 billion. In more stressed scenarios, it could reach €420 billion. These same kinds of fluctuations would present challenges for most investors.
Repo Markets
As a further result of Basel III, repo markets have contracted as European banks became more dependent on central bank funding. One high-profile bank announced it would close its tri-party US Treasury business in June 2016. As a result, the repo market’s value fell to less than US$4 trillion at the end of 2015 fromUS$7 trillion in early 2007.
Market Uncertainty
Uncertainty in markets has not helped investors and asset managers either. Panic over Brexit initially wiped US$2 trillion from the world’s markets, with Moody’s, the credit rating agency, pushing its outlook for the UK banking system from stable to negative. The firm said it expected the referendum result to “lead to reduced demand for credit, higher credit losses and more volatile wholesale funding conditions for UK financial institutions.”
In the US, Moody’s has warned recent market volatility will negatively affect the performance of several large US pension schemes, with unfunded pension liabilities growing by at least 10% in the fiscal year 2016, even in the most optimistic scenarios.
Central Bank Intervention
One-third of all euro area government bonds now have negative yields and there is an estimated US$13 trillion of global negative-yielding debt, according to some reports. That compares with US$11 trillion before the Brexit vote, and almost no negative yield debt in mid-2014.
Of course, all investors do not have the same needs and requirements and every organization needs to chart a course based on their particular situation. However, there are steps you can take get on the front foot as you seek to balance liquidity demands with the search for returns.
1. Maintain a liquidity ladder to forecast needs and match it with known cashflows. This can be done by using robust cash forecasts to segment cash (daily, reserve, strategic) and ensure you hold enough operational cash to settle obligations. This will help you understand what proportion of your cash flow portfolio you need to keep liquid, and what you can deploy over the long-term. Start thinking about having an accessibility ladder for when it’s required, and think about duration. A long-term forecast means understanding strategy as well. Would your funds maintain their agility should a particular opportunity present itself?
2. Consider how to source cash in times of market shock/stress. Consider a bank facility or repo facilities, or facilities with central banks or a corporate sponsor who is often long cash. All these scenarios are important to consider. Plan for the worst. Emergency sources of funding can be very costly, so thinking about them ahead of time is important.
3. Look at your long-term plans, strategy and whether there are major moves on the horizon such as adopting more or less liquid investment strategies – these may all require extra flexibility in terms of holding liquid assets.
4. Model the asset liquidity profile and stress test it to understand the true benefit/cost of embedded funding costs, as well as margin requirements on derivative positions. For example, think about the cost of maintaining a cash position. If a fund holds 6% to 7% cash in a zero / negative yield environment, what is the real rate of return and what impact does cash drag have?
5. Identify any unusual sources of liquidity the fund might have. For example, repos that could be called upon as needed.
As outlined at the outset, there is no one-size-fits-all solution to the liquidity conundrum. Rather, there are a wide variety of potential options including peer-to-peer lending, raising cash against a TRS or accessing the repo market.
But in times of market stress, the repo market could shut down, or a bank may not be able to provide an investor with liquidity. Similarly, you might not be able to sell something in the market quickly.
When no solution can be guaranteed, it is necessary to use and combine a variety of solutions that give you the strongest protection. Understanding a portfolio from the point of view of how liquid it might be is critical – particularly as the cost of cash liquidity is likely to increase. Like a rebellious teenager, guaranteed liquidity comes at a price, with no easy path to adulthood.
Sources for this article include:
- PI Online, “J.P. Morgan Exit from Repo Market Seen as Further Regulatory Fall-Out,” 16 August 2016
- Moody’s, “Moody’s Changes Outlook on 12 UK Banks and Building Societies,” 28 June 2016
- Moody’s, “Volatile Market Likely to Increase Unfunded US Public Pension Liabilities in FY 2016” 17 March 2016
- Business Insider UK, “A Third of All Euro-Area Government Bonds Are Now Negative,” 7 December 2015
- The Wall Street Journal, “Black Hole of Negative Rates is Dragging Down Yields Everywhere,” 11 July 2016
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