Technology Priorities For Corporates
Recent surveys show that the priority issues for corporate treasurers are access to liquidity, counterparty risk and risk management in general. Treasurers are increasingly turning to technology to help them see the bigger picture of their ecosystem of buyers, sellers, banks and other trading partners, and to provide transparency of information as part of a holistic approach to risk management. An essential tool in this effort to achieve effective risk and liquidity management is complete and up-to-date information.
As traditional sources of liquidity have become less reliable, maximising the use of available cash has become critical to the survival of some businesses.
The intrinsic value of a corporation is based upon its ability to drive free cash flow in a predictable fashion. Corporations today are challenged by manual processes, disparate systems and lack of workflow automation. This means the treasurer needs to look beyond traditional cash management and focus on increasing the working capital available to the business. In addition to reducing payment and transaction costs, cash, capital allocation, capital at risk and intraday liquidity need to be tracked so that companies can optimise, predict and protect their liquidity and thus help maximise the intrinsic value of a corporation.
By using automation, workflow, and connectivity that spans receivables management, treasury, risk, cash management and payments processing technology can increase the velocity of free cashflow and provide greater certainty of information to the treasurer on which to base investment decisions. It can also help foster connectivity through the ecosystem between suppliers, buyers, banks and other trading partners.
Reliable financial data that is accurate, consistent and accessible should be the bedrock of day-to-day treasury operations. But when data is inadequate or incorrect, the consequences are felt throughout the organisation.
In an increasingly competitive and global marketplace, corporations need dependable data to help improve productivity, reduce risk and exposure, and ease the compliance burden. Corporations are often challenged by inadequate information, making it difficult to capture the data needed to make sound business decisions. It is not unusual for a number of days to have passed after period close before all foreign exchange (FX) exposures are quantified, as it can take time to consolidate and drill down into the data, especially when it is held in disparate systems in a global company.
When we consider one-week versus one-day volatilities, a company can reduce its exposure to risk by as much as 90% with fast hedging decisions. This is impossible without an efficient method of consolidating and reporting exposures.
Key to making the correct hedging decision is transparency to the underlying risk data – exposures can often be hidden within consolidated balance sheet information for instance. Operating in a global economy makes FX exposure unavoidable. Exposures in overseas investments can often be rolled up and reported in the balance sheet of a foreign subsidiary. Attaining complete data and making timely decisions depends upon companies being able to achieve greater visibility to the exposure data within their business systems.
Effective use of technology is the only way a treasurer who manages global exposures can consolidate and analyse information quickly and accurately enough. Automating the exposure management process eliminates errors, creating opportunities for optimal cost savings and risk reduction. By interacting with enterprise resource planning (ERP) and accounting systems and other exposure data sources, treasurers and risk managers are able to accurately identify, quantify and manage exposures based on complete data, with minimal dependence on IT or finance.
Recent surveys have indicated that counterparty risk is now the priority issue for treasurers. While there appears to be little consensus on how to mitigate this risk, the following approaches are being adopted:
Once again, transparency of data is needed to understand the exposure. It is very important to understand concentration risk in the portfolio to avoid taking too much exposure to a particular industry or geography, for instance. Limits can be adjusted or investments taken off quickly if the exposure is transparent.
The consequences of poor and incomplete data can be serious. Faulty data can result in breaches of limits, and out-of-date prices can lead to incorrect revaluation of portfolios, and poor decision-making.
Treasurers have often set counterparty limits according to credit ratings. While this is a valid criterion, recent events have shown that institutions with good ratings can very quickly develop issues with liquidity and have problems repaying debt.
In addition to credit ratings, limit management should at a minimum take into account country and industry risk, as well as understanding the group structure and ownership of counterparties, to avoid doubling up on exposure.
As with any reporting tool, things to strive for are the ability to look at information in different ways and in real time. Many companies are considering greater use of derivatives to manage risk. This will introduce more complexity when measuring counterparty risk. While using a simple percentage of the nominal amount is valid as long as the limit is set appropriately and reviewed regularly, the ability to measure the market value of derivatives, particularly in these volatile times, is vital. This requires availability of up-to-date market data and appropriate systems that can value their positions. Also important is the ability to apply different limits to exposures depending on time to maturity and to automatically adjust these limits as the maturity date approaches and the level of risk changes. Once again, up-to-date market information enables accurate pre-trade limit checking and alerts of potential limit breaches prior to trade with the resulting reduction in operational risk.
Recent turbulent market events have revealed the limitation of opaque risk models that rely heavily on one measure without proper supporting testing (and stress-testing) of the results. Corporate treasurers are increasingly employing a ‘back-to-basics’ approach in setting risk policy that provides complete transparency of the risks and the interdependence of the parts – a holistic view. Treasurers also need to react quickly to changes in market conditions and adjust policy if necessary.
Enterprise risk management and a holistic view over asset classes (credit, interest rate, FX, commodity and equity) as well as over risk types (market, credit, operational and liquidity) needs to become accepted best practice. Let us now consider the building blocks of this holistic approach:
The first stage in understanding risk is to ensure that all positions are consolidated and reported in one instance. Any data that is maintained separately and not included in analysis may cause incorrect decisions to be made and can lead to unnecessary cost and risk.
Once the risk is quantified, the treasurer needs to be able to value and mark the exposure to market. When considering counterparty risk, this means adopting systems that can value the underlying risk as well as the instruments used to hedge these exposures.
If you can explain your P&L you can take measures to ensure that you have formulated the optimal hedging strategy. A basic understanding is key in formulating the right risk management policy. The ability to ‘slice and dice’ data in real time gives a deeper understanding of how the exposure is made up. For example we could look at the position in terms of business unit, currency pair, counterparty, or by dealer.
Up-to-date market values are crucial, but to fully understand how risk and the exposure are affected by market movements a forward looking approach is required. This means running various what-if scenarios that shift or tweak market rates and report how this affects the value of any open position and the P&L. For those using derivatives it is important to understand the convexity risk of options and how this is affected by movements in both spot exchange rates and volatilities.
To date VaR methodologies have played a large role in producing risk numbers. However, VaR models, whether using Monte Carlo or historical simulation, are not useful at predicting catastrophes. VaR also tends to provide metrics on ‘business as usual’ and cannot show the magnitude of potential downturn. That aside, VaR is probably the best single measure of risk in that it is enterprise-wide and covers all asset classes and remains a vital component of risk management reporting as part of a holistic approach.
The VaR approach that identifies the 5% worst-case scenario to a corporation’s risk does not account for events when historical correlation patterns break down. The only way to address such issues is to conduct stress tests. First, shift forward curves arbitrarily and see the resulting change in the net asset value (NAV). Second, simulate price movements to mimic a historical event like a hurricane or a stock market crash.
Conducting stress tests identifies the potential impact of a catastrophic event to the portfolio. This should be done with a view to identify a company’s liquidity needs in such a scenario. These scenarios should not be limited to what are considered ‘normal’ events.
In today’s volatile world, policy needs to be reviewed and updated constantly in response to events. Performance benchmarking against a ‘do-nothing’ or budget rate benchmark allows the treasurer effectively to manage risk and to monitor the effectiveness of the company’s hedging policy.
The need for effective technology in risk management is clear, especially in light of the increasingly strategic remit of the treasurer in recent years. The events of the ‘credit crunch’ have exacerbated this and the spotlight is very much shining in our direction. The treasurer is often one of the few individuals within an organisation that has a thorough understanding of enterprise risk and how the individual components of this, whether it be movements in exchange rates or corporate credit ratings, affect the risk profile, liquidity, and ultimately the value, of an organisation. Organisations are asking for more from their treasurers and, in turn, treasurers are asking for more from the technology they use.
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