Treasury management: no longer the poor relation
Treasury operations within hedge funds have traditionally been the ‘poor relation’ to other functions. Even funds with substantial amounts of uninvested cash have had a tendency to treat their treasury operations as an afterthought in comparison to their trading activities, instead focusing primarily on systems for executing trades and portfolio reporting. While some consideration was given to record keeping and margin management, proactive cash management was never built into their systems. However, this is changing.
The industry is now starting to look more closely at how to maximise the treasury function, spurred on by three major drivers: the effect of Basel III on prime brokers, the arrival of EMIR and increased complexity across collateral pools and product lines.
The shifting relationship with prime brokers
Prime brokers have long been the main source of leverage to the hedge fund market but a number of factors – in particular the advent of broader banking regulation – are causing prime brokers and their hedge fund clients to reassess their relationships.
Basel III, the third ‘accord’ by the Basel Committee on Banking Supervision (BCBS) initially put forward in 2010, aims to reduce systemic risk by regulating banking activity in three ways: increasing bank capitalisation requirements; improving liquidity coverage ratios and imposing constraints on bank leverage. Each of these measures impacts prime broking activity in a way that has direct knock-on effects for the hedge fund industry.
Increased capital requirements are pushing banks to reassess their various business units and allocate capital away from capital-intensive businesses that are expected to generate low returns on equity. A recent illustration of this would be the reorganisation of Credit Suisse, announced in October, which will see it reduce the capital allocation to its securities unit by scaling back its prime services businesses to the global macro space. The two other pillars of Basel III – improved liquidity coverage ratios and constraints on bank leverage – represent a straight-forward increase in funding cost for prime brokers.
In the wake of the financial crisis in 2008, fund managers were awakened to the idea of counterparty risk and accordingly sought to mitigate this by adding more prime brokers to their panel of providers. However, more recently this trend has reversed. With prime brokerage costs rising, providers are looking to capture a greater ‘share of wallet’ by focusing on the entirety of a clients’ services, such as custody, execution, fund administration and financing.
Whether this retrenchment is a genuine long-term market trend or a knee-jerk reaction to the post-financial crisis regulatory environment, hedge funds must take note. If they can no longer rely on their prime brokers as a source of cost-effective short term financing, they need to access alternative funding sources, which in turn requires a developed treasury function.
An ability to monitor financing rates across prime brokers and apply it to portfolios, combined with real time information on the cheapest to deliver securities in combination with effective repo financing, should now be a key element of any fund’s treasury optimisation strategy. Effectively done, it can have a major positive impact on the fund’s returns.
The 2008 financial crisis led governments and regulators worldwide to look for ways to improve the derivatives market, specifically in regards to transparency and risk. The European Market Infrastructure Regulation (EMIR) was one such effort, aimed at implementing a requirement for the central clearing of over-the-counter (OTC) derivatives. EMIR is now fully in effect, with all parties now required to report derivative information to trade repositories and clear all transactions through a central counterparty.
This has a direct effect on treasury functions because in all derivative transactions, funds are now required to post high quality assets (such as G20 government bonds or cash) as collateral; this means the ability to monitor cheapest to deliver (CTD) securities closely, so these can be offered as collateral, is critical. Having a treasury function with the capability to effectively and efficiently value securities, apply discounts and make sure the collateral book is marked properly, is essential for navigating EMIR.
A further complication imposed by EMIR is a set of requirements mandating efficient operation (specifically with regards to confirmations, reconciliation and daily valuations) for non-cleared derivatives. Without proper systems and procedures, this is very difficult to complete in an efficient and cost-effective manner.
Collateral pools and counterparties
While hedge fund managers may be scaling back their panel of prime broker relationships (and hence simplifying collateral management somewhat), when you include the usage of a custodian bank, SWAP dealers and futures clearing merchants, there are still a large number of collateral counterparties. Add to this the increasing complexity of funds themselves with multiple product lines, hedge funds, managed accounts, 40 Act funds, and pure mutual funds, the operating environment can become very complex, with potentially more than 100 accounts to monitor on a daily basis.
The increase in product complexity has led funds to focus on managing their liquidity cycles more efficiently, aligning them more closely to those of their investors: another trend that has accelerated since the 2008 crisis. The move to more liquid products in the hedge fund market has further increased the focus on the need for efficient management of liquidity cycles and to have a treasury function able to provide proper cash forecasting. This may seem a very basic tool, but given the complexity and required tenor, can in fact be a highly complex function.
This makes it crucial for funds to have a central repository (either proprietary or a third-party product) of real time account information in order to manage clients’ portfolios effectively. Moreover, this should not be viewed as a silo activity, as treasury traditionally has been, but as a key element of the broad portfolio system.
What can funds do?
There are several approaches that funds can take to optimising their treasury function, as outlined in the excellent article ‘Strategic Alpha Generation’ by JPMorgan. These range on a sliding scale from a decentralised approach, where the treasury function operates in fund silos; to a centralised approach with external optimisation of counterparty relationships using the fund’s group footprint; to a fully optimised function where both internal and external optimisation is centralised using the fund’s group footprint to deliver optimisation across all the funds.
Typically the move along the spectrum of complexity happens as a firm grows its product range, with the subsequent investment required at each stage of this growth path impacting the ability of the fund to generate the profitability that makes this investment in time and cost worthwhile.
However, there is an alternative route, which is to leverage the fund service provider to provide a solution. If done correctly, the fund can utilise the economies of scale that come with the provider’s resources and day to day service capabilities. However, this model will not necessarily provide the fund with the tools it needs to complete the optimisation process.
A new model would be co-sourcing, whereby the service provider works in combination with the fund group to provide the right technology and the resources for data gathering and cleansing, but ultimately the information is presented to the fund group’s team, who now have the tools to make the optimisation decisions.
Whichever way funds choose to optimise their treasury functions, it is crucial to recognise that they are no longer the poor relation to other back office functions. They are, in fact, integral to the efficient management of a portfolio and increasingly to the generation of alpha.