In this Q&A, Alastair Sewell explains why investors need to urgently rethink their approaches to collateral cash management.

Read this article to understand:

  • The practical steps investors can take to strengthen their collateral policies and portfolios in the near term
  • The importance of a diversified portfolio tapping into multiple liquidity sources
  • The benefits of mutual funds in providing the required credit quality, liquidity and diversification

Collateral management practices have been a key focus for many investors in the wake of the September 2022 volatility in the UK gilt market. We believe investors can take practical steps to strengthen the resilience of their collateral cash portfolios in the near term; chief among these is to review collateral cash practices.

Over a longer timeframe, we think liquidity will become more of a total portfolio consideration, as opposed to distinct portfolio buckets (e.g., liquidity, liability matching, growth). This implies potentially material changes to strategic asset allocation frameworks. We will comment more on this evolution of the market in future articles.

In the meantime, the following questions can help in a near-term review of collateral portfolio management practices:

When did you last update your collateral portfolio management policy?

There is no better opportunity than now to review and update a collateral management policy. Lessons can be learned from recent volatility but, as a general rule, the gold standard is to update policies at least annually.

Is your collateral pool sized appropriately?

A perfectly understandable reaction to the recent stress would be to increase the size of collateral portfolios. But while there will be a need to rebuild some collateral portfolios, size is not everything. Absolute size helps in a liquidity crunch, yes, but the composition of the portfolio can be just as, if not more, important.

How liquid is your collateral portfolio?

Regulation and market practice can involve a lot of assumptions about liquidity

This may seem like the wrong question to ask, but the reality is that regulation and market practice can involve a lot of assumptions about liquidity. We saw higher liquidity in market sectors conventionally thought of as less liquid in September. This highlights the importance of a diversified portfolio benefitting from multiple liquidity sources.

Is your collateral portfolio as diversified as it should be?

As the old adage goes, you should never put all your eggs in the same basket. Collateral portfolios that primarily held gilts were caught out by the recent volatility. In contrast, portfolios with more diverse exposures fared better.

What does your collateral policy not include?

Regulation usually applies zero or very low risk weights to government bonds, naturally leading schemes to hold high volumes of them in collateral portfolios. The fact is there are a range of high credit quality and liquid instruments available to investors. It is worthwhile checking that your policy does not exclude potentially useful instruments.

Does your collateral management policy include mutual funds?

There is no good reason why collateral portfolios cannot include mutual funds. Firstly, operational processes can be established easily. Secondly, some mutual funds settle same day. This can be more useful than securities for liquidity management, given securities usually settle two days after the security is sold.

Does your collateral portfolio policy constrain you to one investment manager?

There is a common view the same manager should be responsible for both the collateral and liability matching elements of a scheme. This logic typically does not extend to growth-seeking assets.

Third-party solutions can be a valuable part of a liquidity portfolio

We would argue third-party solutions can be a valuable part of a liquidity portfolio, complementing the activities of other managers in a scheme. Mutual funds are freely tradeable and can provide high credit quality, high liquidity and diversified tools for use in collateral portfolios.

What to remember

As Henry Kissinger famously said: “One should never let a good crisis go to waste.” We have had a crisis, we can learn lessons from it and make changes. Now is the time to review your collateral management practices and collateral portfolios.

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