Does Counterparty Diversification Matter Anymore?
Diversification always has been, and always will be, a wise investment strategy. In the past, investors have diversified their risk by spreading investments across a number of instruments and asset classes. Today, a treasury/operations manager is faced with daily choices in their pursuit to manage return relative to risk. But risk comes in many forms aside from the obvious.
Diversification of channels can help mitigate ‘connection’ risk. Being cognizant of product, market and connection risk will be necessary to ensure proper navigation of an evolving liquidity management environment.
Today, due to low interest rates – currently at 0.25% in the US and 0.5% in the UK – yields are at an all-time low. Investors are looking primarily for a safe place for their deposits, which has resulted in increased investment in the historically perceived safe havens of US Treasury bills (T-bills) and US government-insured bank deposits in non-interest bearing (NIB) bank accounts.
Therefore, is diversification for the purpose of risk mitigation still necessary? And how will future interest rates and regulatory reform, such as Basel III, affect investment options and buying behaviour?
While the difficult economic environment has meant slow or reduced investment activity (e.g. in equipment) for many corporates, many businesses have seen their levels of excess liquidity rise. Companies have been moving their investments out of traditionally high-risk asset classes and into low-risk instruments. Many are also reducing or postponing investment in infrastructure. These factors, together with fear of a replay of the 2008 crisis, is leading to companies building up a buffer zone of cash to insulate themselves from market shock.
A chain of events in the second and third quarters of 2011 have also caused angst in the market. These events include:
Due to the uncertainty in the market, many corporates are holding onto cash rather than deploying it as they usually would in a normal market environment.
In this environment, companies want one thing: safety. Historically, there have been several investment options providing corporate investors with a safe haven for their cash deposits. US T-bills remain a popular safe haven despite the US downgrade in August 2011, although returns are close to zero.
A second option is bank deposits. Since the US government introduced government-insured bank deposits, they have represented both safety and value for corporate treasury customers.
Money market funds (MMFs) are a third option. Funds that invest in government-backed paper, such as T-bills, or government-issued paper, such as Fannie Mae or Freddie Mac, offer a secure, low-risk investment.
When the Federal Deposit Insurance Corporation (FDIC) reinstated the unlimited insurance on bank deposits on 31 December 2010, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, it created an attractive, secure investment for companies seeking a low-risk instrument for their excess liquidity. Since then, NIB bank deposits have become the product of choice for companies looking for a safe haven and value for their short-term cash deposits.
Government-insured NIB bank accounts, as their name suggests, do not pay interest on deposits and therefore, from a yield perspective as well as in terms of risk, there is little to differentiate them from a T-bill at the moment while interest rates and yields are low (around zero). However, US banks offer discounts on treasury management services at an average earnings credit rate (ECR) of 25-35 basis points (bps) of their bank deposits. So while corporate treasury clients are not earning a hard dollar return on their deposits, they earn a ‘soft dollar’ reduction in their treasury management fees.
In essence, the FDIC’s unlimited insurance on bank deposits has introduced a counterintuitive situation where treasury clients are receiving better value for their NIB cash balances compared to other bank deposit products, MMFs and other cash equivalents with arguably less risk. This enhanced value coupled with the unlimited FDIC insurance makes the risk/reward profile of a NIB deposit very attractive compared to other short-term investment alternatives. The value that the corporate client receives far exceeds most non-collateralised, non-government-backed cash equivalents.
After the FDIC introduced the unlimited insurance in the wake of the 2008 crisis, a period followed during 2009 when banks had the option of opting out of the unlimited insurance for bank deposits. At the end of 2010, the FDIC reinstated the guarantee and extended it to 31 December 2012.
Today MMFs are suffering from spread compression due to the low interest rate environment. They have been historically positioned as an alternative to bank deposits and perceived as being a safe investment choice. However, in 2008 confidence in these instruments dropped when one fund ‘broke the buck’ and gave clients a return of less than US$1.
So what has changed in the MMF industry since 2008? In 2010, the US Securities and Exchange Commission (SEC) passed a regulatory reform to rule 2a-7, which made MMFs an even less risky investment. Notable changes to SEC rule 2a-7 include reducing the allowance of Tier 2 assets in non-rated funds, lowering the weighted average maturity (WAM) of the funds from 90 days to 60 days (this is on par with rating agency requirements), as well as enhanced holdings reporting requirements. Funds that invest solely in government-backed paper provide a higher level of security.
The aim of the SEC’s reform was to rebuild confidence in the money markets – however, there is a debate on whether or not this has been achieved since the SEC continues to contemplate wholesale changes to the anatomy of MMFs such as introducing floating net asset value (NAV) in lieu of the traditional stable dollar NAV approach. MMFs will continue to provide risk mitigation in the form of counterparty diversification and through ratings agency monitoring from S&P and Moody’s.
However, the low interest rate environment, pending Basel III reform and floating rate NAV discussions will continue to put MMFs under pressure whereby industry consolidation of fund managers could be a likely future state for the industry. The large MMF families are likely to survive, but smaller funds that are not bank sponsored will be vulnerable to takeover bids.
While MMFs represent a secure investment option and diversification in the form of counterparty risk, further diversification is possible by having a broad set of channels to access the funds. This will help ensure that diversification and risk mitigation requirements are met under most circumstances. Investors should have the choice to invest by phone, through a portal or automatically via a sweep.
Ultimately, the choice of channel depends on the investor’s resources for managing short-term liquidity. Ideally a company should have access to both sweeps and portals, depending on their evolving needs. For example, if technical difficulties arise while using one investment channel, i.e. a portal, then the investor can use sweeps or direct access to ensure their cash is safely invested. Using a variety of access channels mitigates the risk of having uninvested cash balances.
Central banks have lowered interest rates in order to stimulate economic growth by making lending to businesses and individuals cheaper, but there has also been a strong regulatory response to the crisis of 2008 – namely the Dodd-Frank Act and Basel III.
Basel III, which will be phased in gradually from 2015, is broadly intended to do two things:
Basel III will ultimately change customer buying behaviour once financial institutions fully absorb the changes and respond accordingly. This response would be a result of downside impact on bank deposits (i.e. profitability). They will be classified by the liquidity coverage ratio (LCR) whereby banks will be required to put up collateral at the percentage points specified by the deposit classification ratio. The classifications are divided by corporate and FI, as well as by working capital and reserve cash. The classifications include:
The LCR is one of the most debated points of Basel III. One problem is that it doesn’t distinguish between non-banking FIs and banks – they come under the blanket term ‘FI’. The 100% collateral that banks will need to provide for FI deposits will in effect make FI deposits unprofitable for banks.
Basel III will have a measured impact on corporate bank deposits in the short term. While interest rates remain low, working capital cash will continue to be placed in instruments that provide safety and value, such as NIB accounts. However, long-term reserve cash deposits may struggle to find a home when faced with lower appetite from the banks and possible floating NAV from MMFs.
NIB bank accounts represent good value and security for investments in the current economic climate, while MMFs also provide ways of diversifying both working capital and reserve and strategic cash. But in a financial environment that lacks stability, there are many factors at play causing market fears and uncertainty. So, how will interest rates and the possibility of a worsening debt crisis on both sides of the Atlantic affect the short-term investing options and buying behaviour for corporates?
According to the US Federal Open Market Committee (FOMC), the US is going to be in a low interest rate environment for a prolonged period of time. Indications from the futures market (at the time this article was published) point to early 2014 for an expected rise in interest rates.
Compound that with continued concerns about the state of the US debt ceiling, the biggest being whether the US political parties will be able to compromise and reach agreement in future. Meanwhile, the broader euro debt crisis continues to introduce global uncertainty and concern over European sovereign and bank exposure.
All else being equal – if interest rates remain low and there are no further downgrades – we are likely to see a prolonged period of activity in NIB accounts and MMFs (the former in particular due to the ECR value).
With Basel III’s LCR, which will be enforced starting in 2015, banks will be more selective in the types of deposits to which they award value. They are likely to continue applying attractive ECR value to working capital deposits, but reserve cash – with its collateral requirement of 75% – may present less value for banks with a trickle down impact to customer deposits. Hence the customers’ choice in the future may be between safety with a relative low return or diversification in a MMF at the possible expense of principle (i.e. floating rate NAV).
Overall, depositors should continue to diversify investment risks and take advantage of instruments that provide value to their treasury business, while at the same time remaining vigilant of market developments that could alter the value they receive for working capital, reserve and strategic cash balances.