The building blocks of liquidity solutions

As it transpired, in 2000 there were 109m mobile phones globally. By October 2014 the number of active mobile connections reached 7.22bn, exceeding the world’s population.

This analogy is relevant for liquidity management, traditionally used only by multinational corporations (MNCs), especially those with regional/global treasury centres and/or in-house bank structures. As businesses expand their operations and complexity, the focus on mobility and effective use of corporate cash has also grown. Regulatory, tax and accounting issues (and sometimes banks) impede the optimal use of liquidity, but the evolution and adoption of liquidity management solutions is accelerating and the pace of change could surprise many.

The 2008 collapse of several financial giants underlined the importance of effective liquidity  management. Improved risk governance structures, cost reductions, cash visibility and an increasing focus on treasury centralisation are key drivers to future-proofing corporate treasuries. Liquidity management structures are key when selecting the cash management bank for most corporate request for proposals (RFPs) received. Based on corporate treasurers’ experience in structuring and implementing cross-border liquidity management, the fundamentals for these solutions are:

Physical Pooling

Also known as cash concentration, cash sweeping or zero-balancing, where balances in the accounts of participating companies are swept to/from a centralised header account. Automated sweeping is conducted at the end of the business day on a daily, weekly or monthly basis, but may be on an intra-day basis too. Cash concentration supports treasury centralisation by automating intercompany lending, allowing more efficient investment of surplus balances in the header account.

Sweeping can carried out one-way (down or up), two-way, or reverse, with defined target balances for participant accounts. Most banks support multiple tiers of sweeping.

Value-added services:

  • To facilitate payments for subsidiaries participating in cash concentration structures, one of two sub-optimal solutions were traditionally used – target balances left in subsidiaries’ accounts, or setting up overdraft facilities for each of these accounts. Nowadays balance-sharing between participating accounts in the liquidity structure is provided by select banks. Sophisticated solutions are available, with flexibility for the parent and child account to share balances (bilateral) or all participating accounts to share balances (multilateral).
  • Balance-sharing between parent and child accounts can be controlled with fixed-amount caps or based on net contribution (or accumulator). Net contribution is the accumulated, net funds-flow from the child to parent account. A powerful tool for cash flow control, it enables child accounts to drawdown on available balances in the parent account, based on their respective contribution to the parent. It also allows clients to set limits on sweeping (i.e. lending) between group companies. Pooling of balances across all participating accounts can also be controlled with specified limits. Although simple in theory, managing such real-time controls cannot be accomplished by many banks.
  • Intercompany loans are subject to scrutiny over transfer pricing principles, so interest allocation with flexible interest rate rules and comprehensive reporting capabilities are essential. Automated settlement of interest payments and computation of withholding/business tax/ stamp duties on inter-company interest and/or borrowings are provided. Intelligent logic embedded into cash concentration solutions optimises tax positions. Variants such as tax-efficient sweeping, horizontal sweeping and hybrid sweeping (a combination of tax-efficient and horizontal) have been developed by agile banks in markets like China.
  • Online capabilities for liquidity maintenances (to change parameters such as target-balance amounts or sweeping frequency; to trigger on-demand sweeping; or to configure user-defined events to generate alerts), simulation and analytics are also increasingly available. Follow-the-sun sweeping, a cross-border technique to centralise cash on a global basis, involves moving funds from Asia to Europe, and thereafter to the US within a 24-hour cycle. It leverages on the time zone differences between key financial centres in these three continents. Against-the-sun sweeping works on the opposite principle; funds move from the US to Europe, or from Europe to Asia for Asian multinationals.

Notional Pooling

Balances in participating companies’ accounts are notionally offset (with partial or full offset of debit and credit balances) for interest computation. Interest is calculated on the group’s net position, eliminating the physical movement or co-mingling of funds.

DBS 1

Notional pooling is popular with companies operating on a decentralised basis. Subsidiaries maintain control and ownership of cash, resulting in account autonomy by avoiding inter-company loans and associated withholding taxes. Client documentation for notional pooling is stringent, requiring cross-guarantees and right of setoff.

Pooling is typically on a single-currency basis, with allocation of interest to subsidiary accounts optional. Where multiple currencies are involved in the notional pool, notional conversions to a base currency (before pooling and interest offset is completed) is undertaken at close of business, with the risk covered through the adjustment of currency-wise credit, debit interest rates or using short-dated swaps.

Physical versus notional pooling

Businesses often prefer physical pooling over notional pooling, due largely to the transparency of intercompany lending associated with cash concentration alleviating regulatory concerns.

Client documentation for physical pooling is simpler to execute, as notional pooling involves requirements such as cross-guarantees for establishing joint and several liability. These may conflict with covenants for the company’s credit facilities. Notional pooling also typically has a more complex regulatory environment, reflecting enforceability issues and differences in capital reporting for banks.

However, physical pooling also has implications, such as thin capitalisation (wherein deductibility of interest expense is limited when debt/equity ratios are exceeded), withholding tax (applicable to inter-company loans) and transfer pricing. Other issues for cross-border physical pooling include higher transaction costs for funds transfers and cut-off times. Co-mingling of funds in physical pooling is unappealing to joint ventures, while the account autonomy resulting from notional pooling supports decentralised treasuries.

Interest Optimisation

Corporations may find liquidity trapped in regulated environments. Interest optimisation or notional aggregation – a multi-country, multi-currency liquidity solution – allows companies to enjoy preferential rates on account balances based on their aggregate regional/global balances with the bank. Certain banks only offer preferential rates on credit balances; others can provide preferential rates for both credit and debit balances. The total global balance is notionally computed in a base currency by factoring in applicable regulations; for example some countries prevent companies from earning better rates on domestic aggregate balances, but allow these to contribute to the global pool. Other countries restrict contributions of domestic balances to the pool.

DBS 2

This solution is considerably simpler than cash concentration or notional pooling, as it neither creates inter-company loans or cross-guarantee obligations. Administration is easier, with no interest reallocation required for transfer pricing purposes. Companies can maintain decentralised account ownerships, although this is also a limitation of the solution as it does not provide effective control on group liquidity.

With the focus on liquidity and risk management, treasurers are increasingly using interest optimisation for trapped cash in domestic accounts, which cannot be incorporated into cash pools – physical or notional. This solution effectively leverages trapped surplus cash to optimise earnings from balances in non-regulated jurisdictions.

Hybrid Liquidity solutions

A combination of physical pooling, notional pooling and/or interest optimisation offers companies a complete cross-border liquidity management solution, allowing centralisation of funds and notional pooling or interest optimisation of resulting balances. As local operating companies often have accounts with domestic banks, the network bank offers an overlay solution, which funds or defunds these local bank accounts from an overlay account in each country. Thereafter, funds are concentrated into a central notional pool with the network bank, with funds typically continuing in the companies’ names. This significantly reduces – or eliminates – fragmented cash positions existing in multiple countries.

Where the network bank lacks a presence in the particular market(s), bilateral arrangements are put in place with local banks via SWIFT MT101 (Request for Transfer).

Value-added services:

Cross-border liquidity solutions can integrate with payments files from clients’ payments factories, using “just-in-time” funding concepts, to provide funding to subsidiaries for domestic payments on the required date. Sophisticated liquidity solutions have in-built algorithms and mathematical models to determine the preferred path for a participating account which is overdrawn, to automatically draw funding from another participant, based on rule-based algorithms to minimise cost or tax impact; or to empower the treasurer with real-time flexibility to alter structures.

Taxation Matters

Although evaluating the tax impact of pooling requires a separate article, depending on the corporate structure and selected liquidity management solution possible taxation issues include: internal transfer pricing (based on arm’s length principles); withholding tax; thin capitalisation; stamp or capital duties; permanent establishment; and value added tax (VAT).

Treasurers should have a transfer pricing policy prepared for intra-group transactions. Companies should seek tax and legal advice before implementing cash management structures. Banks may provide general information on country regulations and products.

Regulation

Inconsistent country regulations increase the complexity of a regional or global approach to liquidity management. Countries can be segregated into unregulated (Singapore and Hong Kong), regulated (China and Taiwan) and restricted (India) for cross-border liquidity solutions. In Malaysia and Indonesia, where local currency is more restricted than foreign currency, the former is managed using domestic liquidity solutions while the latter can be concentrated offshore.  In-country regulations also define the types of participating entities allowed to participate in liquidity structures.

Regulatory changes enable new liquidity structures to be implemented. With the renminbi (RMB) gradually liberalised by Chinese regulators, automated sweeping options are available so previously trapped cash in China may participate in a company’s cross-border liquidity structures.

The Organisation for Economic Co-operation and Development (OECD) project on Base Erosion and Profit Shifting (BEPS) is progressing rapidly, which could affect some existing global liquidity management structures as 15 action points focus on multinationals’ treasury activities. In particular, BEPS will be a catalyst for shift in tax considerations and is likely to result in changes to most tax-driven treasury structures and the preferred jurisdictions of the entities wherein global cash is concentrated.

The European Union’s Basel III capital adequacy regime will change how banks value liabilities, particularly for operating account balances and for institutional investors. Banks have reviewed Basel III’s impact on notional pooling and several continue to offer this product, subject to requisite client documentation and, of course, profitability. Moreover, the International Financial Reporting Standards (IFRS) requirement of periodic net settlement of balances is typically addressed by banks with an on-demand two-way sweep. Anticipating and responding to change is a critical success factor for liquidity management banks.

Liquidity management execution

The ‘5C’ factors for successfully executing liquidity management solutions are:

Customisability: Effective liquidity management requires the right liquidity, delivered at the right time with the right reporting. Banks must devise bespoke solutions that reflect the customer’s business model, their specific markets, regulations, tax considerations and unique operational and reporting requirements.

Collaboration: First-time implementation of liquidity management by a company is akin to a business process reengineering/corporate transformation project. Experienced banks facilitate this journey via detailed planning and communication, along with different training programmes for subsidiaries, regional/global offices and various levels of staff.

Convenience: Treasurers increasingly seek a wider range of capabilities that can be conducted using a bank’s liquidity advisors or online, for clients with a multi-country presence, regional treasury service centres or decentralised finance functions. Accessibility and functionality must be supported, along with best-in-class customer service.

Consultation: The quality of advisory services and thought leadership in the complex liquidity management and working capital space is a key differentiator. Cost-benefit analysis and a pros and cons of different liquidity structures helps clients select the right solution, followed by a comprehensive implementation-plan reflecting their timeline and priorities.

Connectivity: Treasurers need access to liquidity across geographies, so multi-bank solutions are an integral part of liquidity management solutions.  Global banks have a wider footprint but may adopt a cookie-cutter approach, so agile regional banks can gain competitive advantage by offering seamless connectivity with cross-border, multi-bank liquidity solutions, along with balance sheet commitment and expertise.

The liquidity management landscape is dynamic, as regulation opens up opportunities and sometimes reduces the viability of products. The liquidity profile of businesses is also fluid and evolving, so treasurers should periodically check they use the optimum liquidity strategy and products.

In a volatile world, cross-border liquidity management is an idea whose time has come and will become the new normal for both banks and treasurers.

Atul Bhuchar leads the regional product team for liquidity management, liabilities and accounts in DBS Global Transaction Services (GTS). In this role, he is responsible for product development and innovation, as well as for managing the profit and loss for this key portfolio of products. Liabilities has been a success story for DBS Bank, with a growing customer-franchise across continents. DBS Bank has launched a series of pioneering initiatives for Accounts. Prior to the regional product role, Bhuchar started and headed the bank’s cash management business in India. He has over 16 years of experience across treasury, corporate banking, securities services, trade finance and cash management, with roles across operations, sales, product management and relationship management functions. Bhuchar started his career with Citibank and then worked with HSBC before joining DBS eight years ago. He holds a Bachelor degree in Engineering and MBA from University of Delhi in India.

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