Cash is trash, the investment gurus have always told us, a maxim that reflects the widely-held view that cash should have a very limited part to play in any serious asset allocation strategy. Until recently, cash was seen as a relatively unimportant asset class, ranking well behind equities and bonds but, in the current environment of stock market uncertainty and declining equity values, institutional investors are now looking very closely at how to improve returns and maximise cash-handling efficiencies.
Not surprisingly, these investors are turning to their custodians for support. With such vast flows of trade-related cash flowing through their systems each day, custodian banks are uniquely positioned to offer global cash management services.
Historically, custodians have provided interest-bearing current accounts (IBCAs) in a range of currencies, as well as cross-border money transfer facilities and some form on online connection for reporting and transaction initiation. But today’s global investor demands much more than a standard international banking service, and custodians have responded with enhanced product capabilities.
In Europe, the impetus for change has also been driven by the arrival of the euro. The euro has given corporate money managers the opportunity to consolidate what were previously small individual balances into a much more significant pool. This has proved to be especially important against the background of consolidation of banking providers in Europe.
As banks merge, they look to shrink their balance sheets and therefore
offer less competitive rates for time deposits. This means that investors have to look elsewhere for better returns on their cash.
Cash pooling is particularly useful for institutional investors operating a number of accounts with the same custodian. Pooling involves the nominal, or actual, aggregation of all the client’s individual account balances to arrive at a net credit or debit position for the day. This means that any overdrawn accounts can be offset by surplus balances elsewhere, even if the accounts are denominated in different currencies, thus avoiding interest charges.
Another significant advantage of pooling is that banks often pay credit interest on a tiered basis – the bigger the balance, the better the rate. Concentrating individual balances therefore leads to higher rates of return.
Whilst pooling primarily helps to avoid overdraft charges, cash sweeps are a more proactive method of improving returns on cash. With a sweep, the custodian automatically moves credit balances into specially designed cash investment vehicles, known as short-term investment funds (STIFs) or liquidity funds. Major global custodians offer a range of these funds, for major currencies such as US dollars, sterling and the euro, providing investors with an alternative to time deposits and repurchase agreements.
The custodian’s role in the cash
management process actually begins with the processing of securities trades. For more than a decade, the leading custodians have been offering a
service known as contractual settlement date accounting (CSDA),
specifically to assist investors with cashflow management.
With CSDA, the custodian undertakes to settle the cash side of a bargain on the contractual settlement date, regardless of whether the trade actually settles in the market, subject to certain pre-conditions such as adherence to cut-off times. CSDA offers investors the certainty of cash flow forecasting, by guaranteeing a date on which cash entries will pass across their account. Investors can then book foreign exchange and money market deals against those anticipated movements, without the uncertainty that actual cash settlement brings.
However, CSDA is not applicable to all types of investor: pension funds with static holdings that are rarely sold, for example, will find little benefit in CSDA on purchase transactions, as they would effectively be paying for stock whether they received it on the contractual settlement date or not. The decision on whether CSDA or actual settlement date accounting (ASDA) is more appropriate depends largely on the degree of active cash management that is undertaken by the investor.
Custodians have also developed services to overcome some of the problems associated with collecting foreign income. No two markets operate identically in the payment and processing of dividends, and investors often find it difficult to make accurate forecasts of the cashflows that these payments will generate. Foreign currency dividends will give rise to an exchange rate exposure, and uncertainty over the precise timing of receipt means that it is impossible to book forward foreign contracts which exactly match the payment date of the income.
To obviate some of these issues, many custodians offer contractual income policies, where they undertake to pay income on a mutually agreed date close to, or on, the payable date. Certain funds, particularly those linked to an index, rely heavily on this because the index performance calculation assumes full income reinvestment on the payable date. Delays in income processing can therefore lead to tracking errors. Contractual income alleviates the problem.
The security of a contractual policy also allows investors to book foreign exchange deals for overseas income in advance: going one step further, some custodians offer a policy that will automatically pay income in any currency, removing the need for such deals. This also allows clients to hold a single account for income, rather than multicurrency accounts that may increase the cost of administration.
One of the most important functions of the custodian is to provide market liquidity to assist the settlement process. By extending short-term credit lines to clients, custodians are funding exposures that might otherwise result in failed trades. For buyers of securities, who need to position cash to fund their purchases, the custodian may offer credit facilities to cover shortfalls in available funds.
These may be on an overnight basis, simply to finance mismatches in the settlement periods of different securities markets, or may be longer-term, funding strategic positions taken by the investor. Additionally, custodians establish ‘daylight’ overdraft facilities and limits to cover exposures created when a client is buying and selling securities for settlement on the same day.
Naturally enough, technology is playing an increasingly important role in the cash management process. Web-based tools, for reporting, forecasting, analysis and transaction initiation, are now a common feature of the global custodian’s product range. We, for example, have recently launched db portfolio, an innovative solution to the problems of portfolio data management. As a fully web-enabled platform, this provides combined market, product and portfolio reporting through a single gateway for a truly global view. The service answers the customers’ need for a comprehensive, ‘single-shot’ view of global cash and securities positions, wherever they are held.
E-trading is also taking hold, with investors using custodians’ online services to initiate money market deposits without the need for manual intervention, thus enabling full straight-through processing of these trades. This is undoubtedly the way forward, as an increasing number of transactions are processed electronically, reducing the cost and risk of managing cash across borders and time zones.
There can be little doubt of the heightened awareness of the need to manage cash effectively. Since the events of September 11th, balances in liquidity funds managed by Deutsche Bank in Europe have grown substantialy, demonstrating the flight to cash by investors. The market’s re-evaluation of cash as an asset class means that custodians have a pivotal role in ensuring that institutional investors optimise their returns and improve processing efficiencies.
Stefan Gmuer is head of customer management Europe, Middle East and Africa for Deutsche Bank, based in Frankfurt