Technology vendors have an opportunity to provide the money market industry a chance to thrive in a market that is testing those funds very survival.
The credit crisis has shattered investor assumptions about the nature of the money market industry, and many money market funds themselves.
On the investment management side, overnight interest rates are at near zero and look set to stay that way for an extended period. As a result, many money market funds have had to wipe out management fees in order to show competitive rates; effectively running their businesses at a loss. This, coupled with existing manual aspects of managing the investment process, has caused many investment managers who support the money market industry to exit the market. According to the Investment Company Institute, since January 2008 the number of money funds has decreased by 8% in the U.S. since January 2008. As money funds collapsed, investors were sideswiped with the underlying counterparty and liquidity risks associated with these supposedly liquid investments. Whether it was oversight by the manager or a once-in-a-lifetime run on the bank is still open to debate. It is certain that the institutional investment community was brought to its knees by the crisis, ending some funds in their tracks, and raising questions about the long-term viability of several others.
What went wrong?
Traditionally, institutions such as large asset managers, the investment divisions of corporations and pension funds have been relatively passive when it comes to cash management. They typically park large amounts of cash in investment manger-run money funds and/or money funds at custodial banks or their prime brokers. In certain instances, managers just want to focus on managing their core equity or fixed-income holdings and don’t want the expense or operational burden of cash management. In others, the money manager hands over portfolio and risk management to the custodian as part of a service level agreement. The problem with the traditional model, however, is that the system support and level of communication between the institution and money fund has tended to be quite poor. Often the process is highly manual leading to missed opportunities for attractive yields.
What happens next?
The money fund certainly has a future, but the downturn and heightened regulatory environment has caused firms across the board to review their liquidity, reporting and compliance requirements, driving the need for changes in the money-market industry in the months and years ahead. Whether you are a money market fund or a money market fund’s client, the past 12 months have certainly placed a considerable amount of pressure on the business and this is where technology will prove to be invaluable over the coming years. For those firms that decide to tough it out in the money market business, cost cutting will become a major initiative to eke out a margin in the tough operating environment. The answer will come in the form of increased automation in operational areas that mitigate risk while slashing costs.
As investors, institutions can do as much due diligence as they want on a money market fund, but if the fund freezes liquidations then the investor is in a bind. And all the while, the investor thought they bought liquidity management for 15-50 basis points. Obviously, we now know that cost is insufficient. Investors can no longer be passive; they want 100% transparency on their liquidity. In the end, usage of money funds will depend on a firm’s liquidity needs. If you are an investment management firm then “in-house” management of short-term liquidity needs and counterparty risk will be something to consider seriously. Who better to manage your firm’s liquidity and counterparty risks but you.
In order to address these issues, firms are going to turn to technology. From timely collateral management on the liability side to straight counterparty/term selection on the investment side, we are already seeing a tremendous amount of automation occurring in both order and execution management. In the future we will see funding desks and more proactive collateral and credit risk management. Positions will have internally managed liquidity ratings to allow for more accurate risk analysis and regulatory capital reporting.
In today’s world, a firm that has $5B parked in money funds sees $5-7MM per year in fees (about 15bps in fees / yr). Five years on, after automation, the same asset management firm, through ‘in-house’ management will manage that $5B from a much lower cost basis and with better overall liquidity and risk management from both a client and firm-wide perspective. From order management through execution management, technology firms will provide the solutions that enhance this new business model reducing risk and management costs while providing real alpha.