Could money market funds be the answer to the management of short-term foreign exchange cash reserves? Anne Queree reports on a radical idea.
Central banks are starting to look at money market funds for the management of their short-term, foreign exchange cash reserves. This may sound like heresy – they have traditionally kept their investments tightly controlled and segregated – but it is a trend which, along with other outsourcing solutions, is gaining ground.
Central banks have recently had to reckon with low returns and increasing credit risk on short-term deposits of their foreign exchange reserves. In this climate, say investment banks and asset managers, triple A-rated, pooled money market funds, which are also known as liquidity funds, are an attractive option.
Market grows
Money market funds are certainly in vogue and growing, benefiting from cash-rich corporations and an increased asset allocation to cash by the life insurance industry. The market in Europe alone was approximately $130.4bn in December 2002, according to data from iMoneyNet Inc.
The funds’ selling points are better yields, less credit risk and broader diversification than traditional deposits. But do they offer a suitable home for central bank liquidity? And is there value in outsourcing the management of foreign exchange reserves in this way?
Efficiency drives the trend
Central banks’ use of external managers is not new, according to Mike Wilson, managing director, fixed income portfolio management, at JP Morgan Fleming. “Central banks have historically turned to asset managers for longer term investment of portions of their reserves,” he says.
Central banks’ use of money market funds for short-term cash management is an innovation, however, and it is being driven by the current focus on operational efficiency, according to John Nugée, head of the official institutions group at State Street Global Advisers (SSgA). “Active management of cash can add significant administration costs, while money market funds provide a predictable and secure performance enhancement net of costs,” he says, suggesting that money market funds provide a good fit with the “security first, performance second” stance of central banks’ investment policies.
With about $100bn under management in money market funds and related structures, Goldman Sachs Asset Management (GSAM) is one of the largest providers. Andrew Ellis, executive director and head of money market fund sales at GSAM, says he sees some tentative use of money market funds by central banks. “The counterparty diversification that the funds offer is attractive to them.”
The 173 central banks worldwide would represent a significant niche clientele for the providers of money market funds. But, in reality, central banks’ needs and appetites for such investments vary widely.
As a participant of European monetary union, Finland is unlikely to need to intervene in the foreign exchange markets and has adjusted the management of its reserves accordingly. “We emphasise return over liquidity so we do not invest much in the short end of the market,” says Pentii Pikkarainen, head of market operations at Finland’s central bank, Suomen Pankii. The bank does not use external managers for any of its investments, although its policies do not exclude this, he says.
Differing views
A spokesperson for de Nederlandsche Bank agrees that short-term cash yields are not a specific focus. “We are refocusing our foreign exchange reserves away from treasuries to more spread-related products. But we would handle the sort of investments that typically make up a money market fund ourselves.”
Others take a different view, from a different situation. Estonia’s central bank, Eesti Pank, had its foundations in 1919 but its current operations date back to 1990, making it one of Europe’s newer central banks. Among its objectives is to ensure the value and integrity of the Estonian kroon. It makes some use of externally managed, pooled funds within its long-term portfolio and is considering money market funds for some of its short-term investments, too.
“We would see added return and diversification as the principal benefits,” says Katrin Rahe, deputy head of Eesti Pank’s financial markets department. By diversification, she means not just a broad range of investments within a fund but also diversification of investment decisions.
But, given the need and the appetite, is the opportunity there? One central bank was recently reported to be looking for a home for E1bn ($1.1bn) and, while such sums may be exceptional, the size of central bank deposits can be large enough to adversely affect a smaller fund should they need to be withdrawn. Mr Wilson says the recent growth of the larger funds makes this less of a problem today.
The requirement for confidentiality varies. While Norway’s central bank, Norges Bank, names the external managers of its long-term reserves on its website (the bank’s short-term cash reserves are mainly in overnight deposits and treasury bills), several central banks approached for this article would not speak about these issues, and some only off-the-record.
The central banks that do outsource to external managers appear to do so in a limited, tactical way. Some use external managers as a control mechanism, placing a portion of their short-term reserves in external funds as a benchmark for the performance of the internally managed portfolio portion. Another tactical use of professional fund managers is to get exposure to the relatively sophisticated investment techniques of the funds, suggests Paul Higginson, principal, central banking at Trema, the treasury software supplier to 10 central banks, including the European Central Bank.
“They mirror the transactions in their own systems. Part of the reason central banks are willing to make significant investments in technology is that they see it as important to keep up with newer techniques in the markets.”
Appetites vary
Central banks do not form a single constituency. Their needs and appetites for outsourcing options, and for money market funds in particular, vary according to their resources, expertise and market stance.
But for those that do embrace money market funds and outsourcing, there are other efficiency opportunities, suggests SSgA’s Mr Nugée. “Overlay structures using forward foreign exchange contracts and bond futures are an excellent way of adding extra value while preserving the liquidity of reserves,” he says.
While he agrees that many central banks are still wary of using derivatives, others are increasingly using such structures. Ms Rahe says Eesti Pank uses derivatives and would not have a particular problem in an external manager using these. “Although we would take care no leverage was involved,” she adds.
Wisdom or heresy?
None of the central banks ruled out the use of external managers for either long-term or short-term investments, or stated that their policies would prohibit this.
While smaller central banks, especially those that do not have in-house expertise in some of their reserve currencies, may generally be expected to find more value in money market funds (depending on the course of the markets), some of the more conservative central banks may yet pool their funds with those of the hoi poloi in the future.
