Liquidity and yield – the post-crisis challenges


Lloyd Michaels photoLloyd Michaels, Head of Securities Finance & Delta One Sales Europe & Asia, Societe Generale Prime Services

In recent years, a low yield market environment coupled with challenging liquidity conditions has raised significant hurdles for investors of all types.

The decision of central banks across Europe to keep rates at historic lows, alongside the absence of a compelling economic recovery in developed markets,  has lead to the risk/return profiles of years gone by becoming impossible to reach. High up on the list of priorities for all money managers is the challenge of identifying additional sources of return. Growing assets for their investors and beneficiaries is after all their core function, and achieving additional returns in an unrelentingly low rate environment remains a key challenge for all.

This backdrop has been further complicated by the advent of a raft of new regulations over the past five years, especially with regards to institutional solvency. Banks seeking to provide clients with the right solutions to suit their needs – be it individual return expectations, liquidity requirements, risk appetite or investment horizons – are faced with newly stringent capital requirements. This in turn can constrain their ability to provide the diversity of liquidity to meet investors’ individual financing needs – whether they are pension funds, insurance companies, asset managers, hedge funds or sovereign wealth funds.

The banks at either end of the size spectrum have been especially challenged in this regard. For the smallest, it can be evident that they may not have the economies of scale and market presence to access untapped liquidity. Whilst larger banks may not face this specific issue, they typically have to adhere to tougher capital requirements due to their size. They are more likely to be deemed systemically important institutions and are mandated to adjust balance sheet provisions. Smaller banks can lack the resources, and the largest the flexibility to change allocations quickly.

It has become increasingly evident that banks need to be able to take a holistic view of their various clients’ needs. Solutions to these challenges must be put in place to constantly evolve, not only with the ever changing regulatory environment but also the diverse needs of their clients too. While they may often be perceived as such, investors are not homogenous, institutional or otherwise. Banks must be smart about how they tailor solutions to these different groups and to shifting market conditions.

Different investors, different needs

At SG we believe that in the current environment, we cannot adopt a one size fits all type of approach.  Different types of clients have different needs and we need to be able to service them in an efficient manner whilst managing scarce resources. Take pension funds for example:  Currently, many pension funds are facing a situation where their liabilities exceed their assets.  Whilst adhering to their fiduciary duties they still have to search for innovative ways to make money to fill that gap without taking on excessive risk.  A potential solution for this problem is to introduce leverage to get the same exposure to the underlying assets, but for equal returns using less cash consumption.

Insurance companies, on the other hand, need to maintain access to short term cash to be able to meet interim demands on their liabilities. Corporate treasurers need to enhance the yield on this cash to ensure it works hard for them and does not depreciate in line with inflation. Risk management, on the other hand, and counterparty risk remains a challenge for Asset Managers which is why diversification is key.

An additional factor that all client types need to consider is counterparty risk, and their differing needs and appetite for credit and liquidity risk. At SG we have successfully launched a campaign named ‘Solutions To Capture Yield’ where products are offered to customers that allow them to get additional yield, specifically adjusted to their risk tolerance. Equally, different clients also have diverse investment criteria as not all types of investors are allowed to invest in all types of products.  Their choices will normally depend on regulatory constraints, and their specific investment criteria which must also be taken into consideration. Products of varying maturities can help clients with unpredictable needs when it comes to demands for cash or other securities. This depends on where liquidity can be sourced.

Tailored solutions to the liquidity/yield conundrum

Repurchase (repo) transactions are an example of a product which can help to meet yield needs.  In recent times tri-party arrangements have become more favoured over bi-lateral due to the fact that assets are segregated and managed by a third-party.

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Alongside repo transactions, collateral transformation trades are becoming more common, given the increased demand for asset classes. This is particularly important from an asset holder’s point of view, who may find themselves long sovereign or corporate bonds, which is collateral that can be utilised for other purposes. Indeed, non-cash collateral now accounts for 60% of the market. Another popular trade right now is the collateral upgrade/downgrade trade, for all purposes taking government bonds, posting equities as collateral, and then pay additional spread to the asset holder. The wider the collateral schedule of assets that the  bond lender is willing to receive will lead to a higher return on the bonds pledged. Whilst equities can return a modest return, the further one moves down the liquidity spectrum, the greater the spread will be. This is also linked to the risk tolerance of the client but if for example the lender of Govt bonds was willing to take CB’s or ETF’s as collateral then the spread they will receive will be far greater than that vs Equities as pledges.  Typically, this is a way for firms to upgrade collateral in order to get additional yield in a secure way. In an environment where collateral resources can be scarce, these types of transactions are key to optimising the assets that are available.

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Given the greater focus on balance sheet utilisation, there has been increased costs associated with trades on balance sheet. Previously REPO was actively used however banks are looking to move towards swaps in order to be more balance sheet efficient. In order to meet client’s needs for enhanced yield some special purpose vehicle (SPV) structures have been set up in order to segregate collateral assets and cash in order to offer an enhanced return on client’s collateral. Lyxor Asset Management has also launched an ETF that replicates the yields that can be sought from the Repo markets. Essentially there are many different wrappers and methods to invest that will meet all clients investment schedules that can pay a greater return than standard MMF’s whilst meeting clients specific investment criteria and risk tolerance.

 

Flexibility is paramount

These shifting conditions have impacted the prime brokerage market in particular, with providers themselves adapting in response. The relationship between hedge fund clients and their prime brokers in particular is an illustrative example of changing relationships as both parties face new market and regulatory constraints.

Hedge funds have traditionally accessed prime services for leverage, market access and balance sheet management. These areas have all been heavily impacted post-financial crisis due to new solvency rules. Regulations that govern balance sheet management have affected how banks and other market participants must allocate their scarce resources.  However, this has favoured larger institutions, such as SG, who are able to dedicate whole trading teams whose primary job is to optimise the balance sheet,making it as efficient as possible, and finding new sources of liquidity at reasonable cost to the client. Prime services businesses are having to become ever more innovative about how they tackle these issues.

In general, prime brokers are facing their own balance sheet constraints, especially larger prime brokers connected with sizeable institutions that are considered systemically important. As a result, they are required to assess the return on balance sheet from specific clients, and now seem to be looking at relationships with a magnifying glass so as to assess whether it is beneficial allocating scarce resources to them.

The prime brokerage model is changing so it can adapt to new market conditions – considering collateral requirements holistically across their client base and optimising their balance sheets; even changing internal corporate governance procedures where needed. Another concern that is increasingly coming to the fore for institutional investors is how to manage their collateral and balance sheets, so banks can advise their clients with these challenges too.

We are likely to see providers seeking to work with clients who are themselves well-capitalised and without excessive leverage on their balance sheet who will be able to implement effective collateral management processes. There are some more technical solutions that can play a part in this. Synthetic trades ask less of the balance sheet, so these have become more prevalent. Assisting clients with collateral management is also key, given the competing demands on their capital.

This environment undoubtedly favours prime brokers fully integrated into global, multi-asset investment banks, which can look at a client that is primarily seeking leverage from its prime broker and assess which further needs it can serve by drawing on the wider bank’s expertise. This is one of the factors which has seen the relationship between prime brokers and their clients evolve and significantly deepen – stretching wider to cross-asset and multiple product propositions. Brokers which sit within bigger capital markets businesses can help to match clients with the ancillary services and products that they need.

Institutions which will thrive in markets of the future will be those that focus on the opportunities provided by the intersection of liquidity and yield challenges rather than the problems they pose. Banks are constantly looking for new sources of liquidity, and institutional investors are looking for additional yield.  This is why SG works closely with its clients to find out what they need and want, developing a bespoke suite of best solutions for them, irrespective of the type of client and what their varying needs may be, underpinned by our expertise as a global bank transacting in global markets.