Treasury management staffers at hedge fund management shops are belatedly realizing that the difference between either knowing or not knowing the answer to the interrelated questions could translate into the difference between average and higher investment performance. The savviest hedge fund managers are turning to third-party applications platforms or outsourcing some or all of the Treasury management work to fund administrators.
At its core, Treasury management can encompass anything from cash management and managemnet of securities finance transactions all the way to collateral and counterparty management. Optimization of Treasury management takes the mechanics of when and where to move cash and securities to the higher objective to knowing how much cash and what value of securities to use when and through which prime brokers. Although the Treasury functions are considered distinct from traditional middle office operations, Treasury operations staffers and their middle office brethren typically report to the same director of operations or chief operating officer.
“Once seen as simply a single process of periodically reviewing borrow rates and understanding counterparty exposure, active Treasury management has become a core competence for successful hedge fund managers,” says Sameer Shalaby, chief executive officer of Hazeltree Treasury Solutions, a New York-based Treasury managment platform provider.
The 2008 financial crisis provided the first impetus for hedge fund managers to improve their Treasury operations as fund management firms realized the need to expand their pool of prime brokers to reduce counterparty risk. Optimizing returns from cash, collateral management, and securities finance operations is the new rationale.
Reducing borrowing rates, gaining higher yields on excess cash and actively disputing collateral calls help a hedge fund manager’s bottom line. Shalaby predicts that depending on the size of the fund, its fee structure and the level of automation, effective Treasury management could add as much as 50 basis points to 70 basis points to a portfolio’s performance per year.
Yet another ancilliary benefit to effective Treasury management is reducing headcount which can be reallocated to optimizing cash management and other Treasury functions rather than doing operational tasks. New York-based shadow accounting and middle office operations specialist Viteos Fund Services estimates that a fund manager with multiple funds and prime brokers could require staff to spend at least 12 hours validating several margin calls each day and three hours validating borrowing fees.
The Status Quo
Handling daily payments and invoices could take even longer depending on the number of prime brokers and service providers involved. “Keeping track of payments may sound basic, but it is necessary for reducing fees further down the operations chain,” explains Albert Bauer, head of products at alternative fund administrator Citco Fund Services (USA) Inc. Those bills could be for legal counsel, a prime broker, or other third-party service provider.
The challenge of managing payments comes from fund managers needing to know the security controls of each counterparty or service provider. Then there is the issue of keeping track of intended authorizations for different level of payments. the higher the value of the payment, the larger the number of signatures needed for approval. Mistakes can be costly. “Managing Treasury functions, such as settling over-the-counter trades, transfers between accounts and paying invoices is critical to avoiding extra fees, settlement fines and in the case of over-the-counter derivatives unwound deals,” says Bauer.
For fund managers who succeed in paying their bills on time, the next logical step involves knowing whether they have extra idle cash or securities sitting around that aren’t making them any money or even worse costing them money. Driven by Basel II requirements, banks are less willing to hold onto extra cash. Required to allocate balance sheet resources for cash held, prime brokers now want hedge fund managers to pay minimum monthly fees or move their cash, or even entire business elsewhere.
Knowing which prime brokers hold which cash positions and what fees they are charging is the critical first step to increasing returns. The next logical one would be to sweep excess cash out of prime brokerage accounts into money market and other liquid vehicles to allow for easy access and an incremental yield.
Figuring out what to do with excess collateral is far harder than excess cash, because it involves knowing not only which counterparty and transaction are owed collateral, but also whether it is less or more than necessary to back a transaction. “As a rule of thumb, broker-dealers will always ask for more collateral, but never return extra unnecessary collateral,” says Ritesh Rathi, executive vice president of fund services for Viteos Fund Services. “Therefore, fund managers need to make certain they do the right margin calculations quickly enough.”
Do they? Chances are they might when it comes to knowing whether a margin call asking for more collateral is accurate. However, once they have sent out the collateral they could easily forget to do follow up calculations on whether they should ask for any return of collateral. Rathi estimates that about half of the 25 percent of disputed margin calls involve overcollateralization.
Just as important as recalling excess collateral is optimizing the use of collateral. Hedge fund managers need to know which contracts allow them to use cash, which permit securities and the haircuts involved. Then comes calculating the best mix of cash and securities either by contract or an entire swaps book of business will result in the lowest cost to the fund manager. Prime brokers typically prefer cash, but relying on cash alone is cost prohibitive for fund managers. The mix of cash and securities as collateral will differ over time depending on market conditions.
The higher the number of prme brokerage relationships a hedge fund manager must handle, the higher the potential for unnecessary administrative costs. There is no guarantee that the mix of counterparties selected will generate the best result– an increase in investment performance. It could in fact drain the bottom line.
The relationship between hedge fund managers and prime brokers is a two-way street. Fund managers need to evaluate each prime broker based on its relative financial health and creditworthiness, ability to source and maintain securities finance deals, coordination with other divisions of the bank and service levels. Likewise, prime brokers need to decide whether a client is worth keeping based on a complex formula of return on assets that goes beyond the revenues generated.
“Securities borrowing costs are among the most important components of a hedge fund manager’s wallet spend,” says Shalaby. “For difficult-to-find or scarce assets, borrowing fees can be high enough to have a material impact on the economies of a trade.” Therefore, hedge fund managers need to evaluate the reasonableness of securities borrowing rates by comparing rates from multiple prime brokers and independent sources.
Fund managers who decide that their prime brokers are worth keeping have to also make themselves worthy of being kept. Fund managers must make certain they maintain an appropriate level of a return on assets (ROA) for each prime broker they choose. Fund managers which fall below the bank’s ROA will either be charged higher fees, lose access to lines of credit or be asked to find another prime broker, says Shalaby.
Because there is no consistency among prime brokers on the methodology used to calculate ROA, fund managers need to measure their ROA based on the individual prime broker’s metrics. The answers could be used to decide what types of business to allocate to specific prime brokers. However, as Shalaby says, hedge fund managers need to balance those choices with the unintended potential of increasing one-way counterparty risk. That is where measuring counterparty strength, such as financials, and tracking red flags, such as widening spreads for credit default swaps, come into play.
Where do automated Treasury management systems fit into all of the hedge fund manager’s needs? They are a good way to consolidate and normalize data from multiple internal platforms and prime brokerage portals into a single location. After that occurs, decisions can then be made for anything as simple to when and where to make cash payments to recalling excess collateral. Optimizing cash and collateral management and allocating a book of business among multiple prime brokers are the next levels.
Treasury management systems differ in functionality, so hedge fund managers can decide which of their Treasury functions need which level of automation or optimization. Last month Citco Fund Services’ parent Citco Group of Companies released Aexeo Treasury, a new cloud-based software-as-a-service platform which allows alternative fund managers to centralize their Treasury and payments functions. Those fund managers can customize and prioritize workflows and the approval processes within their organisations.
Hazeltree and Viteos Fund Services say their Treasury management platforms centralize cash payments, validate margin calls, and validate stock borrow and financing fees. Hazeltree’s also allows hedge fund managers to sweep excess cash into liquid money market accounts as well as measure the value of prime brokerage relationships. Hazeltree has teamed up with BNY Mellon for hedge fund managers to sweep their excess cash into money market vehicles via BNY Mellon’s direct cash portal. Those managers don’t have to be using BNY Mellon’s hedge fund administration services.
For hedge fund managers who don’t wish to do all of their Treasury management work in-house, there are several fund administrators offering to do the labor for them as part of their middle office processing services. “Treasury management systems are meant to generate exceptions which staff then have to investigate and clean up manually by calling prime brokers,” says Rathi. The majority of Viteos’ clients rely on the firm to do their Treasury operations work using its own platform. Citco’s Aexeo Treasury also lets alternative fund managers outsource their Treasury and payment functions to Citco.
The hedge fund services unit of Chicago-headquartered administrator Northern Trust is using Hazeltree’s cash optimization application to allow its hedge fund administration clients to earn a higher return on their excess cash by automatically sweeping excess cash into Northern Trust’s foreign exchange and liquidity programs. New York-based hedge fund administrator HedgeServ recently expanded its use of Hazeltree’s Treasury management platform for its middle office services from handling cash wire and over-the counter derivatives collateral management to include cash management, securities finance, security transfers, all margin management and counterparty management.
Ignorance Isn’t Bliss
Despite the abundance of choices, not all hedge fund clients are up to speed with using automated Treasury management solutions or using service providers to do their work, Treasury operations managers at some US hedge funds tell FinOps Report. Only the largest hedge fund managers have dedicated Treasury manager and centralized Treasury management units using a single platform. Most are still at the stage of automated cash optimization, while some still rely on an army of staffers in multiple departments which may be using manual intervention or multiple systems that don’t communicate with each other.
Operations managers typically aren’t decisionmakers. They only inform multiple Treasury managers or other operations managers where cash and securities are used and execute any decisions those managers make as to how to reallocate the cash and securities. Choices on wallet spend often fall on dedicated risk managers who need information from multiple internal applications for cash management, securities finance and collateral management as well as their own prime brokers.
The decentralized and often manual approach to Treasury management is ripe for errors, higher costs and opportunity costs due to the inability for optimization. “Fund managers may be overpaying for stock borrows, financing charges or draining their productivity using too many staffers for basic cash wires,” says Viteos’ Rathi. “They could also be missing out on revenue from higher-yielding money market funds or lending fees.
Why aren’t more hedge fund managers doing more to improve their Treasury operations? “They may believe that inefficiencies in Treasury management result in only a small cost per function, even though it can all add up to a sizeable amount combined.” says Rathi. “The question hedge fund managers should be asking themselves is whether they can afford to leave money on the table.”