When buy-side FX trading platforms were launched four to five years ago, they were given only a qualified welcome by treasurers. “We will not implement standalone platforms,” was the almost unanimous chorus. The underlying message being that there was little value in automating front-office dealing operations if much-vaunted STP savings fizzled out into a paper trail in the back office. Automation was, of course, nothing new to corporate dealing rooms, but it really only took off when improvements in systems connectivity allowed transaction data to flow across the entire trade life cycle. Although many corporates now boast impressive STP rates, the scramble to standardise and document procedures in preparation for IFRS (international financial reporting standards) and the Sarbanes-Oxley Act (SOX) has found many treasuries’ risk management processes lacking – and sophisticated instruments remain unsupported by many of today’s technologies.
Pressures for Change
More than this, high STP rates in the treasury are of limited use in isolation. Even a fully automated treasury cannot be truly effective if it is starved of cash flow information from the business units. Effective risk management decision-making is hamstrung by incomplete, inaccurate or out of date information from business units. Similar to the argument made by treasurers in 2000, piecemeal progress is not enough. This article looks at how higher levels of automation and control can be attained much earlier in the risk management process and argues that only a fully integrated approach to automating cash flow information will yield the returns to justify the investment. It also proposes that trends in regulation, internal pressures and use of technology are leading to a greater centralisation of risk management. The key pressures for change in risk management fall into three broad categories:
1) Internal Pressures: Broader Responsibility
The pressures on the treasurer to perform are evolving. Few treasuries are profit centres in the traditional sense, but the services they supply to subsidiaries and the CFO are expected to realize tangible financial benefits. How this is measured varies from company to company. For some time, the treasurer has been encouraged to apply his risk management skills to a broader canvas of corporate activities, such as insurance and pension funds. Also, corporate governance pressures from the board are creating new demands on the treasurer to bring risk management activities under greater central control. Recent requests for proposals (RFPs) already reflect the extent to which treasurers are expected to coordinate with business units as part of the risk management process. The global display of aggregated FX and interest rate positions (but maintained locally), integrated measurement of counterparty default risk and integration with accounting systems are among the most common requirements of both clients and prospects.
The most obvious extension of the treasurer’s risk management remit may be the closest to home. The treasurer’s growing influence over cash flow management at subsidiary level, for example, is a natural development. After all, the treasury exists in essence to deal with the implications of the often random cash flows thrown up by the business. If the treasurer can stem these risks at an earlier stage, the costs of offsetting these risks should be minimised.
2) Regulation: Double Trouble
SOX has been characterised as a box-ticking exercise that simply obliges firms to follow good practice in documenting their processes more clearly, while IAS 39 is said to work against existing best practice in FX and interest rate hedging. Neither assumption is completely true, but the underlying question is whether the compliance effort can be used to reinforce best practice and take treasury efficiency to new levels. Sarbanes-Oxley had begun to lead towards more documentation and standardization of risk management processes, but not necessarily automation. In the rush to audit and sign off existing financial processes, many firms have not looked to modify their approach beyond the minimum required to satisfy their auditors’ interpretation of SOX compliance.
Elsewhere – especially those non-US firms given a stay of execution until 2006 – companies have taken the time to create a one-time fix by automating and consolidating information flows, where once manual input was considered satisfactory. IFRS has had a similarly mixed impact. Many companies, but not all, have regarded the shift to fair value reporting as a call to re-examine risk management processes more closely. The use of more simple hedging transactions to guarantee hedging accounting treatment is often accompanied by a reassessment of the data on which transactions are based. This may mean ensuring cash flow data can stream into market-facing systems without manual intervention or overhauling processes and systems to accelerate transfer of data from the business unit to the treasurer, thus aiding earlier identification of FX exposures.
3) Technology: Toward Greater Integration
Many treasurers that have pursued automation of traditional risk management processes, i.e. through using online trading systems and creating seamless links for confirmation and reconciliations, are now looking at earlier identification of exposures at subsidiary level via more accurate cash flow forecasts delivered to the treasury by standardized web-based reporting tools. But at present many problems remain, often stemming from organizational bottlenecks and lack of systems integration. If a cash position is held in one system and FX hedging transaction in another, mistakes – such as hedging the wrong amount or the wrong currency – are simply more likely. The implications of this operational risk are substantial, but are often ignored, despite the availability of single platform solutions.
As interoperability increases, through initiatives such as XML-based message format standards and service orientated architecture, the industry is removing barriers to the free flow of data. But the first steps are already well advanced as corporates replace multiple systems: witness the prevalence of treasury management systems to support company-wide in-house banking structures. Inside and outside the treasury, the increased levels of visibility and control that can be secured through use of fewer and better integrated systems are a force for centralization of risk management.
Broadening the Treasurer’s Remit
Given the forces for greater centralisation and coordination of risk management discussed above, possibly the greatest impact the treasurer can have is by automating risk management processes outside the treasury. In its role as a support function to the operating units, treasury first offered advice on local banking relationships then increased its influence by channelling more business to partner banks or consolidating requirements internally via an in-house bank. This influence can now be pushed still further. By lending new impetus to cash flow forecasting processes – spurred by very real regulatory compliance concerns – the treasury can again reduce local business unit costs and improve risk management efficiency within the treasury.
Most firms’ financial planning systems are a patchwork of different technologies that have spread haphazardly as the company has grown. A lack of strategy has sent many a treasurer or local finance manager on a wild data chase. Accounts payable information might be held in the sales forecast or any number of other reports with no clear process for data validation or integration. Regulatory compliance can help secure the budget to address this issue, but only if the treasurer makes a cast iron case. A treasurer who does not use the current regulatory infrastructure to secure investment that can drive through change will have missed a unique opportunity to create an infrastructure that supports improved cash flow forecasting and risk management. Advocacy skills are not normally considered a key part of the treasurers’ armoury but the ability to convince the CFO of the tangible improvements to treasury management of regulatory compliance could be fundamental to his ability to add bottom-line value. Moreover, it also raises the treasury’s profile at board level, giving the department a platform to demonstrate its ability to foster best practice and drive efficiencies across the organization.
Hurdling the Barriers
Every treasurer knows the value of cash flow forecasting in terms of modelling cash movements within a company, predicting how income will cover actual costs, and detecting liquidity and risk problems at an early stage. They also know the frustrations of trying to compile accurate and timely cash flow information from colleagues in other units that do not appreciate the benefits and keep the necessary information in a myriad of different systems and spreadsheets. Some figures, such as investment projections used in long-term forecasts, will always be anomalous. And exploration or extraction firms, for example, are faced with predicting prices in the commodities market months ahead. Of course some factors will always be too unpredictable to be included in forecasts, but that cannot be used as an excuse when it is now possible to calculate so many of the variables. The risk management benefits of improved cash flow forecasting will vary from corporate to corporate, but it is hard to escape the logic that outputs improve in line with the quality of inputs. The price you pay in the FX market will differ if you only deal the currency when you actually need to (i.e. spot) compared to if you deal forward. But accurate cash flow forecasts across time horizons also enable you to choose between dealing when you receive an invoice and predicting payables in a specific currency six months in advance. Depending on the range of instruments you are able to deal in, improved cash flow forecasting gives you considerably better hedging options. By pinning down as many factors as possible, the treasurer can at least narrow the field of possible outcomes he will have to manage at a later stage in the financial markets.
In addition, poor short-term liquidity management is probably the biggest credit risk to even the largest corporate. As the kings of cash, treasurers have always focused on short-term forecasts, for example to tell them when to dip into the commercial paper market to avoid a shortfall. But now not only must short-term forecasts be used to good effect, they must be seen to be used. One of the aims of SOX is to improve the quality of information in the market. Under SOX, ratings agencies will be scrutinising the Section 404 ‘internal financial operations’ returns of corporates for evidence of robust forecasting processes as part of their ratings assessments. It is no coincidence that cash flow forecasting is typically performed with far more zeal in the US, where a higher percentage of funding is secured through the capital markets, than Europe. As capital markets increasingly replace traditional lenders in Europe, robust and transparent cash flow forecasting will become an ever more important tool for managing firms’ own credit risk.
Silver and Gold
Most treasurers will find it disconcerting that economically sound hedges are being abandoned in the face of hedge accounting. Some may argue that they have only so many ‘silver bullets’ and must pick the battles they can win given the resources at their disposal. Perhaps, the recent regulatory onslaught is, however, a golden opportunity to bed down – once and for all – some of the basic processes whose imperfections have bedeviled the treasury in the past. A number of firms have already ridden out the IAS 39 wave and are already looking for new frontiers in risk management. The improvement in exotics and structured products functionality by some TMS vendors and the creation of direct CLS links by FXall to facilitate automated settlement is giving the treasurer options to cut out manual processes still further.
Much remains to be done before the treasury can say that it has fully automated its risk management activities. But options for integrating closer with the banking infrastructure and customers – or pursuing more cutting-edge hedging techniques – are available, if only to those that have first invested in the supporting infrastructure.