Published: June 01, 2008
Regular readers of TMI’s annual Money Market Funds Guides will have witnessed the almost meteoric rise in the popularity and acceptance of money market funds (MMFs), growing from US domestic instruments to widely accepted liquidity instruments in other parts of the world, particularly Europe; or, as we described it this time last year, American Idol to Global Superstar. As we are all very well aware, the financial markets have changed unrecognisably since last year’s Guide was published. While the gloss has rubbed off many financial instruments (commercial paper, FRNs and even the comfortable deposit) MMFs are moving from strength to strength, rather like American Idol in fact. After all, like Idol, which now attracts thirty million votes each week (surely as many as the presidential election - perhaps a change to the election procedure is in order) MMFs have shown remarkable resilience. In this article, I would like to look at why MMFs are such a compelling proposition today, and how they might develop in the future, in terms of what they could represent as a global proposition and how I envisage they will be traded in practice.
MMFs have proved their resilience to fluctuating market conditions.
In previous Guides, we have emphasised some of the benefits of MMFs which enable treasurers to satisfy the investment demands of Security, Liquidity and Yield. Twelve months ago, these requirements were valid but for treasurers who have been in the profession for less than 15 years or so, largely untested. A year on, the majority of Boards will have demanded to know from their treasurers the extent to which they have applied these laws of liquidity. For example, various companies with which I work had cash invested in UK bank Northern Rock when its problems first became known. While the loss of this amount would not have resulted in financial collapse, it would have been devastating for the reputation of one in particular, a major charity, and significantly impacted its ability to attract future funds. For any organisation, financial loss through counterparty collapse which could have been avoided by basic risk management is damaging financially, reputationally, and causes serious concern amongst the company’s stakeholders. In the case of Northern Rock and similar cases in other parts of the world, both retail and institutional investors were ultimately protected through government intervention, but amongst institutional investors in particular, this is by no means inevitable. Most companies will have cash deposited in banks which have been subject to their own headlines and speculations. Do we think that there is a realistic threat that money invested in these banks will be lost? Probably not. But this is the point of risk management. We should not be ignoring possible occurrences, even if these seem highly improbable. Our responsibility as treasurers is to identify and manage risk and any investment decision, particularly when investments are not diversified, brings an element of risk.
The need for diversification is more acute than ever, not just during the current period of uncertainty but as a wake up call that we have often been complacent during the years which preceded it. With the same pressures affecting the whole banking community, security of capital cannot be assured simply by depositing cash in different banks. As Jean-Claude Trichet, President of the European Central Bank warned recently, the banking market is continuing to go through a major correction. To truly diversify, a treasurer needs to spread his/her risk across instruments of different risk profiles as well as different counterparties, so that risk to each asset is very limited and risk of loss to one asset class is offset by stronger performance in another. MMFs are inherently diversified, with a range of instruments underlying them.
Of course, treasurers could invest in multiple assets themselves - after all, there will often be a member of the treasury team with a relevant background. However, doing this relies on developing a familiarity with the market which most treasurers cannot afford to do, and constantly assessing credit. I know of only two of three corporations with a treasury team geared to doing this, and as these organisations have a treasury department eight or ten times larger than most, it is rarely if ever a realistic proposition. Furthermore, it is not treasurers’ mandate to become investment managers, but to ensure that a company’s cash is invested securely and available when required, and gaining a respectable yield in the meantime. In fact, those companies with the scale and capability to invest in a truly diversified portfolio are increasingly making the decision that investment banks with a whole army of credit analysts and minute-by-minute appreciation of the market. Investing in money market funds effectively outsources some of a treasury’s credit risk management function. Outsourcing is generally most effective when every organisation outsourcing a particular activity has similar needs, and bearing in mind the commonality of credit considerations across corporations, tapping into the MMF credit departments is potentially a very valuable opportunity. [[[PAGE]]]
Investing in a diversified range of financial instruments is not only labour-intensive and costly in terms of credit analysis, but also in day-to-day treasury operations. For companies with a sophisticated treasury system, with automated links to the banking system for payment and matching system for confirmations, increasing the daily volume of transactions may not seem to be a particular issue. For companies with lower levels of automation and constraints in staffing (which in the latter case in particular would appear to be the vast majority) increasing deal volumes means greater operational risk, more time spent on operational rather than strategic matters and more difficulty with segregation of duties, trying to find approvers from a small pool of people. Using MMFs can greatly reduce the operational burden of liquidity management by having a single transaction each day (or none at all if there is no increase or reduction in short-term investment levels) to either invest or draw down funds.
Another reason for placing money in multiple deposits is to obtain different tenures, to ensure that liquidity is maintained and often to coincide maturities with large outgoings of cash. Deposits are inherently illiquid and bearing in mind how difficult it is for many treasurers to forecast cashflow accurately, even in the short term, there is inevitably more cash held in very short-term deposits, often overnight, than is absolutely required. The effect of this is lower yields and more money held in working capital. While money market funds cannot solve the working capital dilemma, they can help to counter the problems of predicting cashflow. Investing in MMFs (which will typically have a higher yield than many deposits) avoids the need to make short-term investment maturity decisions. Companies which can sacrifice a day or two’s liquidity may also consider Enhanced Funds, as a way of further boosting liquidity with a negligible increase in risk as these are often still AAA-rated, unlike most of the deposits in which treasurers happily invest.
Enhancing yield is becoming increasingly difficult with the current trend in declining interest rates, which theoretically leads to two things. One is an increase in investment in other currencies with higher yields and swapping back to base currency (asset swap) and one is an increase in investment in instruments with a lower credit rating. In the current climate, these are either impossible, with low levels of liquidity, or undesirable from a risk perspective. Consequently, MMFs represent the best way of achieving comparable or enhanced investment yields for most organisations without increasing risk or complexity.
MMFs are moving from being a US phenomenon to a European one, and increasingly, we will see the same products are emerging in Asia and South America.
The points above will all be familiar to regular readers of TMI but the arguments are more compelling than twelve months ago, not because MMFs have changed, but the opposite. They have proved their resilience to fluctuating market conditions and continue to deliver treasurers’ requirements in satisfying treasurers’ security, liquidity and yield considerations.
Until recently, MMFs were typically denominated in USD, GBP and EUR. While this will accommodate the majority of American and European corporates, there are increasingly demands for the same products in other currencies, both by companies based outside these markets, and those with significant financial activities outside their home market. Consequently, we have seen the introduction of AAA-rated money market funds in JPY, AUD and CAD.
There has been a lot of talk about similar products in emerging markets, particularly Brazil, China and India. However, while there is certainly demand for MMFs in these currencies, both amongst large companies based in these markets and foreign companies operating there, a note of caution. As the credit crisis loomed during the summer of 2007, many of the so-called money funds or money market funds in countries such as France made substantial losses. Not all instruments known as money market funds are the same, hence the importance of IMMFA, the industry association for AAA-rated MMF providers, providing investors with confidence in the integrity and credit quality of MMFs. When moving into new markets for MMFs, there needs to be assurance that ‘AAA’ means the same in one currency as in another. It is probably a little too early for this to be the case, until consistent credit monitoring and accounting can be guaranteed, but MMFs on which investors can rely will be a huge advantage for corporations in these markets and we would expect to see these instruments developing quickly. [[[PAGE]]]
Another likely development in the MMFs market is a change in the way that these instruments are traded. MMF portals, including single and multi-bank portals are now gaining traction in much the same way as FX trading portals did a few years ago. There are different opinions on the likely evolution of this market. One view is that one portal will emerge as an industry ‘standard’ and others will fall by the wayside. In a competitive world, I don’t think this will happen. Instead, I envisage that the concept of a MMF portal will evaporate, with liquidity portals materialising in their place, probably developing from existing portals or mergers between them.
From a corporate treasury standpoint, it makes little sense to have different trading channels for different daily transaction requirements e.g. one each for FX, deposits/loans, commercial paper issuance and MMFs etc. The more portals a corporate treasury needs to access, the more diluted the potential advantages of straight through processing and operational risk management, with the need to try and integrate each portal with the back office systems. Consequently, in my view, the portals which will achieve the greatest success in the medium to long term are firstly, those with the closest integration with back office processing, which will generally take place through the treasury management systems and secondly, the widest breadth of instrument coverage.
As Dave Mishoe, Managing Director, SunGard Global Execution Services explains,
"While portal capabilities like multi-trade tickets, multicurrency views and reporting are important, a portal cannot distinguish itself based on these factors alone. Critical differentiators that investors need to look at include a portal’s ability to attract liquidity, and how closely it can be integrated with the business systems to consolidate the various risk elements. Dealing decisions through the portal need to be part of the whole transaction process, including audit trails, automation of back office processing, reduction in errors and in operational risk overall.”
A few banks are already incorporating MMFs into their cash management solutions, such as automatically sweeping pooled funds not into bank accounts or deposits but into MMFs instead. This is a very positive move and emphasises that MMFs should not be seen as standalone instruments but as an integral part of a company’s overall liquidity strategy. It will be interesting to see how banks will develop these opportunities further.
If ever there was a time for corporate treasurers to look to MMFs, then it is now. Certain markets, such as the UK, have embraced MMFs more than others in recent years, but with UCITS III legislation allowing investment banks to provide MMFs across Europe, and some burnt fingers in some markets resulting from the credit crisis, national preferences for short-term liquidity products should not influence today’s decisions. Gradually, MMFs are moving from being a US phenomenon to a European one, and increasingly, we will see the same products are emerging in Asia and South America. Over the next few years, it is entirely feasible to anticipate MMFs as the liquidity instrument of choice across Europe and further afield, transacted through broad trading portals which deliver a wide range of daily instruments required by treasurers and integrated automatically with back office systems.
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