The Science Behind Cash and Liquidity Management

Reprinted from Issue 2 June 2010 Investment Management Review A Quarterly Update for the Investment Management Industry Risk, Yield and Cost Management: The Science Behind Cash and Liquidity Management Roger Brookes Director, EMEA Client and Sales Management Global Transaction Services, Citi Hugo Parry-Wingfield, Director EMEA Liquidity and Investments for Citi s Global Transaction Services

While the markets remain on a jittery path, investment managers have sought new ways to maximize their performance and better their risk-management processes. Operational excellence has been one of the defining characteristics for those asset managers who have outperformed during the recent melee. IMR 2

As complex businesses with a variety of operational activities support their core services, investment managers frequently find themselves spread across multiple currencies and locations. Cash management touches most of these activities, and the value of optimizing these practices can be extremely high as can the cost of getting it wrong. The industry currently faces a number of challenges, some quite clearly derived from recent market conditions, others arriving as the industry continues to change and evolve. How can investment managers turn these challenges into business opportunities? Cash management is a logical area to focus on for quick wins. Moreover, it helps to support long-term change in a company s strategic direction, underpinning operational and structural processes, infrastructure and technology. This article reviews some of the cash and liquidity management tools and techniques that investment managers are currently using to manage costs, improve transparency and boost the liquidity of their funds when required. with far greater calls from investors for increased transparency. Balancing Yield and Liquidity. As the global interest rate environment is expected to remain low into 2011, managers are returning to the question of yield on cash. While this must be in the context of a robust risk management approach, it is also important to weigh up liquidity to ensure it can meet obligations without having the opportunity cost of too much cash in hand. Understanding Different Profiles of Cash Two rudimentary but extremely effective steps that serve to identify opportunities where control and returns can be improved are to define where cash balances can lie within business and to understand the differing nature and profile of the balances. An investment manager can have cash in a variety of pockets, both within the investment operations and at a corporate or treasury level. So what must be changed for a benefit to take place? What Are the Key Challenges? Managing Costs. As the industry strives for greater efficiencies, the focus continues on ways to manage costs by either direct cost-cutting or by seeking more effective ways to operate in order to contain those costs and to increase value. Controlling Risks. Much has been achieved in risk management since the financial crisis first hit the headlines, but investment managers continue to seek ways to enhance the risk framework as well as the process of execution. Increasing demands from regulators are also coupled The following diagram illustrates the variety of cash purposes and activities that can exist within an investment management company and how these are linked to the underlying transaction flows. Receivables Subscriptions Fees Cash Management Investment of Client/Fund Cash Client Cash USD EUR CHF Investment of Corporate Cash Corporate Cash USD EUR CHF GBP Cash as an Asset Class Investment in cash/liquid instruments as a defined asset class within a portfolio (within a fund or an individual mandate). Cash as Collateral Cash that must be held and managed as collateral/margin, for example, for derivatives or within securities lending programs. Cash as an Operational Biproduct Large amounts of residual cash generated as a result of operational activities such as securities settlement, and cash flows before/after. Corporate/Treasury Cash The house cash of the business that needs to be managed for operational needs and strategic activities. Regulatory Cash Capital required centrally and across markets to adhere to the multitude of local regulatory requirements. Payables Redemptions Dividends Commissions IMR 3

How Can You Optimize Your Cash and Liquidity Management? The panacea of most firms is to deliver real results reducing or controlling costs, managing risks and generating business and operational efficiencies. 1. Enhanced Cash Visibility Identifying the variety of pockets and locations where cash can reside is only the start of the journey. The complexity that many face in the investment management world, indeed a challenge for cash managers and treasurers across industries, is to gain maximal visibility of those cash balances, whether that is corporate cash or client/fund cash. While great strides have been made in recent years to improve visibility, it is clear investment managers need to enhance this further: Manage counterparty risks. Knowing where and what your balances and exposures are at any given point in time. Control currency exposures. Understanding the individual currency balances as well as the aggregate. Mobilization of funds. With cash residing across a variety of bank providers, business functions and locations, full visibility provides the basis for determining where funds can be most optimally deployed if they are to benefit from efficiencies in concentrating/pooling cash balances. Support forecasting and decision-making. Continually reconciling actual cash positions against planned positions, and feeding this information into the operational and investment decisions. This approach is frequently used when considering the duration of a cash investment or the required time to access liquidity. Improve transparency. For internal and external reporting and governance. If an investment manager can maximize their cash and short-term investment visibility, they achieve a crucial milestone on the journey to enhancing their overall cash management processes. This quick-win option gives an investment manager s cash manager the chance to quickly review the associated risks or opportunities. At Citi, many of our clients use our TreasuryVision application for a single view of all their cash and investment balances, irrespective of bank, currency or location. Tailored reporting is combined with strong functionality so that the potentially sizeable information base is perfectly aligned to the underlying client s own corporate structure. Moreover, improved access to cash and effective platform management work to improve cash forecasting and support critical decision-making and executing, e.g., the profile and tenure of cash investment programs. 2. Leverage Liquidity Structures Driven by the exacting demands of treasurers at multinational corporations, the leading service providers in the global cash management world have developed many sophisticated tools to assist the mobilization and optimization of cash balances. These tools are used by the investment management community for their own working capital and treasury management. They can include liquidity structures that automatically concentrate or sweep cash balances between multiple accounts and locations, even between multiple banks, with the goal of having a single position to manage at the end of each day. IMR 4

The notional pooling of cash balances is another option provided this is permitted by the company s legal structure and country rules. Of course, notional structures achieve the same goal without the physical movement of funds associated with concentration structures. enhance risk management. The primary drivers for these changes are still typically associated more with managing risks and liquidity than with yield, although the goal would still be to maximize returns commensurate with a robust risk framework. What is for certain is that, when cash balances reside in a variety of locations around the world, only those banks with a truly international proprietary network, such as Citi, can provide the consistent approach an investment manager needs to manage their balances effectively. A recent addition to the liquidity management toolbox is the ability to pool across multiple currencies. By managing several currencies as a single position without the need to perform FX swaps, investment managers can take advantage of a multicurrency pool, where individual currency balances can be treated as a single position, to support specific currency-related strategies, such as FX hedging. 3. Revisit Cash Investment Practices Given the low global interest-rate environment, coupled with a renewed focus on risk and liquidity, many investment managers have been content to restrict the investment of their cash balances in highly liquid options. This has included government securities and repos, overnight or short-term bank deposits concentrated with the stronger counterparties, and money market or treasury/government funds. While there will be no radical change in the market overnight, we do see a gradual shift as investment managers look for ways to minimize the operational effort associated with retaining liquidity on a far shorter basis than in the past. The trend also includes the consideration of outsourcing cash investment execution as a way to reduce costs and Cash balance investments are driven by different requirements, especially when the manager has a variety of cash profiles to consider, as well as whether the cash belongs to the business, a fund or an underlying investor. Indeed, regulatory cash must also be considered as must the restrictions that surround how it is to be managed. There is, however, a common set of approaches that can be applied as appropriate to those pockets of cash, and at Citi the following have been of particular focus for many clients as they look to enhance these activities. Deposit Accounts vs. Time Deposits. Fixed-term bank deposits are an extremely valuable way to place available cash for a defined period in return for a defined rate. Managing multiple time deposits across tenures and counterparties requires operational effort and generally requires good forecasting to ensure you are accessing the best rates as early in the day as possible. This does not always lend itself to cash management operations where cash can arrive later in the day, whether it is the investment manager s cash, from a security settlement or from other investment activities. Using high yielding deposit accounts can be an attractive alternative that pays a competitive yield typically in return for a cash balance that has a largely stable nature. Unlike a time deposit, these accounts can offer access to immediate liquidity if needed, and they are also able to pay the agreed rate for the closing balance on the account, which could benefit later-day flows. A deposit account can reduce the operational effort associated with time deposits and requires no daily action since the balances do not need to be moved. Overall, these are effective and automated options that do not necessarily forgo yield or liquidity. IMR 5

Accessing Money Market Funds. Money market funds diversify a cash investment across a variety of money market instruments while retaining the desired liquidity and capital preservation of the investment manager. At the height of the financial crisis, many investors retained their appetite for a pooled fund approach but shifted toward government or Treasury-style funds, although that trend has been steadily reversing. For many, the decision to invest in a money market fund is to maximize their investable cash while retaining full control and visibility of the balance. Investment portals are available from a number of providers, giving a single entry point to access multiple fund families. Citibank Online Investment (OLI) simplifies the cash investment process and provides a consolidated view of a firm s cash investments. The portal covers ten different fund families (for offshore funds), with simple settlement from a Citi or even a third-party bank account, in 21 countries and 18 currencies. Directed Investment Mandates. Investment managers are increasingly looking to tailor their investment guidelines for short-term cash while managing their operational balances with cash management or custody providers more effectively. Investment managers should employ the scale and expertise of their provider by setting parameters for instruments, tenure and counterparties. Thus they can leave the provider to manage the cash on a daily basis as it adheres to the investment guidelines and adds value via its own monitoring and control framework. Such a service can provide an easy route to diversify residual, or investment, cash balances across multiple counterparts through repo, cash deposits or a variety of other instruments. Finding the Right Path Investment managers face myriad challenges in protecting and investing cash, while managing costs, meeting regulatory requirements and maintaining a vigilant eye on risk management disciplines. Given the tumultuous environment we still seem to be in, it is as critical as ever to find efficient ways to manage these needs without overly distracting from the fundamentals of the business. That said, with the right tools there are clear opportunities for investment managers to enhance their current practices and achieve many quick, yet real, wins from reduced operational effort and costs to improved control and risk management. With the right partner, these can become flexible, long-term strategies. Given the current environment, this is a benefit that cannot be dismissed. While there will be no radical change in the market overnight, we do see a gradual shift as investment managers look for ways to minimize the operational effort associated with retaining liquidity on a far shorter basis than in the past. IMR 6

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