Funds seek new options for holding cash
Cautious funds know they need to keep cash on hand, but banks don’t want deposits and creating a treasury function is expensive
Today’s low-return, safety-first financial world impacts hedge funds’ unencumbered cash in two ways. Not only are there high levels of cash because managers understandably don’t want to take undue risks, but also the low interest-rate environment is deterring bank-owned prime brokers from hosting that cash on their balance sheets.
This is a major problem. According to the UK Financial Conduct Authority’s June 2015 Hedge Fund Survey, funds had an average of 29% of NAV in unencumbered cash. The survey indicated there was approximately $121.22 billion of unencumbered cash (as at September 2014) across the $418 billion in NAV surveyed. The figure included 132 funds managed by 52 firms.
Banks don’t want to hold cash
The impact of new regulations stemming from the global financial crisis, such as the Liquidity Coverage Ratio (LCR), is severely hampering banks’ ability to finance their businesses from deposits – especially with cash deposits from institutional investors. This is forcing many banks to re-evaluate their product offering. Due to the impact of low interest rates on the high-quality liquid assets banks are required to hold to comply with LCRs, they regard taking cash deposits – and in particular ‘non-operational cash’ – as a poor use of their balance sheets. As a result, many banks are dissuading hedge funds from placing cash with them, and others are charging balance sheet utilisation fees.
In our view, the problem is likely to worsen towards the end of 2016 as banks reduce cash on their balance sheets at the crucial year end reporting period. To add to this, the search for a cash alternative is further complicated ahead of new US money market fund regulations, due in October, that move prime funds to a floating NAV while also allowing redemption penalties and suspensions in certain instances.
This gathering squeeze on hedge fund cash has serious implications. Not only does it potentially diminish fund returns but also it adds to operational costs if staff need to devote time to managing cash.
As prime brokers turn cash deposits away, managers are responding in a number of ways: by turning their cash over to custodian banks, holding highly liquid securities such as treasuries, buying money market funds or a combination of these. According to EY’s 2015 Global Hedge Fund and Investor Survey, 58% of managers have resorted to custodians, with 35% opting for each of the other options respectively.
This illustrates the operational burden placed on hedge funds from the changing prime broker landscape, as well as the emerging need to improve management of counterparty risk and collateral. The largest managers are building their own treasury functions.
None of the options available for hedge fund cash is ideal. Custodian banks are unwilling to take cash on their balance sheets, so are encouraging clients to put cash into specific money market funds. The new regulations are resulting in large flows from prime funds and short-dated treasury bills are arguably richly-priced due to money flowing out of money market funds into these securities.
Citco Bank has capacity for deposits
At Citco Bank, we continue to have capacity for our fund administration clients’ deposits due to our conservative approach to balance sheet management, which includes our longstanding focus on primary allocation to high-quality liquid assets.
We believe that today’s squeeze on unencumbered cash will not abate until interest rates rise significantly. Until then, hedge funds will find unencumbered cash hard to deposit.
9th September 2016