There are a lot of hidden costs in the funds industry. They are the bits of the iceberg lurking beneath the surface. And they are not always of a firm’s own making.
Liquidity costs are a good example and they arise in a variety of settings. Ultimately, the solution is to ensure there are clear lines of responsibility for liquidity management, integrated systems giving clear visibility over cash flow, and mitigation measures in place to deal with most eventualities. Getting on top of the payments and settlements process – and getting a clear and early picture of what’s due when – is one of those measures.
Unplanned liquidity issues
Most platforms, distributors and transfer agents encounter unplanned liquidity issues. They are often the result of delayed reconciliations, rekeying howlers and late payments in what remains a largely manual settlements process. Given that the majority of settlements are still done gross, the sums can be substantial.
Then there’s the game of chicken played on settlement day. Lots of funds, TAs and distributors like to delay their payments out on settlement day until they have received payments in. At its worst, this can set off something of a doom-loop reaction as everyone sits on their hands.
Distributors or fund managers often have to fund the cash gap. Minor mistakes with cash payments can force firms to fund positions overnight. When interest rates were close to zero, the impact was minor. Today, it is what one market participant calls ‘a big deal’.
Traditionally, firms have either had a cash float with a custodian (often well into seven figures) or an agreed facility with their bank on which they can call for intraday borrowing. But custodians may levy a fee if a client exceeds agreed limits. And many banks have tightened their lending criteria in the past couple of years, making credit more costly and difficult to arrange.
In any event, bank lines cost money and will normally have to be collateralised in one form or another. On top of that, someone has to manage it all.
America’s move to T+1 will tighten the cash squeeze
Commentators have been drawing attention to the challenge of dealing with the planned shift to T+1 settlement in North America’s securities markets from the end of May next year. Given a UK fund settlement cycle which can stretch to T+4, this is set to create a funding gap for UK funds with heavy weightings to the US. Many will respond by shortening the settlement cycle for those funds.
But, as John Allan, Head of Innovation and Operations Unit at the Investment Association, has remarked, that will still pose problems if other funds within the same range stick with longer settlement cycles: ‘There is a potential impact’, he says, ‘for firms who do not have a consistent settlement cycle across their entire fund range – if switches take place between funds with different settlement dates the mismatch may require firms to fund the account in the meantime’.
In a funds industry survey Calastone conducted in 2020, two out of every five firms said intraday liquidity issues posed a challenge to their settlements processes. At their worst, the knock-on effects of delayed cash payments could actually cause firms to stall some of their trading activity as they waited for cash to come in.
John Read, Founder and managing partner, Prodktr, says capability around cash management is vital: ‘You need a centralised front to back platform with single data source of the truth’, and it is essential that somebody owns the whole process. Too often, cash management sits somewhere between the CIO and the COO. Is it operations or is it investments?
Similarly, he says, there needs to be clear visibility over cash – both external, involving perhaps an overdraft with a service provider, and internal. ‘If you have everything – cash forecasting, cash positions, reconciliations, collateral, the cash ledger – all on one system you’re ahead. It’s all about visibility.’ Sooner or later, he says, the regulator is going to take a much closer interest in the way this is all managed.
One problem is too many competing demands on management – most recently from the new Consumer Duty requirements and planning for the shift to T+1 settlement in the States
Automation can bring payments certainty …
Two major developments can bring the liquidity challenge under control. One is automation, which can bring certainty of payments and settlements. In an automated environment, the settlement team can gauge the precise settlement sums with some certainty, knowing all reconciliation issues have been dealt with and there can be no surprises on settlement day.
Calastone Settlements automates the settlement calculation and payments process between fund managers, TAs, platforms and distributors. It removes all the number-juggling between systems, reconciles the trade-to-payments process and manages the payments.
Importantly from a liquidity perspective, firms can start the reconciliation process trade date onwards. Once agreed, payments are locked in. Firms get certainty that what is due will actually arrive on the settlement date. That eliminates the need for any prefunding. They can fund the account with the precise amount for settlement day.
All of this will become more pressing with the shift to shorter settlement cycles. With the US and Canadian equity markets set to move to a T+1 settlement cycle from the end of May next year, it is a racing certainty that any fund with an element of US exposure will have to shorten its own settlement cycle. The Investment Association has made a series of ‘suggestions’ in this area.
… and open the door to net settlements
But what automation also offers is the chance to move from gross settlements to net. This is the big prize. It has the potential to cut payment amounts from, say, the high seven figures to the low six.
It will simplify cash forecasting and lower cash requirements overall. It will reduce the number of payments, and with it bank charges. It will also cut the need for bank lines and reduce the cost of collateral.
Now this is not going to happen overnight. The path to net settlements stretches some way ahead. All Calastone clients can use Calastone Settlements to automate their gross settlements, irrespective of whether their counterparty is on Calastone or not. But, to settle net requires both parties to be on the same network.
I know from the many conversations I’ve had that net settlement is by far the preferred option for most of the funds industry. It makes enormous sense – and it can sweep away a lot of those hidden liquidity costs the industry currently bears. It will also bring new efficiencies across the board.
It is important to put this in a wider context, too. Fund firms have a duty to their customers, the investors, to drive out unnecessary cost from the fund trading lifecycle and maximise value. Automated, low-intervention processes that minimise the number of moving parts are a key part of that.