Asset owners, particularly pension funds, coming under pressure from sustained low interest rates and the unintended consequences of a variety of market regulations, are caught in an increasingly challenging liquidity conundrum.
This is according to Northern Trust's latest white paper “Cash: an Asset in Adolescence”, which suggests a shift in asset owners’ approach to managing cash that may help them manage through the liquidity conundrum.
"Whilst the low interest rate environment and associated market dynamics, as well as the regulatory changes focused around liquidity, have affected many institutional investors differently, we see pension funds coming under the greatest pressure as a result of a confluence of these factors," says Mark Austin, Institutional Investor Group, Northern Trust. "For the majority of defined benefit schemes closed to new members and in net decumulation, finding and maintaining appropriate liquidity is vitally important and is becoming increasingly challenging with many schemes across Europe struggling to balance liquidity while creating returns."
There are various reasons for this. Firstly investors, such as pension funds, driven by the need to support evolving investment strategies have increased their allocation to cash. However, in today's low interest rate environment, investors can expect a zero rate of return which can become negative after inflation.
Secondly, regulations such as the European Markets Infrastructure Regulation (EMIR) which calls for over-the-counter (OTC) derivatives to be cleared through a central clearing counterparty, have, according to the paper, unintentionally given investors liquidity challenges.
"Whilst central clearing has served to de-risk the market, the requirement under EMIR for the variation margin for cleared trades to be posted in cash multiple times a day is challenging," says Steve Irwin, head of asset servicing liquidity solutions at Northern Trust. "We have already seen two of Europe's largest pension funds highlight how, under current guidelines, they could be required to divest physical assets to raise required cash or, perhaps, avoid derivatives entirely."
Northern Trust’s white paper, which details the challenges and unintended consequences from a number of regulations and profiles the impact of market uncertainty and a difficult macro-economic environment for cash investors, also calls for action.
"Cash is an important investment-enabler – pension funds cannot earn from it but cannot invest without it. However, as the available liquidity in the market tightens and returns on cash positions are reduced, pension funds can no longer be passive about cash," explains Austin.
In order to start to address the liquidity conundrum, Northern Trust suggests that investors take the following steps to 'future-proof' their investment policies to ensure a balance of security, liquidity, yield and operating efficiency: understand investment portfolios from a liquidity perspective by maintaining a liquidity ladder and considering future calls on cash; model and stress test your asset liquidity profile to be aware of the worst case scenario and potential sources of liquidity in normal and stressed markets; and determine optimal short and long cash positions and arrangements.
"There is no magic solution to this conundrum. However, we believe that understanding a portfolio from the point of view of how liquid it might be at any point in time is critical, particularly as the cost of cash liquidity will only continue to increase," says Penelope Biggs, head of Institutional Investor Group, Europe, Middle East and Africa at Northern Trust. "Through our years of experience of working with some of the most sophisticated asset owners around the globe we have developed a range of cash and liquidity management solutions that can be tailored to individual client and market needs, ensuring Northern Trust is well placed to help our asset owner clients achieve their business and investment objectives."
