Treasury Today Country Profiles in association with Citi

Market commentary

Snail climbing up a leaf

It would be fair to say that the current short-term investment environment for corporates is a challenging one, to say the least. Treasurers might have hoped that now, eight years on from the financial crisis, the times of regulatory disruption and market turmoil would be behind us. But the opposite is in fact the case. Today’s cash investors are facing an array of challenges – some new and some more familiar – that are forcing them to think differently about their cash investment priorities.

The post crisis world

The financial world changed considerably following the global financial crisis. At the heart of this change has been a comprehensive review of the regulatory landscape, led chiefly by the Financial Stability Board (FSB) and the Basel Committee on Banking Supervision (BCBS), to ensure another such crisis could not occur again. The result of this review was an unprecedented period of new banking and financial regulation that is still ongoing.

Aside from this regulatory upheaval (which we will explore in more depth later in this section) the post-crisis world is also defined by financial uncertainty and slowing growth around the world. Aside from a few bright spots – most notably emerging Asia – growth has stagnated. And this is despite the best efforts of governments around the world who have initiated quantitate easing (QE) programmes, and various other strategies, that have pumped liquidity into the market at record levels. Highlighting the still fragile state of global economy, the IMF recently downgraded its outlook for growth for a number of regions in early 2016.

According to the IMF, we are in a new era; one with few historical parallels: “Experts have been confounded since the financial crisis by trends that in some ways have defied economic history,” state the IMF. “Wages haven’t risen significantly in advanced economies even though unemployment has fallen. Inflation has remained dangerously subpar despite ultra-low borrowing rates engineered by major central banks. And those historically low loan rates have yet to encourage businesses to step up investment meaningfully.”

Cash on hand

In the face of rising economic and geopolitical uncertainty, corporates around the world have been increasing their holdings of cash. The 2015 S&P Global Corporate Capex Survey, for instance, revealed that globally companies are now holding some $4.4trn of cash and equivalents on the balance sheet.

This growth of cash on the balance sheet presents concerns around what to do with it all. Regulatory change has created significant challenges with respect to the way that treasurers invest surplus cash and manage their investment priorities and policies.

Chart 1: Global non-financial corporate cash holdings by region and cash/total assets
Chart 2: Consolidation in euro-area MMF industry

Source: S&P Capital IQ

The reason for this is twofold. Firstly, the deterioration in the credit quality of many banks post-crisis has led to a shrinking of the universe of financial institutions that fit within the parameters set out by many corporate investment policies.

However, even when a corporate’s policy allows them to invest cash with a bank certain types of deposits may no longer be welcomed by that bank. The banks are increasingly seen to be encouraging investors to move deposits off their balance sheets, a move driven by the demands of Basel III. Under the Liquidity Coverage Ratio (LCR), introduced as part of the Basel III regime, the value of different types of cash to the banks has changed. Operational deposits (general working capital and cash held by depositors for transactional purposes) is still welcomed by banks, non-operational deposits (which include other cash balances not immediately required by the corporate), have been assigned a higher run-off rate. This is due to such balances being viewed as less stable and there more requiring more capital to be set against them under the new rules – making them a far less attractive prospect for banks to take on to their balances sheets.

As a result of these regulatory changes, investing cash with banks has become more challenging, and often more costly. But despite this, banks remain key to corporate short-term investment activities. Indeed, in some regions the banks appear to become even more integral. The 2016 Association of Financial Professionals (AFP) Liquidity Survey shows that US corporates are now investing 55% of their short-term investment portfolio in bank deposits, and only 17% in money market funds (MMFs). Before the 2008 crisis, these numbers were approximately the reverse.

Regulatory upheaval

So why, with bank deposits apparently becoming a less desirable or in some cases achievable investment option for corporates, is the instrument actually becoming more popular? In the US this might be accounted for by the fact that corporate treasurers are now feeling a little more confident about the health of their banking partners, which amid a new regime of annual “stress tests” coordinated by the Federal Reserve, are now said to be the strongest they have been in decades.

However, another factor may also be at play, namely the changing regulatory environment around the money fund industry and the capital markets. Although MMFs did not play a causal role in the financial crisis, the industry’s systemic importance together with its perceived vulnerabilities in times of severe market stress have led to regulatory initiatives on both sides of the Atlantic. And the challenge for treasurers presented by these proposals is that they altogether threatened the existence of one of their preferred short-term investment vehicles: the constant net asset value (CNAV) MMF.

The US: setting the standard

In the aftermath of the 2007/2008 global financial crisis, the Securities and Exchange Commission (SEC) in the US tabled a series of regulatory changes as a means of bringing more resilience to the market, reducing the interest rate, credit and liquidity risks of portfolios. More was to come. In 2013, an SEC committee voted unanimously in favour of proposing further measures to reform the way that MMFs operate under its guiding Rule 2a-7 of the Investment Company Act of 1940.

MMFs are deeply interconnected with the money market as a whole and with the banking sector. Any disorderly failure might cause broader consequences, therefore, such as contagion to the real economy and bail-out risks for their sponsor and, ultimately, public authorities.

The key valuation figure of a MMF is its net asset value (NAV) which is the market value of the fund’s assets. The main change proposed was for the imposition of a floating or variable net asset value (VNAV) for prime institutional MMFs (where the NAV can fluctuate). For prime funds, the incumbent CNAV model (where NAV is targeted at a constant or near constant $1/£1/€1 per share) can only be continued by limiting asset purchases to government securities.

In normal circumstances, to avoid a fluctuating share value, a CNAV MMF uses amortised costs to value its assets. The buffer was deemed necessary to offset the possibility of the CNAV dropping below $1 – known as ‘breaking the buck’ – the fear being that a major MMF might not be able to maintain the promise of immediate redemptions (liquidity) and preservation of value (stability) leading to market panic and a rush to withdraw funds (a ‘run’), bringing the whole system to its knees. That has happened just a few times in the history of the MMF. A floating valuation would not allow this to happen simply because value is expected to move, regulators have argued.

The other proposals include allowing funds to charge liquidity fees and impose redemption gates in times of stress to try and prevent a run. These rules could either be used alone or together and would effectively make investors think twice before withdrawing their money too quickly because it would cost them to do so or prevent them from doing so all at once. In July 2014, these requirements were formalised by the SEC, subject to a two-year notice period before implementation.

In April 2016, the first range of changes came into effect, with US prime funds reporting a range of new information on their websites. This information includes daily and weekly disclosures of market based NAVs, net shareholder flows and the occurrence of sponsor support. This information is significant for treasurers as it may help them to improve risk assessments.

In October 2016, the final set of SEC reforms were implemented. Now all prime funds are required to publish NAV’s based on the current value of the assets they hold, allowing the funds to fluctuate with market conditions, rather than preserving the value of its investments at $1 a share. In addition, if the percentage of a fund’s assets can be liquidated within one week fall below 30% its managers will be permitted to impose a 2% fee on redemptions, and a 1% fee if that metric falls below 10%. Redemptions can also be prevented completely for up to ten days if weekly assets fall below the 30% threshold.

The Corporate View

Auna Dunlevy, Head of Front Office
at Royal Mail

Sensing the direction likely to be taken by EU lawmakers, some treasurers have concluded that it would be better to become accustomed to alternatives to CNAV MMFs now, before the coming regulation forces their hands.

“Perhaps the thing we spent longest thinking about is CNAV MMFs,” Dunlevy told the Association of Corporate Treasurers conference in 2015. Unlike some of its corporate peers, Royal Mail’s board policy already covered VNAV funds. But treasury, being very comfortable with the CNAV funds they had used since the early 2000s, had always shied away from VNAV products. As the policy direction at the European-level became apparent, however, the department decided it was time to revisit the products.

The way they approached this task should serve as a useful best practice guide for other treasurers, many of whom are likely to have similar decisions to make in the coming years. “We looked at the volatility of VNAV and also the underlying volatility of CNAV funds,” she explains. “We considered the duration of which we could invest our funds. Then we considered some historical examples and, of course, checked out the accounting and spoke to some other corporates before we made the decision to invest.”

Many treasurers who, like Dunlevy, have gone through this process, have been pleasantly surprised by the muted volatility and general stability of the funds (Aviva Investors, which converted its daily sterling liquidity fund to VNAV seven years ago told Treasury Today in May 2015 that since its inception the valuation has never moved away from one). But a careful approach is nevertheless advisable, as it would be for any new instruments, and at Royal Mail investment limits are, for the time, at a lower level than for a corresponding CNAV fund.

Europe: an industry in transition

Meanwhile, across the Atlantic, the various policymaking bodies of the EU have been discussing their own regulatory changes for some time, following on from recommendations formulated by the Financial Stability Board (FSB) and the European Systemic Risk Board (ESRB). After several years, negotiations now appear to be drawing closer to a conclusion.

The European Parliament and the European Council of Ministers have each now contributed their own versions of the regulatory proposals. Under the latter, CNAV MMFs are granted a two-year switch-over period to lower risk public debt instruments, or conversion into a VNAV fund. CNAVs could also convert into a newly created hybrid money market fund known as low volatility net asset value (LVNAV) MMF.

According to Reuters, the European Parliament, which has joint say with EU states on the draft law, wants CNAVs to convert once the rule comes into force, with LVNAVs losing authorisation within five years under a so-called sunset clause, unless further action is taken. But under the Dutch EU Presidency compromise, CNAVs would have two years to make the changes, and LVNAV authorisations would not automatically lapse after five. Instead, there would be a review of the rules to see how they affect markets and investors before any further changes.

With no action to take as yet, many providers are adopting a ‘business as usual approach’ but obviously keeping a watching brief on any developments. Most funds in the UK for example are CNAV and an enforced switch to VNAV will see fund managers reassess their operations. There is anecdotal evidence of a likely withdrawal from the market altogether by some fund managers – and indeed some investors – if the decision is not considered to be in their interests.

Industry consolidation

Asset managers in both the US and Europe have made it clear over recent years that they have concerns about the direction of regulation around MMFs. However, while all asset managers are challenged, some providers face bigger challenges than others.

Amid all the aforementioined regulatory disruption, the MMF industry appears to be consolidating, with smaller asset managers being bought up by larger providers (chart 2 highlights the consolidation of MMFs in the euro area). Blackrock’s acquisition late in 2015 of Bank of America Merrill Lynch’s MMF is but the latest example of this trend. Over recent years we have also seen Federated Investors agree to acquire $1.1bn in assets from Huntington Asset Advisors, Aberdeen Asset Management purchase Scottish Widows Investment Partnership (SWIP) from Lloyds and RBS selling its MMF business to Goldman Sachs.

Chart 2: Consolidation in euro-area MMF industry
Chart 2: Consolidation in euro-area MMF industry

Sources: BoE, ECB, Deutsche Bank Research

“Industry consolidation is particularly acute in the US,” says Vanessa Robert, Vice President, Senior Credit Officer at Moody’s Investor Service. “Regulation is a key factor,” Robert says. “It is weighing heavily on the already challenging landscape for money funds and it might accelerate this trend. The ability for mid-tier sponsors to thrive has been materially reduced.”

The trend has both positive and negative consequences for corporate investors. Larger asset managers naturally have more resources to tap during stress periods and so are sometimes perceived to be more stable. On the other hand, however, industry consolidation means that assets are inevitably more concentrated and, in the event of another crisis, that could create more mark-to-market NAV volatility.

Dealing with negative rates

The confluence of a sluggish global economic recovery and regulatory pressures on banks and MMFs is exacerbated by another pressure on corporate investors and the fund managers investing on their behalf.

In recent years, unconventional monetary policies pursued by the Federal Reserve and European Central Bank (ECB) have pushed down yields on the short-term debt instruments that MMFs purchase, making it increasingly difficult for fund managers to generate positive returns for their investors. With no directional change in policy at the ECB appearing to be on the cards in the near future, credit ratings agency Fitch says, in its 2016 MMF Outlook, that it expects yields on euro-denominated MMFs to remain in negative territory throughout the course of 2016 (in contrast to its outlook for sterling and dollar MMFs, which it says may see “yields picking up timidly”).

The risk of large redemptions by corporate treasurers unwilling to pay a fund to hold their liquidity would appear to be minimal though. Indicative perhaps of the dearth of good short-term investment alternatives out there at the moment, outflows from MMFs not only stopped in Q315, they actually began to reverse despite the average euro MMF gross yield remaining at a negative 0.06%.

“I think that shows that corporate treasurers are, however reluctantly, now accepting negative yields on euro MMFs,” says Alastair Sewell, Senior Director at Fitch Ratings’ Fund and Asset Manager Rating Group. “We think that is a very material development.”

On the investor side, some corporate policies may have to change. Corporate treasurers are already becoming more active in their forecasting and the segmenting of their cash. As a consequence of this, Fitch expects to see the European market for short-term investment products for treasurers grow significantly. “We are certainly aware of various fund providers having approached us with ideas for new funds targeting yield hungry corporate treasurers, who wish to generate a little bit of incremental return but at the expense of selectively taking more risk.”

Improved accuracy in the forecasting of cash requirements would enable balances to be spread further along the yield curve. Generally, banks’ appetite for deposit maturities is greater beyond three months and their ability to bid competitively for cash improves dramatically where they are able to avoid liquidity buffer charges (eg for balances that are inaccessible within 30 days, such as notice accounts). This applies equally to direct investment and to indirect investment through suitably-rated short term funds along the lines of those offered by the money fund providers.

Naturally, any decision to extend maturities of liquidity investments whether directly or indirectly implies a need to consider the additional credit and market risk that would be part of a longer duration investment.

For most treasurers, a change to liquidity investment practices would require an overhaul of treasury policy since it would need the business entities to refine their planning of cash requirements and, implicitly, accept the risk that cash will be tighter internally. Ideally, forecasting of cash requirements would be daily for the next three months. Where, however, this is impracticable, bucketing of cash maturities might readily be based upon the models used by regulators in the reporting of banks’ own liquidity positions. The maturity buckets could, for instance, be: sight; next day; one week; two weeks; one month; three months. Recognising that planning can never be an exact science, forecasts would necessarily contain an element of contingency which, when taken together with short-term requirements would dictate the quantum of cash that might be directed to money fund investment with the balance allocated to longer-term investments.

Outlook

Amid an economic outlook that remains very uncertain treasurers are likely to remain challenged by the combination of the necessity for large cash balances and a low to negative yield environment.

Treasurers should feel encouraged, however, that new regulatory environment for MMFs is now taking shape in the US and that Europe appears to be not too far behind. In light of the ratings and regulatory pressures baring down on the banks as well as the negative interest rate environment, treasurers may find they need to rethink their short-term investment policies in the near future. However, while better cash forecasting and segmentation may allow some liquidity to be allocated to less traditional products and instruments (see Section 2), both bank deposits and MMFs should remain the treasurer’s principle mechanisms for the deployment of liquidity.

Reader Comments 

Please login or register to submit your own comment