In this excerpt from the book QFINANCE: The Ultimate Resource. Mark Camp and Emma Du Haney examine the options for treasurers when it comes to investing cash in the wake of the global financial crisis.

It has become crystal clear that cash must be treated as a separate asset class. This means taking care when considering how, and with whom, cash should be held and invested.

It is equally clear that risk is a very relevant factor for cash. Institutional investors have discovered in the past year that so-called safe cash investments have not been as secure as they thought. For many years, investors have ignored the fundamental principle that extra yield is associated with extra risk. It is now clear that the especially attractive rates paid by Icelandic banks came with significant additional risk.

In times of plenty we tend to overlook or downplay risks and concentrate on the rewards. All we tend to think about is who is top of the league table so that I can maximise my interest income. What can be all too easily forgotten is that the return of your money is always more important than the return on your money.

A flight to quality, or perceived safety, can quickly become an unstoppable tsunami that can take the good with the bad; witness the ever-lengthening queue outside Northern Rock (a British bank) last September, and the subsequent effect on confidence in all British banks. Everyone now wants a guarantee, and an absolutely safe investment.

What does ‘guarantee’ itself mean? We now know that it is only as good as the counterparty that gives it. Having to worry about counterparty risk is something most of us thought was the thankless and purely box-ticking task of compliance officers, or the credit committee. Now we know better. It must be stressed that it is very unusual for an institutional investor to receive a specific guarantee on a cash placement, except to the extent that a bank, or investment product, receives overt support from a relevant authority that one trusts.

What can be all too easily forgotten is that the return of your money is always more important than the return on your money.

What no one wants to say is that, ultimately, there is no absolute guarantee. This may seem more obvious now, after a year in which we have seen that AAA credit ratings do not guarantee security, and that even a government guarantee is only as good as the economic strength of the country that gives it.

The whole financial world is built on confidence, and if that is fatally cracked then the whole pack of cards can come down, with disastrous economic consequences for us all. That is why all the major governments and central banks, in both the West and East, finally acted as decisively as they did toward the end of 2008, coughing up some $6.75 trillion to save the world. This is equivalent to some 10% of the entire $65 trillion global economy [CIA World Factbook 2007], and has been used to recapitalise banks, buy up toxic assets (including subprime-related assets), make loans to financial institutions, and give state guarantees to get the wholesale markets moving again. Even with the size of this unprecedented rescue, risks remain in the financial system according to a recent Bank of England financial stability report.

So what choices does a treasurer have when investing cash?

Very large treasury operation — The very largest holders of cash can afford to run a well-resourced internal treasury, including a fully functioning cash desk. Aside from the major banks, however, such entities are few in number, as you have to be investing very large amounts on a daily basis to do this properly.

Treasuries with small or intermittent balances — At the other end of the scale, if one has cash balances that arise only intermittently, or if they are less than $1.5m, leaving them with your main clearing bank(s) (having done appropriate due diligence and negotiated the best available rates) is probably the best approach.

Netting and pooling are a must — It is assumed that any treasurer will have already maximised any pooling, netting, and aggregating possibilities, across currencies if necessary, as these always offer the best value operationally and economically — and usually in terms of security too.

For treasuries in the middle ground the main strategic options are as follows.

1. Utilise internal resources

This has been an attractive option in the past, often because it is considered a low-cost option. But what are the risks involved with this approach? Even if one hires a good cash specialist, where is the back-up if he or she falls under the proverbial bus? Where is the back-up for the credit specialist? It is no longer good enough to rely solely on the credit rating agencies, or review the agreed counterparty list once a year. Instrument and counterparty credit ratings are just one of the guides to utilise, and they can, and should, be challenged from time to time. Certainly, just calling your friendly money broker from time to time for advice cannot now be considered best practice.

2. Outsource to a specialist provider/treasury portal

The bank — The first option is to see what your clearing bank, or custodian (if relevant), can provide, especially if cash can be automatically swept on a daily basis. The problem here is risk concentration with just one, or only a handful, of counterparties. A good example of this type of situation is a hedge fund with a single prime broker. Not only does the fund have a serious risk with the prime broker as the derivative counterparty, but the cash margin/collateral would typically be held with the same party, doubling the counterparty risk. Before the Bear Stearns and Lehman Brothers troubles, the main global prime brokers were considered too big to fail; this is not the position now.

Before Bear Stearns and Lehman Brothers, the main global prime brokers were considered too big to fail.

Investment manager — If an institution has large and relatively stable cash balances to invest, then an investment manager can be approached to run a segregated cash mandate. The advantage of this approach is that you get to choose the investment manager, and you can also specify the investment parameters and benchmark, and in that way control risk. Invested cash should also be held with a third-party custodian, thus ring-fencing the assets from the investment manager.

The downside is that it is a relatively cumbersome and expensive process to set up in the first place, and it is not very flexible. A serious bespoke cash investment manager will usually require a large minimum investment balance ($150m plus), and/or minimum fees. Frequent redemption, or movements generally in the mandate, will not be welcomed, as they can materially affect investment strategy and performance. Such arrangements best suit long-term investment cash, and not volatile cash investment.

Pooled funds — Money market funds have been invaluable to many corporate and institutional treasurers in recent years, freeing them from the task of spreading their funds around the various banks. However, money market funds come in many guises, and, as some investors have found to their cost, some of these funds have invested in assets that have proved to be far from low risk.

Treasury portals — Use of portals is extensive in the United States, and brings operational efficiencies if one is a multi-fund user. Such portals are now available in Europe.

Money market funds

Let’s remind ourselves why money market funds became so attractive. They now account for some 40%, or $4tn, of all cash held in the United States. This reflects a 25% rate of growth over the past 12 months, as investors have generally seen SEC registered (Rule 2a-7) money market funds as a safe haven, in spite of a few funds exhibiting obvious stress that has required promoter support, and the well-publicised failure of both ‘The Reserve’ and the ‘Lehman Funds’. However, what this overall growth disguises is a clear move by US institutional investors away from traditional so-called ‘prime’ funds, to US Treasury and government-backed security money market funds, even though the yields on such funds are very low, and even went negative for a short period.

This trend has been much less noticeable with European-domiciled money market funds, although there are now a small number of Euro-denominated government securities, and one Sterling government fund that has been recently launched. Demand for these new funds has largely been from European subsidiaries of US multinationals, and it remains to be seen whether such funds catch on with European institutional investors.

European money market funds now account for some 420bn ($500bn) equivalent in the three main currencies, and this includes around 100bn ($145bn) plus of Sterling funds. The past decade has seen a very rapid growth for such funds, and although there are recent signs that growth has checked among institutional investors, it seems that high net worth investors are now taking up any slack as they move out ofenhanced funds that have contracted sharply or been closed down.

However, not all cash funds are the same

Typically, ‘liquidity’ or ‘treasury-style’ funds are managed to a short-dated benchmark such as seven-day Libid (London Interbank bid rate). They offer daily liquidity, carry AAA ratings, and have a constant net asset value (or stable pricing). First of all, they offer diversification — by issuer, instrument, and maturity — and to a greater degree than most institutions could achieve on their own.

If an institution has large and relatively stable cash balances, an investment manager can be approached to run a segregated cash mandate.

Other variants of money market funds, often called cash-plus or enhanced cash funds, would typically be managed to three-month Libor (London Interbank offered rate) or similar, have two-day or longer settlement, and a variable net asset value (i.e. daily market pricing). Such funds can carry an AAA rating, but often they are lower rated. Their attraction is that they should carry a higher yield or return, because they can invest further out along the money market curve (given different benchmark and settlement requirements), and can invest in a wider range of credit instruments, including derivatives and asset-backed paper. All this depends on the extent to which they are ‘enhanced’.

It may seem obvious now, but going forward investors will need to decide what their priorities are from an investment perspective. Security, liquidity, and yield should all be part and parcel of a money market fund, but there has to be a trade-off between yield and the first two. With the credit ratings agencies somewhat discredited, it is all the more important to seek out a professional manager who has the resources to carry out detailed credit analysis on names and instruments.

It is also worth confirming that an offshore fund is run under the IMMFA (Institutional Money Market Funds Association) Code of Practice, as this is a useful ‘kite mark’ to have. IMMFA currently has more than 20 active members, and reads like a Whos Who for the money market fund industry.

Going forward, simplicity is also going to be key. Historically, floating-rate instruments, asset-backed securities, medium-term notes and repos may have seemed ideally suited to a money market portfolio. That has proved costly for some, particularly as far as liquidity is concerned. For a pure liquidity fund, the only really acceptable instruments are deposits with reputable counterparties, certificates of deposits (CDs) issued by solid bank names, and short-dated government issued debt. Conventional floating-rate notes or CDs may play a part in some funds, but for those with liquidity as priority, the poor secondary market in these instruments needs to be factored in. The commercial paper market, meanwhile, has all but dried up, removing it as an investible option for many funds.

Current issues in the cash world

Finally, a few comments about the current state of the interbank markets. Liquidity has become a huge issue amid the ongoing financial crisis. Even instruments such as CDs with well-rated banks, which would normally be completely liquid, have become difficult to trade — indeed, the market has even been shut at times. In the United States, the Federal Reserve has recently announced that it is now giving Rule 2a-7 (treasury-style) money market funds access to the Fed window to provide them with liquidity to meet outflows, especially if these are abnormally large. The Bank of England is now committed to providing a similar facility and the European Central Bank may do something similar. A further plan to support funds is to set up a deposit insurance scheme for retail investors similar to that for bank deposits.

A further plan to support funds is to set up a deposit insurance scheme for retail investors similar to that for bank deposits.

As a defensive move, in late September 2008 most funds increased their overnight liquidity (in Sterling it was probably in the region of 20bn30bn, or $30bn$45bn), and this dislocated the interbank markets even more, exacerbating the gap between overnight rates and Libor rates. However, this exercise came at a cost to performance, especially for those funds with a higher proportion of less liquid securities like floating-rate notes and commercial paper, whose managers therefore felt that the funds they managed had to hold an even greater proportion in overnight investments, at a time when overnight rates were collapsing.

Sterling and Euro money market funds generally seem to have weathered the storm for now, but of late the disparity between different fund performances has been much greater than usual, as has the gap against their respective fund benchmarks. This is an area worth exploring, as it can tell you a lot about how the fund has been managed and what issues have arisen. It will be interesting to see how funds cope with the recent downturn in interest rates globally. Usually funds are at their most competitive when interest rates are falling.

It is clear that regulators both in the US and Europe will be reviewing whether, and how, money market funds should be specifically regulated. Watch this space, but in the meantime expect funds to be much more conservatively managed and operated.

Making it happen

• It is important to have a clear strategy and credit procedures

• The days of do-it-yourself are probably numbered, unless you can gear up to run a fully functioning, professional cash desk

• Your bank, custodian, or financial adviser should be the first port of call

• Longer term cash can always be placed in a segregated mandate with a specialist cash investment manager

• There is now a viable choice of pooled funds, as long as you do the appropriate due diligence and get comfortable with the fund and the providers credentials

• Treasury-style money market funds can provide professional cash management at low cost with a smoothed return, and give the operational flexibility that is essential for working cash balances. Portals can offer operational advantages for the multi-fund user

• You do have a choice, and best practice demands careful consideration of all the available options

‘Investing Cash: Back to Basics’ by Mark Camp and Emma Du Haney is an excerpt from QFINANCE: The Ultimate Resource, published by Bloomsbury Information Ltd, 2009.