Speculate, Calculate, Accumulate

The Art of Balancing Risk with Return

Does prudent risk management necessarily prevent treasury from being a profit centre? Oleh Kurinnyi, a global treasury and operations specialist, calls upon his own banking and corporate experience to answer that question for the wider treasury community.

Life is full of trade-offs. When you drive to another city across the country, you are (or should be) constantly balancing speed against safety. In a similar way, the treasury function must constantly assess risks and seek a balance between a desire to optimise cash and investment performance, and the need for caution.

In both scenarios, a fine line can be drawn between success and failure. But for treasurers in banks, FIs and large non-financial corporations with significant treasury operations, such as multinationals or conglomerates, how can that line be navigated with confidence?

The cushion effect

Treasury is the heart of every enterprise. Its activities reflect all aspects of business development. In a bank or FI where money is its core business, the role of the treasury is vital. It is not without reason that banks and FIs are referred to as the circulatory system of the economy. But within the corporate structure of large industrial, trading, and service companies, the treasury, as part of the finance department, plays a similarly vital role.

The primary objective of any business is to generate profit, which of course is the difference between incoming and outgoing cash flows. Treasury manages these cash flows, taking responsibility for ensuring the level of liquidity necessary for the organisation to meet its obligations on time, while hedging currency, interest rate, credit, and liquidity risks.

Risk hedging transactions are carried out in FX, money, securities, and derivatives markets, as well as using banking instruments (such as forwards, deposits, repos, swaps, options), and trade finance instruments (including documentary collections, LCs and guarantees).

The most common way to hedge against the risk of a liquidity shortfall is to establish and maintain a safety cushion of unencumbered high-quality liquid assets (HQLA). These are cash and cash equivalents (such as currencies, bank metals, traveller’s cheques, and cryptocurrencies), open credit lines, and overdrafts. They may also take the form of highly liquid securities (typically AAA-rated government bonds, certificates of deposit issued by central and government banks, and blue-chip stocks).

In banks and FIs, the minimum size of the safety cushion is dictated by the regulatory demands of the liquidity coverage ratio (LCR) and net stable funding ratio (NFSR). These are approved by the Basel III agreements, which are designed to ensure resilience to short-term and long-term liquidity crises. I wrote about this in detail in my TMI article on crisis management. In addition, many treasury settings undertake the hedging of cash gaps across an organisation’s various branches and departments during the process of transfer funding and pricing.

The result of the above operations is not only peace of mind regarding the hedged risk, but also a specific net profit or loss. Thus, alongside other front-office departments, treasury clearly influences its own organisation’s financial results, with the anticipation that it will maximise profit and minimise loss.

Speculation meets calculation

When an organisation has funds set aside as a reserve, it may want to use them to generate income. To do this, speculative trading, carried out on the FX, money or stock markets, can assist. The guiding principle here though is always ‘buy cheap, sell high, lock in the profit as cash’.

Engaging in speculative trading at scale (as might be seen in a bank or multinational) offers a dual benefit: it provides treasury traders with regular practice, and it generates income. As a result, the organisation itself may become a market maker; that is, an active market participant influencing market trends. Other market participants turn to the market maker for quotes.

It is important, however, to maintain the aforementioned reserve of funds at a level no lower than the initial amount, otherwise the point of this operation is lost. Thus arises a need to manage the risks of open trading positions, which in banking is usually handled by the risk management team.

Within this function, risk analysts study the volatility parameters of each asset, as well as the trading portfolio comprising these assets. Of particular interest are changes in the asset price over time, the range of price fluctuations, and the standard deviation. Based on this data, the value at risk (VaR) – the maximum sum of potential losses when purchasing an asset for a specific period – is calculated for each asset class.

Based on data from the risk analysts, recommended limits for open trading positions and maximum loss limits are calculated for both individual asset classes and the trading portfolio. The maximum loss limit for treasury’s trading portfolio is determined, on the one hand, by the risk appetite of the organisation’s management, and on the other hand by the size of its equity capital and any capital requirements set by the appropriate regulator (the national regulatory authorities and central banks).

The maximum limits for open trading positions and maximum loss limits are approved by a resolution handed down by the Asset and Liability Committee (ALCO) of the bank or FI, and verified by the organisations’ CEOs (some of the larger non-financial corporates may have this setup too).

Eyes wide open

Primary monitoring of compliance with these limits is carried out by the treasury manager during the trading session. This is typically achieved using a TMS integrated with the trading platforms on which traders execute transactions (such as Bloomberg or Thomson Reuters).

Secondary monitoring of trading limits is carried out by the risk management department every day following the close of trading on the money and stock markets. Subsequent monitoring is carried out by the internal audit department at intervals established by the organisation’s internal regulations.

When engaging in trading operations, it is essential to constantly monitor liquidity risk, as purchasing a particular asset reduces the cash balance in the base currency used for settlements related to the organisation’s operational activities. As experienced treasurers say, ‘cash is king’, especially in these turbulent times on the global markets.

To hedge against liquidity risk, it is recommended to carry out speculative trading transactions on a spot and forward basis, so that the cash manager has time to prepare funds in advance, based on cash flow forecasts.

Money markets moves

Treasury can generate income not only from buying and selling currencies and securities, but also in the money markets, by placing and attracting funds through bank loans, deposits, and swap and repo transactions with fixed or floating yields. This gives rise to interest rate risks, counterparty risks, and liquidity risks.

As with trading operations, limits are set on the open resource position (for each currency individually and in aggregate across the portfolio), as well as limits for each counterparty bank and each trader. When assessing counterparty risk, publicly available data from rating agencies (commonly S&P, Moody’s, or Fitch) is most often used, as well as an analysis of financial conditions based on standard financial statements certified by external auditors (such as Deloitte, EY, KPMG, or PwC).

Transactions in money markets are conducted using the same automated information and trading platforms. Primary controls on open position limits, counterparty limits and trader limits can be incorporated into the trade confirmation algorithm. This involves an automated query to dedicated limit databases (populated solely by risk specialists). Secondary and subsequent checks are carried out in the same way as for trading operations.

For online analysis of data on open positions and current financial performance, it can be beneficial to use a dashboard with a visualisation tool, such as Power BI or Tableau, which automatically retrieves information on executed trades from the TMS, as well as live market data.

Despite the opportunities it can present, I always caution treasurers against becoming overly enthusiastic about high-risk trading operations. As the saying goes, ‘the love of money is the root of all evil’. And remember, treasury is the heart of the business. When you look after its heart, it will live long and prosper.