Liquidity management techniques and best practice: General principles, specific applications

Market conditions have driven the need to minimise liquidity risks, reduce funding costs and maximise strategic financial flexibility without compromising solvency. As a result, treasuries around the globe have been assessing various liquidity management techniques and their suitability for addressing these needs. While these techniques can be combined into sophisticated and complex liquidity management structures, at its most basic level liquidity management is essentially simple; namely the optimal combination of positive and negative cash flows with other funding sources or investments.

One size doesn't fit all

How this optimal combination is achieved is a highly organisation-specific matter; there is no universal "right" solution to liquidity management. While certain generic best practice principles do apply (see "Ten Best Practice Principles"), their precise integration into a corporate liquidity management strategy will depend upon a host of individual factors, including:

Existing business and banking processes;
Corporate culture;
Geographic footprint;
Business model(s); and
Technology.

Furthermore, these factors are unlikely to remain static over time, so today's optimal liquidity management strategy is unlikely to be tomorrow's. Therefore, treasury must monitor for any changes that may trigger the need for the strategy to evolve to the next level.

Depending upon individual circumstances, that process of evolution may encompass techniques that range across a wide spectrum of complexity. At the simplest end of that spectrum is the active or passive linkage of operating accounts with domestic interest-enhancing products, ranging from credit facilities to savings accounts.

Nearer the centre of the spectrum are arrangements that cover a group of accounts in order to aggregate and consolidate multiple cash flows. These arrangements can be broadly divided into two categories: one that relies on actual physical transactions across accounts (cash concentration) and the other on notional calculations (notional pooling).

At the most advanced end of the spectrum are sophisticated techniques that are capable of optimising the management of cash flows across multiple legal entities, currency positions and jurisdictions. However, deploying such techniques effectively may require material investment in internal processes and technology. It is also dependent upon the establishment of specific structures, such as an in-house bank, netting centre, re-invoicing centre, etc.

Nevertheless, irrespective of their degree of sophistication, the actual gains realised by these techniques will ultimately be heavily influenced by the degree of information, understanding and control that treasury has of a corporation's processes and cash flows. The most advanced techniques can perform indifferently if these are lacking; by the same token, relatively simple techniques can deliver significant gains if treasury has a firm grasp of these elements.

Potential benefits

If an appropriate liquidity management solution is effectively implemented, the corporation stands to enjoy a range of benefits (these otherwise representing opportunity costs):

Balance consolidation: This is realised by eliminating the cost of maintaining cash deficits and surpluses in the same currency that could otherwise have been offset. In financial terms, it is determined by the differential between the interest rates applicable to the credit and debit balances that are offset.

Balance aggregation: Increasing the size of the aggregate cash position attracts better interest terms than those achievable on individual balances left idle or invested separately. It is a function of the interest-rate differential between the rates achieved with and without aggregation.

Balance stability: Connecting multiple accounts into a larger liquidity structure has the portfolio effect of reducing overall net balance volatility. As a result, it becomes easier to identify and isolate a stable liquidity "core" within this net balance. This confers two primary advantages:

The structure is better able to absorb unexpected cash flow events and mitigate their impact, thereby also minimising the effect of any inaccuracies in the cash forecasting process.
Determining accurate "time slicing" of available cash is easier, thereby facilitating more efficient distribution of investments across the maturity spectrum.

(An accurate assessment of this type of benefit is more complex and requires the utilisation of statistical concepts.)

Net balance utilisation: This is the minimisation of the opportunity cost of being unable to extract the maximum value from the aggregate net cash flow. The scale of this benefit depends upon various factors, including:

The size and stability of the core element;
Medium-term cash forecasting accuracy; and
The corporate's financial position (i.e. whether typically a net depositor or borrower).

In financial terms, the net balance utilisation benefit results from the interest-rate differential between the current and the alternative usage of the net liquidity (i.e. reduced funding cost or enhanced investment yield).

Other benefits: Other potential benefits derived from effective liquidity management include:

Management cost/time savings, particularly when using passive and fully automated techniques;
Increased visibility and control of cash flows;
More rigorous counterparty risk management, such as on idle balances or balances invested locally with institutions not validated/approved by treasury;
Reduced dependency on local credit facilities;
Improved enterprise-wide liquidity risk management; and
Greater strategic financial flexibility.

Techniques

Liquidity management techniques broadly fall into two main groups, depending upon the method used to consolidate balances:

Physical balance consolidation:

Cash concentration, also referred to as zero balancing, sweeping or physical cash pooling.

Notional balance consolidation:

Notional pooling.
Interest enhancement.

Cash concentration

Cash concentration works by making transfers between master and subordinate accounts to aggregate balances physically. These transfers can be subject to various criteria specified by the client, which can include a number of options:

The balance to be left on the subordinate account (e.g. zero or pegged/target account balancing).
Whether flows are single or bi-directional (i.e. whether flows are always moving in a predetermined direction - such as from subordinate to master account in a one-way sweep transaction, or both).
The frequency and timing of concentration (e.g. intra-day and/or end-of-day; single or multiple events at predetermined times).
The layering and sequencing of the concentration activity, i.e. single or multiple account concentration levels (single tier: many to one, or multi-level: many to few to one).
The control of transaction execution by applying additional discretionary configurations, including (among others) a balance threshold, minimum transaction size, credit or inter-company lending limits.

Cash concentration achieves the mobilisation and consolidation of the available balances to a master account from where the net position can be invested or funded. One unique characteristic of this technique is that it does not automatically compensate a participant entity for its contribution. Instead, this is accomplished via a separate mechanism, which can be offered as a supplementary service or independently administered by the user.

Advantages

Cash concentration combines simplicity and clarity of how funds move through a complex liquidity structure and is an accepted technique in many jurisdictions, even more regulated ones (as regards onshore transactions).

It can operate on a single or cross-entity basis. Since it establishes clear bilateral relationships across participating accounts and their respective holders, this facilitates inter-company lending arrangements if different entities are involved. If that is the case, the basic service can be supplemented with inter-company lending portfolio administration.

It is important to note that cross-entity concentration does not automatically imply the initiation of an inter-company loan; this is ultimately determined by the business relationship among these parties. For example, if an agency arrangement is in place, whereby the subordinate account entity is a collection agent for the master account entity, then the relationship has a different nature and it will be covered by the agency agreement rather than an inter-company loan document. The underlying arrangement determines how the contribution of a participant is compensated. In the case of an inter-company loan transaction, the loan terms between the two parties (e.g. interest rate, interest period and frequency of settlement) regulate such compensation. This process can be administered by the user, with the assistance of a treasury management system or similar tools, or outsourced to the banking provider who offers it as an on-demand service.

Two other important features are specific to this technique. First, by making use of inter-company transactions for multiple entity structures, the financial reporting of any cash holding is improved. Typically, a reduction in the size of the balance sheet is possible; by netting off opposite positions held by the master account holder, as well as reporting related party holdings instead of cash or short-term financing with banks. Second, a properly engineered cash concentration structure leads to a reduction in both overall and participant-level credit requirements. This is because the group of accounts share intra-day credit facilities with a much more limited overnight credit line at the top of the structure.

At its simplest level, cash concentration offers simplicity and improved control, in addition to the generic liquidity management benefits outlined above. Depending upon the jurisdictions involved, these benefits may also apply in the case of cross-border cash concentration.

Caveats

The distinction between single and multi-entity cash concentration is important. A single-entity structure introduces little if any additional complications, but cross-entity concentration involves transfer of ownership, which must be properly structured and appropriately documented if re-characterisation risks are to be minimised. (For further information on re-characterisation and other tax-related risks, please see Lennon Lee's article "Regulation and Tax: Matching Efficiency to Opportunity"). Furthermore, taxation implications - such as withholding or other local taxes - may be triggered by the bilateral relationship established, which therefore requires careful planning and due diligence.

Related matters to consider are thin capitalisation and transfer pricing. In order to maintain the validity of interest expense deducibility, as well as the legitimacy of the concentration transactions, it is critical that any thin capitalisation (also referred to as the debt-to-equity ratio) limitations relating to individual participants are carefully considered. Furthermore, as regards transfer pricing, any pricing conditions applied must be aligned with the rates that would apply if the transactions were undertaken with third parties as opposed to group companies.

Cross-border cash concentration is less straightforward in more restricted jurisdictions, where foreign exchange (FX) controls and capital movement regulations apply, such as China, India, Indonesia, Korea, Malaysia, Taiwan, Thailand and Vietnam.

Cash concentration is typically available as a single-currency service; there has not been a significant demand for the cross-currency version of the service, either domestically or cross border. The main reasons for this are the change in FX risk generated by the currency conversions and the complexity of establishing an appropriate benchmark rate for the conversion.

Typical user

In our experience, cash concentration techniques are more suitable for corporations that have some of the following characteristics:

A functionally centralised (or centralising) management culture;
A preference for fully automated or passive management tools;
An existing (or intended) inter-company lending framework;
A focus on balance sheet reduction and/or tax planning;
Aversion to complex legal documentation and cross-indemnity provisions;
The ability to support an inter-company due diligence process, but not more complex operations;
A desire to establish a regionally or globally consistent liquidity management model with no or few variations; and
A desire to reduce dependency on credit.

Notional pooling

Notional pooling differs from cash concentration in that it operates by performing an interest calculation across a group of designated accounts on a purely notional basis. There is no physical movement or commingling of funds and therefore the original beneficial ownership structure of balances is maintained.

The other main differentiating feature of this technique relates to how it generates what is commonly referred to as the "pool net advantage", or net benefit. In the more standard version of notional pooling, an algorithm is used to determine the impact of two factors:

The degree of balance offsetting in any given day (i.e. the matching proportion of debit and credit balances); and
Any interest differential between the pool-level and account-level conditions applied (different interest rate settings can be applied to each level).

These two factors determine the pool net advantage, which is then applied according to the client's preferred allocation method (subject to any regulatory restrictions). The resulting allocation of compensation among pool participants is more flexible than in the case of cash concentration.

One final but important consideration relates to credit requirements. A notional pooling structure is typically more credit intensive as credit lines will be required for any participating accounts that are expected to have material swings in balances or structural deficits.

Advantages

For some corporations, with concerns relating to inter-company lending documentation and administration, the fact that notional pooling does not involve any commingling of funds represents an important advantage over cash concentration. A further unique characteristic is that establishing a multi-currency notional pool is relatively straightforward and much more effective; in significant contrast with the difficulties associated with multi-currency cash concentration.

Apart from the above, notional pooling can be very convenient when dealing with issues relating to corporate culture. If local finance directors have traditionally enjoyed considerable autonomy, there may be significant internal resistance to physical movement of "their" funds via cash concentration. The fact that notional pooling leaves balances in the original entity's control, fully segregated from other funds, allays these concerns. In situations like this, notional pooling can be a useful tactical mechanism to improve liquidity management performance immediately, with a view to moving to cash concentration in the longer term (if appropriate/advantageous).

Caveats

While the maintenance of separate balances clearly has its advantages, it imposes considerably greater due diligence and contractual documentation overheads than cash concentration. Matters such as right of set off and cross guarantees or indemnities must be thoroughly addressed in order to establish a structure able to minimise its balance sheet impact and deliver the benefit of net balance treatment. This is critical to the balance optimisation that the notional pool is expected to deliver. Unless the pool meets the criteria for net treatment, the resulting benefits to the user will be substantially impaired.

Notional pooling is also permitted in fewer jurisdictions than cash concentration, and requires specific individual approval; particularly where local regulations apply to the participation of interest-bearing accounts, the availability of overdraft facilities or the applicability of net balance treatment. Furthermore, notional pooling (in its fully fledged, net treatment version) is only currently feasible on a single location basis; while multi-location notional pooling has been considered, it is in practice overly complex and inefficient because of the regulatory environment, which does not allow (or severely restricts) offsetting of balances across different jurisdictions. Particularly in Asia Pacific, until the legal framework relating to set-off enforceability and the regulatory environment on net balance treatment is more established and homogenous, this remains only an opportunity for the future.

Overall, notional pooling involving multiple foreign entities is a more complex structure to establish than cash concentration. The potential benefits need to be substantial if they are to exceed the costs and effort associated with implementation. Nevertheless, notional pooling remains a very powerful technique that is worthy of consideration.

Typical user

In our experience, corporations more inclined toward notional pooling techniques have some of the following characteristics:

A complex or large legal entity structure;
A functionally decentralised management culture;
A focus on tool-driven multi-currency management;
A willingness to actively manage the overall pool position;
An ability to deal with more complex legal documentation and cross-indemnity provisions;
The capability to support a more complex due diligence exercise; and
A willingness to consider hybrid structures that combine different liquidity techniques.

Interest enhancement

Interest enhancement is conceptually similar to notional pooling in that no physical movement of funds is involved. However, it works by applying preferential pricing across a group of accounts on the basis of pre-determined criteria that are typically based on a net aggregate balance threshold. For example, a company with multiple credit balances distributed across its various operating centres may find that individually these balances only qualify for the lowest interest-rate tier payable on credit balances. By contrast, under an interest-enhancement arrangement, the total of these balances is used to enhance the qualifying tier of the individual balances. Nevertheless, the technique must comply with any applicable banking or local regulations regarding the retribution of an account, in the form of an interest amount.

Advantages

Interest enhancement is an extremely flexible mechanism and can operate on a single or multiple currency, as well as a single- or multiple-location basis. Unlike other liquidity techniques it has far fewer regulatory implications and is therefore well suited to both deregulated markets as well as jurisdictions with capital movement restrictions or FX controls. The main reason for this is that the mechanism works on the basis of relationship-based preferential pricing, rather than net balance treatment.

Interest enhancement is also not static in that it takes into account the dynamic profile of the relationship between bank and corporation as it changes from one day to the next. As such, the interest computation is adjusted on a daily basis to take into account all balances held with the institution and their contribution to the overall relationship to determine the appropriate pricing.

In contrast with notional pooling or cash concentration, an interest-enhancement structure involves considerably less cost and effort on a corporate's part to implement. As such, in addition to being a convenient remedy for balances in more regulated jurisdictions, it can be invaluable as a stepping stone to more sophisticated liquidity management techniques. To that end, interest enhancement also increases the degree of control and automation, as well as improving the net liquidity position of an organisation.

Caveats

Interest enhancement will not typically match the scale of the liquidity benefits that can be achieved through cash concentration or notional pooling. The reason for this is the inability to apply net treatment, resulting in a residual margin that cannot be removed or fully optimised. Nevertheless, this type of structure can still generate significant value depending on the size and geographical distribution of the balances (particularly their allocation between deregulated and more regulated markets).

Typical user

In our experience, corporations more inclined toward interest-enhancement techniques have some of the following characteristics:

Geographically distributed balances, with material holdings in more regulated markets;
A functionally centralised (or centralising) management culture;
A preference for fully automated or passive management tools;
The need of a supplementary/complementary structure to existing liquidity arrangements; and
A willingness to consider hybrid structures that combine different liquidity techniques.

Hybrids

While the various available liquidity techniques have been separately outlined above, reality is seldom this clearly delineated. In practice, the use of hybrid structures is increasingly common, which may involve the use of different techniques in various parts of the structure. The result is a structure that makes use of the most efficient technique depending on the location, currency and region concerned. While this hybridisation is typically very apparent (such as in the combination of physical and notional techniques), at times it can occur almost unnoticed. For example, the use of reference accounts to create a single-entity notional pool can effectively be regarded as the compression of a one-tier cash concentration within a single account.

The use of hybrid structures has both benefits and shortcomings. On the plus side, it allows efficiencies to be achieved that might otherwise be unavailable if using just one type of structure. This is particularly applicable when operating across a mix of regulated and unregulated markets, where not all techniques will be universally available for regulatory reasons. Interest enhancement is the one exception to this (subject to banking regulation), but in practice - unless a company only operates in highly restricted markets or is using this arrangement as an interim measure - it will typically be combined with other techniques anyway. Another important consideration is that the use of hybrid structures can be used to reduce the complexity of a liquidity technique, such as by transforming it from a multi- to a single-entity structure (as mentioned above).

Complexity and also potentially cost are the primary disadvantages to hybrid structures; determining the organisation's optimal combination of liquidity techniques is not an easy matter. All the internal factors (itemised under "One Size Doesn't Fit All" above) have to be considered alongside regulatory considerations and the functionality/coverage of banking partners.

To a lightly staffed treasury with other day-to-day operations to run, the due diligence required to arrive at an appropriate solution is not an attractive prospect. Fortunately, it is by no means an insuperable challenge; a global transaction bank with established expertise in liquidity management is ideally placed to short circuit a lot of the labour of designing and evaluating a liquidity management structure appropriate to the organisation's profile and objectives. However, it is important to emphasise that such a bank must be able to deliver both a macro and micro vision to the task; one or the other in isolation is inadequate. A solely "big picture" perspective will be prone to missing regulatory minutiae, while a narrow regional or single country outlook will fail to deliver on the corporation's overarching objectives. A similarly dual-perspective requirement also applies to any legal and tax/accountancy advisers that the company consults.

Conclusion

The liquidity landscape is fluid at both a corporate and an environmental level; a company's liquidity profile obviously changes over time, while liquidity techniques and combinations thereof continue to evolve.

Therefore, designing and maintaining a corporate-specific implementation of liquidity best practice is the proverbial challenge/opportunity. Nevertheless, achieving this delivers a range of benefits - financial, operational and strategic. While the path to this goal may be demanding and require combining a variety of liquidity techniques, external expertise from banks and other professionals is available.

Given the degree of collaborative analysis required, it is essential that all the parties concerned deliver the appropriate degree of commitment, while having access to the necessary data and sufficient time to perform a complete evaluation. The optimum result can only be achieved by having a clear vision of the desired end-state of the liquidity model and then establishing the appropriate road map for execution. Attempting to short cut this process will only result in substandard returns.

Ten best practice principles

The efficiency of a liquidity management structure will always depend on the underlying account structure design and the individual characteristics of the corporation concerned. Nevertheless, there are some generic best practice principles that are universally applicable.

1. Local currency accounts should be maintained where the currency is cleared and where the clearing instruments are most efficient and comprehensive.

2. Foreign currency accounts should generally be domiciled in accordance with (1.) above. However, if time-zone differences are significant and proximity (of payer and beneficiary or of service user and provider) is a material consideration, then aim for a single location that offers competitive clearing practices across most, if not all, of the required instruments.

3. To realise the greatest benefit, balance consolidation should in the first instance be conducted at a single currency level.

4. Resist temptation to use account structures to resolve reconciliation or internal reporting challenges, as other solutions can address those in a more effective manner. The design of split or dedicated account structures, such as separate disbursement and collection accounts, should be driven by liquidity management considerations such as efficient funding and upstream fund consolidation, particularly in multi-bank arrangements.

5. Payment and collection "on behalf" models, among other techniques, can be effectively applied to significantly simplify the account structure. However, they require system logics to maintain full process automation.

6. Problems with accurate and timely forecasting can be mitigated by aggregating operating accounts under a properly designed liquidity structure, by reducing the volatility around a more easily identifiable and stable core.

7. Liquidity structures are most effective when established with a single bank. Minimise cross-bank fund movements, but if necessary execute those in the domestic clearing and avoid international wires or cross-border, cross-bank arrangements, which are typically more inefficient in terms of cost and processing cut-off times as well as resulting in buffer operating balances left among multiple banks.

8. When cross-border structures are involved, balances should first be consolidated onshore. This minimises cross-border transfer traffic and ensures that consolidation across resident entities is attained before involving any non-resident entities. (Unless the latter is beneficial for a specific reason, such as taxation.)

9. When cross-entity techniques are utilised, consolidate at single-entity level first and involve a tax-efficient entity for further regional or global aggregation.

10. Matters such as contractual documentation make multi-entity structures more complex to establish, particularly in the case of notional pooling. However, there are various simple means of reducing such complexity, such as by establishing bilateral relationships among the participants and one or more designated entities. On the other hand, the avoidance of inter-company lending administration in a pure multi-entity notional pool may prove an attractive proposition.