Treasury Today Country Profiles in association with Citi

in association with

HSBC Global Asset Management

Coping with low rates and changes in the money markets

Jonathan Curry and Nick Jones, HSBC

The low yield environment in recent years has presented many challenges for corporate treasurers – and unfortunately this situation looks likely to continue. Jonathan Curry, Global Chief Investment Officer – Liquidity, and Nick Jones, Head of Sales, Liquidity, EMEA at HSBC, explore changes in the money markets and how new regulation is impacting corporate treasury.

Jonathan Curry

Global Chief Investment Officer – Liquidity

Jonathan Curry is Global Chief Investment Officer (CIO) for the Liquidity Business and has been working in the industry since 1989. Prior to joining HSBC in 2010, Curry worked as Head of European Cash Management at Barclays Global Investors (BGI). He is Chairman of the Institutional Money Market Fund Association (IMMFA), the industry association for AAA rated MMFs, and has been a Board member since 2006. Curry is also a member of the Bank of England’s (BoE) Money Market Liaison Group and a member of the European Banking Federation’s (EBF) STEP Committee.

Nick Jones

Head of Sales, Liquidity, EMEA

Nick Jones is Head of Sales for the HSBC Liquidity Business across EMEA and has been working in the treasury and banking industry since 1987. Prior to joining HSBC in 2004, he held treasury and cash management related sales positions at Bank of America and the former FleetBoston. Jones holds treasury and banking related qualifications with the Association of Corporate Treasurers (ACT), Associate of the Chartered Institute of Bankers (ACIB) and an honours degree in Economics. He is also a member of the Promotion and Investment Education Committee of the Institutional Money Market Fund Association (IMMFA).

There are a number of major changes taking place in the money markets that have been a consequence of the financial crisis in 2008. These changes are impacting all the major participants in the money markets from corporate treasurers and banks to money market funds (MMFs) and many others as well.

Ultra low interest rates

Ultra low interest rates have been a theme in the developed world money markets for a number of years now. This has had a consequence for investors who are earning a significantly lower return on their cash. “We have noticed a trend amongst investors to perform a major strategic review of their cash holdings and their investment strategy for this cash,” says Jonathan Curry, HSBC’s Global Chief Investment Officer – Liquidity.

The review has led corporates with surplus cash to consider strategic options such as increasing dividends, paying down debt, injecting cash into underfunded pension schemes. Many of those that have decided to invest their surplus cash have changed their investment procedures. Strategies used include increasing risk to earn a higher return, or investing in different asset types such as ‘repo’, segregated accounts and more.

These investors have decided to reallocate a proportion of their cash. They have adapted their investment strategy to take on more risk and investment in new asset classes. “However, we are not seeing a high degree of take-up in alternative products mainly because the majority of clients remain focused on security and liquidity as the key objectives of their investment policies,” explains Curry. “At the moment, the risk/return trade-off has not made sense, so they have stayed with MMFs and other lower risk investment options.”

With the market not expecting the European Central Bank (ECB) nor the Bank of England (BoE) to make any changes in short-term interest rates for the remainder of this year and well into next year, Curry expects “investors to continue strategically to look at options for their cash pools”.

What investment options are available to corporate treasurers in this low yield environment?

There are a number of different investment options available all of which have trade offs relative to each other.

Investment option Liquidity risk Credit risk Interest rate risk Return Watch out for!
Money market funds (MMFs) Lower Lower Lower Lower Funds masquerading as MMFs.
Enhanced cash funds Medium Higher Medium Higher AAA rated funds. Same day liquidity.
Segregated accounts Higher Investor driven Investor driven Investor driven
Repurchase agreements (sovereign) Maturity dependent Lower Lower Lower Documentation. Collateral liquidity. Operational.
Structured deposits eg HSBCs ‘ENA’ product Higher Medium Medium Medium Cost of early redemption.
Call accounts Lower Medium Lower Medium Unrated subsidiary. Regulatory change.

Risk remains

As noted, a number of structural changes are occurring in the money markets that are impacting all investors, whether they invest directly in the market themselves, or via a MMF or a segregated account managed by an asset manager. As a result of these changes, the industry faces new challenges.

“For example, we see a supply and demand imbalance for money market assets with shorter maturities,” says Curry. The supply of money markets assets is being reduced, primarily through changes in bank regulation that are negatively affecting banks’ incentives to issue short-term funding. This is increasing liquidity risk. It is also increasing risk through a reduction in diversification, as it is harder for investors to diversify to the degree they would like to.

On the demand side, investors have reduced the number of approved issuers. This is based on their changing perceptions of credit quality, which effectively begins to concentrate demand on a smaller number of issuers. In addition, investors, such as MMFs, now need to carry higher levels of liquidity post-crisis, reducing their demand for longer dated money market assets.

The supply and demand imbalance is creating challenges for MMF managers, as well as direct investors. It takes longer to invest on a day-to-day basis and it is harder to diversify as much as investors would like. As a result, the industry as a whole is more resource and research intensive than previously.

“We are also seeing governments putting new regulation in place in the financial services sector. Firstly to reduce the probability of another financial crisis and secondly to reduce the impact on the taxpayer if another crisis were to occur. The trend here is that in future regulation will allow debt as well as equity investors to take the risk of a bank failure. This development, plus an increase in collateralised lending by investors, has meant that if a default in the banking sector were to occur in the future the risk of being an unsecured debt investor is rising,” says Curry.

In addition, credit ratings agencies (CRAs) are regularly changing their ratings methodologies. This has led to the re-rating of banks and a significant portion of sovereign credit in developed markets over the past few years. This has effectively shrunk the universe of available credit for investors that use external ratings as part of their investment guidelines. Plus CRAs are now much more reactive to market developments, which adds risk to managing money market investments by increasing market volatility.

The increase in risk in the money markets emphasises the importance of credit analysis skills and access to credit resources beyond external CRAs. Analysis of equity valuations and credit default swap (CDS) levels are blunt tools, and without dedicated credit analysts there are not credible options available to investors. This is a difficult environment for resource-strapped investors, who may not have the credit expertise to reduce their dependency on CRAs without limiting the diversity of their portfolio. For example, investors in Europe or the UK – with insight into the credit risk profiles of domestic or regional banks – will concentrate their investments geographically if they don’t have the credit expertise to make informed decisions in outlying jurisdictions.

“One of the advantages of using external providers is that most, but not all, can look at credit profiles across geographies within the parameters set by a specific credit process. This will help to mitigate the supply and demand imbalance that is building up in the market,” argues Curry.

Changing supply and demand dynamics are impacting money market investors

The credit crisis has led to profound changes impacting supply to and demand from money market investors.

SUPPLY FACTORS – a reduction in supply of assets to investors
Reduced short dated issuance from banks Limited issuance from highly rated corporates Reduction in eligible issuers
New regulation requiring banks to extend duration of funding. Corporates have increased strategic cash holdings to reassure investors and respond to reduction in credit from banks. With continued rating downgrades below those typically required by money market investors, the pool of eligible issuers has fallen.
A shift away from wholesale funding.
Longer-term financing available from ECB via three-year LTRO.
Deleveraging by banks reducing their need for funding.
DEMAND FACTORS – A change in demand from investors
Money market investors restrict approved issuers Changes to MMF regulation and practices Increase in collateralised lending by money market investors
MMFs have reduced the number of approved issuers based on changing perceptions of credit quality concentrating demand on a smaller number of issuers. MMFs now carry higher levels of liquidity post the credit crisis reducing their demand for longer dated money market assets. Focus on government only collateral.

New regulations

Currently, regulators consider MMFs to be part of ‘shadow banking’ and are prone to runs. Therefore, MMFs require reform. The regulatory debate is intense in all jurisdictions – in the US, Europe and elsewhere. Despite extensive collaboration and lobbying, there appears to be a worrying lack of objectivity and understanding amongst regulators. However, the industry can take some solace in the knowledge that the new regulations will take some time to implement as the changes are likely to be material.

In Europe, for example, the European Commission (EC) released its MMF reform proposals on 4th September, which was postponed from an earlier target date of 26th July. The next step is for the EC proposals to be voted on by the European Parliament (EP) and the European Council, before being written into law (if they are approved). This will be followed by a transition period for providers, investors and others involved in the industry to make the necessary changes. Therefore, it will probably be mid-2015 or later before funds need to be compliant with the new regulation.

In the US, the Securities and Exchange Commission (SEC) has released a consultation document, requesting comments by 17th September, in order to incorporate these suggestions into its final proposals for reform. These proposals are likely to be released towards the end of 1H14, and implementation will then occur in 2016.

Obviously, all stakeholders in the industry will need to make a number of changes in order to become compliant. Today, there remains much uncertainty that needs to be resolved before investors and industry stakeholders have a clear picture as to the final reforms. We need to see collaboration continue between investors, regulators and politicians as we go through this process.

HSBC Global Asset Management has been focused on clarifying what reforms are needed to make MMFs even more resilient and which reforms will not deliver this objective. “We do believe that there are reforms that will benefit all stakeholders in the money fund industry,” says Nick Jones, Head of Sales, Liquidity, EMEA at HSBC, who goes on to say “ the stated aims of the regulators are to reduce systemic risk in the financial system by reducing the probability of runs occurring in MMFs. Anything that makes MMFs more resilient to risk, whilst remaining proportionate and allowing funds to continue to provide a valuable service to clients, are clearly an objective that HSBC Global Asset Management supports.”

For example, HSBC Global Asset Management would support a European regulation that stipulates a minimum liquidity requirement that MMFs should hold to give funds greater ability to meet redemptions, such as 10% in overnight and 30% in one-week paper. HSBC already follows its own stricter, internal policies in terms of how much liquidity their funds need to hold, and believe that this would be a sensible reform and improve a fund’s ability to provide same-day liquidity.

HSBC also supports the following reforms for MMFs:

  • ‘Know your client’ and client concentration policies.

  • Equality between shareholders should be strengthened by empowering MMFs to impose a liquidity fee on redeeming shareholders during periods of severe market stress.

  • Fund sponsors should not be able to support MMFs.

  • MMFs should not be rated.

However, other reform proposals that HSBC does not support include:

  • Capital/net asset value (NAV) buffers, which are ineffective in reducing run risk and brings into question the economics of MMFs.

  • Differentiation of risk between constant NAV (CNAV) and variable NAV (VNAV) funds, which is a ‘red herring’ not based on facts.

  • ‘Hold back’ mechanisms, which are ineffective in reducing run risk and operationally impractical.

  • Restrictions on the usage of amortised cost accounting.

Impact on corporate treasurers

It is clear that corporate treasurers are being adversely affected by reduced yields. In general, money market investors have focused on higher quality issuers as supply falls and demand increases. The new environment is a strain on already limited resources in the treasury department due to an increase in time required to perform the daily investment function, as building a diversified portfolio is more challenging and hence time-consuming. As explained previously, to maintain a diversified portfolio some investors may have to go beyond their current area of credit expertise.

“Corporate treasurers will also see an increase in risk in a number of ways: firstly, as banks borrow more through central banks and repo, unsecured lending becomes riskier because losses would be greater if a default were to occur; secondly, as a result of rating downgrades and increased volatility in the market,” explains Jones.

In addition, corporates may suffer from the fall-out if these new regulations remove an outsourcing option – in a worst-case scenario MMFs could be regulated away – and it is therefore important that they make their views known. Finally, it increases the probability of extreme market events, such as negative yields in core Eurozone Treasury bill and repo (with government collateral) markets.

Conclusion

Time will tell as to exactly what lengths the proposed reforms will go. But based on the direction regulators are heading, it is clear that there will be an impact on the industry as a whole, including corporate investors.

HSBC Global Asset Management will be assisting its clients in understanding the changes and their impact. “We also think it is very important that the voice of the investor is heard, particularly as we enter the political part of the process when the European politicians vote on the reform proposals. They need to understand the impact on corporates and what the reforms mean for the real economy,” says Jones.

Therefore, HSBC Global Asset Management has been actively encouraging corporate investors to get involved in the debate, either directly representing their own organisation or through a relevant industry association. It is important that their voice is heard to make sure that it is factored into any decisions that are ultimately made. “Without this input, it would be difficult to make a fully considered decision on what is appropriate for the industry as a whole,” says Jones.

In addition, understanding the consequences of reform is best practice on the part of the regulatory community and the politicians, to ensure that any reform is in the interest of investors in MMFs, who clearly value them as a cash management tool. But that tool needs to be available to them in a form that works for them.

Short-term investing – a checklist for corporate treasurers

Regularly review investment objectives and investment policies, for example:
  • Liquidity requirements – the cost of liquidity has increased.

  • Risk tolerance – risk levels in money market investing have been redefined by the credit crisis and Eurozone sovereign crisis.

  • Have a position on strategic questions such as whether risk free assets still exist, or whether a bank is indeed ‘too big to fail’.

Keep abreast of regulation (bank, MMF, etc) – it will continue to impact you:
  • Regulation is changing how money markets operate and it is necessary to respond.

Resource level required to meet the riskier, more resource-intensive world:
  • Review internal resource levels.

  • Review outsourcing options, if resources are constrained.

Ensure a dialogue with your asset manager:
  • How are they adapting their investment policies and processes to the changing markets?

  • What is the breadth and depth of their credit resources? How is this changing?

  • What are their views on regulatory change and the impacts on money market investors?

Make your views known:
  • If you have strong views on investment issues that will impact you, make them known directly or through your industry associations.

HSBC Global Asset Management

HSBC Global Asset Management is a leading asset management firm with assets totalling $428 billion1. Liquidity asset management is a core competency of HSBC Global Asset Management with over 20 years of experience advising, executing and managing liquidity strategies. This is evidenced by the fact we have $63 billion of liquidity asset under management, representing 15% of our total assets under management (AUM)1. We employ dedicated liquidity portfolio management investment professionals who focus on active risk management, utilising the extensive credit research expertise of more than 30 analysts who are responsible for covering both liquidity and fixed income. With our extensive global reach, HSBC Global Asset Management is able to offer liquidity products in a range of 11 currencies, applying our consistent investment process to emerging currencies where clients may not be familiar with the local marketplace.

  1. Data as at end of March 2013.