How do you solve the tricky equation of increasing investment returns while reducing counterparty risk?

How to solve the thorny equation of increasing investment returns while reducing counterparty risk remains a tricky question that treasurers intend to find answers to. They can and must diversify their investments. Bank deposits (certainly useful for “wallet sharing” and “ancillary business” to give to bankers) are useful, but must remain limited, as they are not guaranteed. Over-concentration of risk on a single bank, or the multiplication of MMF's invested in a single bank, is not an option.

Diversification, the panacea of any Short-Term investment policy

The first lesson every treasurer learns is that of diversification, a risk mitigation tool. Short-term investments present an undeniable risk, and the spring 2023 crisis involving Credit Suisse and several US banks sadly reminded us that there is no such thing as zero risk, and that a bank can default. We have short memories in finance, and we often forget. The equation remains relatively simple. It's a cursor that can be moved towards “more return” and therefore imply more risk or shifted towards “less risk” and have de facto less return. In the end, it's quite binary. In the treasury sector, the art lies in optimizing return with the least possible risk. It's all about finding the right balance. There is no magic formula. However, by combining complementary products, it is possible to reach this “optimal” level. This is what we shall endeavor to demonstrate in this article. It is possible to respect the sharing of investments with your bankers, without exaggerating the concentration of risk and without exceeding the limits set by internal policies on the subject. To achieve this, you need to combine simple bank investments and traditional deposits, vary maturities to ensure that you always have the flexibility and maturity of your investments (i.e. investments reaching maturity), and use money market funds sparingly to avoid reconcentrating counterparty risks horizontally (i.e. each fund invests in fairly similar products, which together increased risk incidentally, if you're not careful).

Risks versus tenor and versus liquidity of investments

Two graphs show how to position investments by type according to the degree of duration (i.e. tenor) in relation to risk and the degree of liquidity (i.e. immediate to longer) in relation to risk. Returns can be surprisingly (especially with a descending yield curve) better in the shorter term. But here again, by slicing and dicing investments and diversifying, liquidity is assured, risk is limited, and over-concentration of counterparty risk is avoided.

Risk versus Tenor:

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Risk versus Liquidity

Yields may vary according to the short yield curve and steepening. If the curve has the most classical shape, duration is virtuous, and yield increases with duration. But when the curve is inverted, things can be different. Let's not forget that a guaranteed deposit allows you to take on other risks (in terms of counterparties) and therefore increase yield. It is therefore difficult to give a precise idea of the yield on different products, as this can change depending on a few factors.

Guaranteed deposits and tri-party repo’s, an interesting alternative to consider

Treasurers can enhance returns while mitigating bank counterparty risks through strategic use of guaranteed deposits and tri-party repos. They present advantages.

1. Guaranteed Deposits

Definition: Guaranteed deposits are time deposits that offer a fixed return and are backed by collateral or deposit insurance. They reduce exposure to individual bank risks. Leverage collateralization is key, as it ensures deposits are secured by high-quality collateral (e.g., government securities or other liquid assets). This reduces the risk of bank default affecting corporate funds. To optimize return, the ladder maturities may help to balance liquidity needs and interest rate optimization. Longer maturities (typically and usually – not currently) offer higher returns while shorter ones maintain flexibility. Banks may offer better returns for guaranteed deposits since they are collateralized, reducing the perceived credit risk. Therefore, collateralization ensures corporates are protected even if the bank defaults. Treasurers can lock in competitive rates, typically better than standard deposits. Guaranteed deposits often meet internal and external regulatory liquidity requirements.

2. Tri-Party Repos

A tri-party repurchase agreement involves three parties: a corporate entity, a counterparty (typically a financial institution), and a custodian (tri-party agent). The corporate provides cash to the counterparty in exchange for collateral, with the agreement to reverse the transaction at a set future date and rate. Corporates should be advised to accept all types of collaterals (as 100% are guaranteed) and not only liquid, high-quality securities (e.g., government bonds, AAA-rated corporate bonds). The guaranteed deposit of 100% collateral enables to mitigate counterparty and collateral risks. The tri-party agent ensures proper collateral valuation, safekeeping, and margin maintenance. This reduces operational risk.

Counterparties are typically willing to offer attractive rates on repos, as these transactions are collateralized and lower risk for them. Spread transactions across multiple financial institutions enables us to reduce reliance on any single counterparty. However, we should ensure that collateral values remain sufficient to cover exposures (normally 100% is guaranteed and checked by clearing houses). The collateralized nature of repos ensures treasurers can recover their funds in case of a default. ?Repos can have short tenors, making them a liquid investment option. Tri-party repos typically offer returns competitive with unsecured bank deposits, with lower risk due to collateralization. Treasurers can also use both instruments in tandem to optimize the balance between return and risk. The guaranteed deposits for Medium-Term Investments are well appropriated for stable, predictable cash flows that can be locked in for longer periods to earn higher yields. It is a safe strategy to use Tri-Party Repos for Short-Term Liquidity Management for parking excess liquidity in secure, high-yield investments that remain highly liquid. It is recommended to regularly evaluate the financial health of counterparties and custodians and to set Investment Limit exposure to any single institution or investment class to maintain diversification.

Technology and packaging aspect is key

Tri-Party Repo's remain a perfect investment tool, but complicated from an administrative point of view. Platforms such as Treasury Spring therefore make it possible to “package” “guaranteed deposit” type products, with a single set of documentation (instead of one per repo, with a definition of the basket of underlying collateral assets). The idea is to process via platform, digitally, and with a single set of documents instead of one per repo. It's a major and brilliant advance, providing access to perfect tools without the administrative complications associated with them. In this respect, a platform that “packages” products are a real revolution for any treasurer. We can legitimately assume that, in time, it will become a key tool in any MNC treasurer's strategy.

The investments made could then be recorded into a Treasury Management Systems (TMS), which may monitor returns, counterparty exposures, and collateral quality in real time (if adapted and leading-edge solution). By incorporating guaranteed deposits and tri-party repos, treasurers can achieve a higher risk-adjusted returns, a diversification of counterparty risks, a flexible mix of liquidity and stability, a careful planning, regular reviews, and leveraging technology to maximizing the benefits of these instruments.

The optimal strategy is a combination

We can therefore see that when excess liquidity amounts are oversized, which happens very often, the strategy must be adapted to optimize results by diversifying investments, “tranching” maturities to guarantee virtually permanent liquidity, reducing counterparty risk and maximizing returns. An optimal strategy can only be a combination of products, and the guaranteed deposit is one of the components enabling this optimization, while respecting the sharing of ancillary business with core bankers. This is the type of alchemy and distribution that needs to be implemented to limit any excessive counterparty risk.

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Fran?ois Masquelier, CEO of Simply Treasury – November 2024 - Luxembourg