Managing liquidity in today’s environment of extremely low interest rates remains challenging – accentuated by the impact of the COVID-19 pandemic and effects of regulatory considerations. As a result, cash can be a complicated and unrewarding asset for investors to hold.
This article is a preview of Northern Trust's whitepaper providing insights into the evolving cash management environment and impact of the pandemic, as well as ideas and potential solutions for building liquidity through current market conditions.
Balancing Risk and Reward in a Challenging Landscape
For institutions, holding cash has been problematic for years. Published in 2017, our whitepaper, Cash: An Asset in Adolescence described holding cash as akin to having a rebellious teenager in the house: it costs you more, becomes increasingly challenging – and offers you little in return.
All that remains true since the paper was published – but in many ways, the situation has deteriorated. Many countries’ interest rates are lower than back in 2017, while the impact of the COVID-19 pandemic on market conditions have all increased the challenges of holding cash. Today, cash remains a still rebellious adolescent, but one with still higher costs – and that is likely costing many institutions even more money than before.
The good news is that there are steps that institutional investors and their asset managers can take to keep this rebellious asset class in check.
By adopting a cash segmentation strategy, investors can work towards striking a better balance between risk and reward in their portfolios. And by taking a holistic approach to cash, they may be able to enhance returns without exposing themselves to inappropriate levels of risk.
The evolving cash environment
The COVID-19 pandemic has had a devastating effect on people, markets, and economies. This uncertainty has impacted on institutions’ available liquidity and cash management. The global pandemic resulted in the most severe global economic contraction since at least the 1930s[1], and at time of writing no consensus exists on how long and sustainable a recovery will be.
Against this backdrop, slower economic growth, low inflation, and low interest rates are all bringing challenges. The outlook for interest rates is that they will remain lower for longer. The European Central Bank (ECB) began its negative interest rate policy in June 2014[2], and post-COVID-19, many countries’ interest rates are at zero or hovering near it.
Holding cash: a zero-sum game
The fact that interest rates are expected to remain low for the foreseeable future has significant implications for cash management. Lower and negative interest rates mean that holding cash is a zero-sum game.
In a low interest rate environment, and especially in a negative interest rate environment, cash management is critical. Looking at the euro’s short-term rates (€STR) shows this; in September 2020, the cost of overnight lending operations between European banks dropped to the lowest since the €STR came into effect in October 2019.
Recent declines in borrowing costs are a result of the European Central Bank’s (ECB) monetary stimulus programme and show that banks are offering to pay rivals to take money off their hands in the short-term[3]. Institutions currently hold about €2.9 trillion more than they must for reserve requirements – a phenomenon known as excess liquidity[4].
Cash either provides value, or it detracts from it. The latter situation, referred to as ‘cash drag’, means asset owners need to ensure that 100% of their assets are return seeking.
Cash: the great migration
Cash should always play a key part in any liquidity strategy. In March 2020, at the height of the pandemic, taxable bond funds in the United States (US) suffered record outflows of US$240 billion (bn), ending 14 consecutive months of inflows, in which taxable-bond funds collected US$479bn[1]. In contrast, money market funds (MMFs) gathered a record US$685bn in inflows during the month. For the quarter, these funds saw US$694bn of inflows, a 19% organic growth rate[2].
It was a similar story in the United Kingdom (UK), with investors needing more liquidity. In August, 32% of UK retail investors said they planned on moving their assets to cash over their next 12 months[3].
Institutional investor responses
Institutional investors are focused on building up liquidity to avoid becoming forced sellers just to free up cash. Incomes have declined since the pandemic hit, with slashed dividends and decreased fund distributions from private markets.
Pension schemes must be able to settle losses from foreign exchange risk hedging to fund margin calls, and meet capital calls from private markets[1]. These requirements show why it is important to have a robust liquidity strategy in place.
Steps for building liquidity
As a first step to managing these issues effectively, it has always been important for investors to understand their sources of liquidity, from both a provider and market perspective. In the past, institutional investors have turned to a variety of places to build liquidity.
They have used the repo markets for this because of their attractive yields compared to many other asset classes on a risk-adjusted basis, and because of a minimum price volatility compared to other asset classes[1].
However, as market conditions evolve, this source of liquidity may be unreliable. For example, the repo market came under stress in 2019, as demands for funds to settle Treasury purchases and pay corporate taxes overwhelmed the amount of loans readily available[2].
Towards a holistic approach to liquidity management
The good news is that there are many steps that can be taken to address liquidity management issues. One of the foremost ways in which institutional investors can get on the front foot is to forecast their cash requirements to ensure they have a supply of cash at hand to settle obligations.
In practice, this involves maintaining a ‘liquidity ladder’ to forecast needs and matching it with known cash flows. As part of this, investors should think about the performance they need to achieve, and how yield and duration could impact it.
Duration, measured in years and non-linear, looks at how sensitive a bond price is to interest rate changes. In many circumstances, three months is probably not far out enough to drive the extra duration and, therefore, the yield that is likely required to help meet liquidity plans. Those who put in place long-term liquidity forecasting at least a year before they need it will be in a much stronger position.
Maintaining a liquidity ladder means adopting a cash segmentation strategy. The segmentation of cash allows investors to put a framework in place to work towards achieving a better balance between risk and reward in their use of cash.
Segmenting cash into three ‘buckets’ of operational, reserve, and strategic requirements also allows investors to consider investments further along the maturity spectrum, seeking higher yields and longer maturities beyond cash or money market funds[1].
By doing this, investors can move beyond cash and money market products into conservative ultra-short, and ultra-short strategies to enhance their high quality, short-duration exposure, without taking on inappropriate levels of risk.
This is a snippet of Northern Trust’s whitepaper, Cash: An Asset Still in Adolescence. To read the full whitepaper, use this link to download it.
[1] Northern Trust: Sterling Conservative Ultra-Short Strategy: A Holistic Approach to Cash Management
[2] PIMCO: Repos: A Fresh Look at a Key Driver of Short-Term Returns, 6 May 2019
[3] Reuters: Repo is Wall Street’s Big Year End Worry. Why? December 2019
[1] Pensions & Investments: After Extinguishing Fires, Asset Owners Turning to Liquidity, 18 May 2020
[4] Morningstar: Morningstar Reports US Mutual Fund and ETF Fund Flows for March 2020, 15 April 2020
[5] Ibid
[6] Wealth Adviser: UK Investors Look to Cash Savings to Minimise Risk Exposure, 25 August 2020
[7] The Wall Street Journal: Oversupply of Easy Money Sends European Borrowing Rates to Record Low, 3 September 2020
[8] Ibid
[9] Financial Times: Pandemic Crisis: Global Economics Recovery Tracker, 9 September 2020
[10] European Central Bank: Negative Interest Rates and the Transmission of Monetary Policy, March 2020