Achieving Counterparty, Concentration and Liquidity Risk Management Objectives

by Hugo Parry Wingfield, Director, Head of EMEA Market Management, Liquidity & Investments, Citi

Cash and liquidity have proved hard to manage in recent years, in particular to find an appropriate balance between risk and efficiency. Furthermore, identifying investment solutions that satisfy treasurers’ security and liquidity requirements, whilst still generating a return on cash, may also be a complex process. These challenges have both external and internal origins. Externally, sovereign and counterparty risk concerns create the dilemma of where cash should be held, and with which counterparties. On one hand, treasurers seek to streamline their bank relationships and investment counterparties, but on the other, they wish to avoid the risk of fragmented cash, processes and technology. This problem is exacerbated by internal operational, organisational and political issues that restrict treasurers’ ability to centralise cash and risk, and standardise processing. This article considers some of the ways in which treasurers are successfully responding to these challenges, and having concentrated cash more effectively, how they can invest cash successfully to satisfy their security and liquidity objectives. 

Prerequisites to effective liquidity management

With the crisis now receding in many parts of the world, corporates are embarking on more ambitious investment strategies, including geographic expansion, M&A and business partnerships, particularly in emerging markets, which in turn create further challenges from a cash and liquidity management perspective. The first of these is achieving visibility over cash, which is the prerequisite to any liquidity management strategy. Fragmented processes, technology and banking relationships all impact on treasurers’ ability to achieve a timely, accurate and complete view of cash; however, this is an area on which treasurers have been heavily focused in recent years. According to Citi’s Treasury Diagnostics research1, 2010 saw 53% of treasurers surveyed achieving daily visibility over 95% of their cash, compared with 42% in 2009 (figure 1). This increase has been assisted by analytical tools such as Citi’s TreasuryVision®, and a reduced number of bank relationships with whom they have a more strategic relationship, and better co-ordination of resources internally.

Mobilisation and centralisation

Having achieved visibility over cash, treasurers are in a better position to control and mobilise cash to the locations where it is required. Cash pooling techniques have a major role to play in achieving this, and again, as treasurers consolidate and enhance their internal and external relationships, they are making progress in their ability to leverage cash pooling solutions, not only regionally but also globally. Citi’s Treasury Diagnostics research indicates that while in 2009, 24% of treasurers surveyed were able to pool cash globally, this increased to 31% in 2010. The amount of cash centralised through cash pools is also increasing. According to the same research, 27% of treasurers indicated that more than 95% of operating flows were included in a cash pool, compared with only 16% in 2009. At Citi, we have seen a notable increase in cash pooling amongst corporates over the past 18 months (figure 1), both in single currencies and across multiple currencies, resulting in direct financial, efficiency and control benefits. 

These statistics illustrate treasurers’ ongoing focus, and success, in aligning internal business units and external banking partners to achieve the company’s overall cash and liquidity management objectives, and enables firms to reduce borrowings, monitor counterparty risk more effectively and maximise the use of surplus cash. Furthermore, with recent geopolitical concerns in markets in the Middle East and North Africa, having full visibility and access to liquidity in those countries is again proving to be critical.[[[PAGE]]]

Building a robust investment strategy

The build-up of large cash balances, resulting from stronger revenues, preparation for major business investment and improved cash centralisation, creates its own challenges. Treasurers are understandably concerned about concentration risk arising from investment in a few chosen counterparties, and while deposits and other cash instruments will continue to play a major role in corporates’ investment strategy, the number of suitable investment counterparties is quite small relative to the size of many corporates’ cash balances. Furthermore, since the crisis, treasurers are now more concerned about systemic risk that could jeopardise investments in similar institutions. Consequently, treasurers of many companies now face the dichotomy of the need for greater diversification in their investment portfolio on one hand, but limited resources on the other.

The financial crisis prompted many treasurers and CFOs to review and revise their investment policies to emphasise the importance of security and liquidity as key investment criteria (figure 2), and to establish more detailed limits on investment levels, permitted counterparties and instruments. According to the AFP’s Liquidity Survey, June 2010, more than half of companies (52%) review their investment policy at least once a year, with a significant proportion doing so every three or six months. However, from our research, we recognise that while many companies have now implemented a valid, flexible and robust investment policy, there is still the potential to improve on execution, and therefore compliance with the policy. As we have already seen, a lack of resources to dedicate to credit research and portfolio construction, and a shortage of potential counterparty banks contribute significantly to this problem.

Using MMFs to support investment objectives

The use of money market funds (MMFs), specifically  the AAA-rated, constant net asset value (NAV) MMFs according to Institutional Money Market Funds Association (IMMFA) guidelines, may offer treasurers the ability to invest in secure, diversified funds, with same-day access to liquidity, and access to the fund provider’s extensive credit research and portfolio management resources. This may enable treasurers to satisfy security, diversification and liquidity objectives without placing additional strain on already constrained resources. Furthermore, by accessing these funds through a funds portal, ideally integrated with treasury’s overall systems infrastructure, treasurers may also reduce operational risk and ensure high levels of straight-through processing. Use of MMFs is already well-established in the United States (2a-7 funds) and in parts of Europe such as the UK.

Adoption is gradually increasing in other parts of Europe and in Asia as treasurers’ familiarity with these instruments develops.While in the past, treasurers were often satisfied with the rating and size of a MMF to determine its suitability, investors are now conducting more stringent due diligence. For example, they need to be  confident in the quality of fund managers’ investment approach, the composition of the fund, and the profile of the investor base, to ensure this is sufficiently diversified to avoid a large number of redemptions in the event of a major market event, before making the decision to invest in a particular fund. We see our clients approaching potential fund providers with a variety of questions, including:

• Fund holdings, both current and historic;
• How the fund manager conducts stress testing;
• The fund management process, including credit research and portfolio risk management;
• How the fund is ring-fenced from the fund provider’s assets;
• The profile of the investor base;l How the fund will change in response to new regulatory requirements and industry guidelines (such as IMMFA).

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Managing operational risk and enhancing efficiency

Despite the advantages of using MMFs, there are two potential difficulties for treasurers and finance managers seeking to leverage these products. Firstly, with an increasing range of funds available in the market, treasurers need to be able to identify the funds that are most appropriate for their company’s needs and subject to the most robust investment processes. Secondly, they need an efficient and convenient means of transacting MMFs that enables them to access multiple funds through a single channel, adhere to internal control requirements and integrate with internal treasury and cash management systems to avoid risk of error. Consequently, we are seeing greater interest in the use of online investment portals such as Citibank® Online Investments (OLI). Using OLI for investment delivers a range of advantages:

• MMFs on the portal are all IMMFA AAA-rated funds, providing investors with a high degree of assurance.
• Policy controls can be set up on the portal, ensuring policy compliance supported by real-time compliance alerts.
• Not only can multiple funds be traded through a single portal, but a single set of documentation is valid across all funds, increasing flexibility should treasurers wish to change or add new funds quickly.
• Post-trade data can be integrated seamlessly with the company’s TMS or ERP permitting straight-through processing and enhanced operational risk management.

We are also witnessing an increased demand for investments that are integrated more closely with underlying cash management activities, such as sweeping surplus balances automatically into one or more MMFs, as well as a broader set of managed investments such as repos or third party bank deposits. Automating investment processes in this way enables the maximum cash possible to be invested within the company’s investment guidelines but without the need for additional resources.

The continuing priority of liquidity management

With increasing controls on bank capital adequacy and liquidity imposed by Basel III, the liquidity challenges that treasurers are dealing with today are likely to persist, so visibility, control, centralisation and efficient investment of cash will continue to be amongst treasurers’ highest priorities. Rationalisation of bank relationships, implementation of sophisticated cash and liquidity management solutions and adoption of efficient technology will all play a part in achieving these goals. In addition, the use of MMFs, particularly through an online investment portal, is therefore likely to become an increasingly significant element of treasurers’ investment strategy in the future, as the need for counterparty, concentration and liquidity risk management becomes enshrined in corporate investment policies. Few treasury departments have the resources to replicate the credit research or investment management discipline of the major fund providers; similarly, the efficiency, convenience and control of an online investment portal is the result of a collaborative approach to pre- and post-trade processes that individual companies could not achieve alone.

Note1 Citi Treasury Diagnostics is a proprietary benchmarking programme first launched in 2009, providing objective benchmarking across a wide range of cash and treasury related activities. Over 250 organisations have since benefited from the programme across all industries and geographies.