The case for more robust treasury and trading operations in pensions and insurance

Summary

Insurers and pension firms are traditionally good at managing risk and available capital over longer time horizons. But the nature of today’s markets and investment strategies also require them to operate in faster and more complex trading environments than they have in the past. Events through the pandemic and more recently in UK markets have underlined the need to tighten markets operations and be better able to manage collateral and liquidity in periods of volatility. Other market developments such as the compression of the settlement cycle (e.g. T+2, T+1) will only amplify this need.

This article at a glance

A look back
Why now is the time to invest in more robust operations
The benefits of getting it right

A look back

Historically the requirements for treasury and trading were reasonably straight forward. Investment strategies focused on a combination of domestic debt, conservative equities, and cash/cash equivalents. Firms had minimal hedging requirements and only a modest use of derivatives. Liquidity was relatively unconstrained with the operational focus on cash management and simple (reasonably low velocity) trade processing and investment accounting.

But, driven by a variety of market forces, firms needed to look further afield to seek the returns required to support their members and policy holders. There was an increased focus on illiquid assets and foreign exposures, bringing with it more complex hedging and valuations requirements. This also included an increase in the complexity and velocity of trading operations and a much heavier usage of derivatives. Liquidity has also become more constrained and uncertain with the focus on illiquid investments and the impact of derivative collateral requirements.

The operational requirement has evolved from that of a traditional corporate treasury operation to that of a complex fund manager. In many cases while the investment strategies have evolved, the operations have not kept pace.

In commenting on mini budget crisis, the FCA said – “In general firms’ systems were not set up to allow them to react with the speed that was needed.”[1]

Why is now the time to invest in more robust operations?

Increasing portfolio complexity – Investment strategies are requiring higher international exposures, a heavier use of derivatives, and significant exposures to illiquid or less liquid investments. With this comes the management of a more complex portfolio with more complex correlations, valuations and required hedging.

Operational requirements – This has come with a need to process higher complexity and velocity trading activities at a time of an increased focus on market rigour; shorter settlement cycles, enhanced derivatives reporting, moves to central clearing, higher collateral demand and complex collateral processes.

More constrained liquidity – Issues during the pandemic and more recently in the UK illustrated that liquidity risk in pensions and insurance is far from theoretical. While liquidity often plays second fiddle to solvency in the competition for executive attention, the changing dynamics brought on by the evolution of investment strategies (illiquid investments and greater use of derivatives) and persistent levels of higher volatility mean it deserves more attention.

Regulatory requirements – As referenced earlier, the amount and complexity of financial markets focused regulation applicable to insurers and pensions firms hasn’t decreased. In addition, there is a growing focus from pensions and insurance regulators on the robustness of treasury and trading operations, overall operational resilience, and liquidity risk.

Reputation – While insurers and pensions firms are arguably low true credit risks, a lack of discipline in confirmation, settlements, margin valuation and payments can undermine one of their most important assets – The trust of policyholders, market counterparties and regulators. As requirements increase, it is that much more important that firms have the rigour in operations expected of such an important market participant.

But I outsource my asset management and /or operations …

Regardless of whether some or all of the asset management value chain is outsourced, firms are still subject to the fundamental regulatory rules and other requirements and “expectations on business continuity, governance, operational resilience, and risk management[2]”. This isn’t limited to setting and monitoring mandates, but also includes ensuring MI is in place and operational processes are “fit for purpose” and appropriate business recovery/resilience plans are in place and periodically tested. This is particularly important in a multi-manager environment.

The benefits of getting it right

Growth facilitation, and operational risk and cost avoidance: A robust operating model that enables safe and efficient operational scalability has significant impact on the safety and efficiency of your operation. On the topic of required resources, one respondent in our 2023 Treasury and Trading operational survey described it – “In a well-controlled and highly automated environment, volume increases have a fractional impact. But, with low levels of automation and poor controls, volumes could quickly have an exponential impact”.

Asset optimisation: A robust treasury and trading infrastructure ensures the most efficient use of fund assets across all collateral obligations and helps to optimise liquidity buffers (and reduce the resulting drag on returns). Understanding an up-to-date view of cash and securities positions and being able to accurately forecast requirements over a variety of time horizons is essential in avoiding the need to hold excess buffers to deal with “frictional” requirements. This connects to the ability to effectively manage collateral obligations. Rapidly understanding applicable collateral, available inventory and applying “cheapest to deliver” rules.

Problem solving and agility: Rather than taking days to understand positions, a robust infrastructure will give firms the data and analytical tools to rapidly understand and adapt to changing market conditions and the external connections to provide liquidity if required. It will also enable firms to adapt more efficiently to changing regulatory requirements, whether this is the range of markets-oriented regulation already in the pipeline or new requirements as they come up.

Conclusions

Now is the time to ensure treasury and trading operations are “fit-for-purpose” and sufficiently robust to address the requirements of the investment strategies and operations they support. Not only should this more robust operating model be a prerequisite for safely operating in this faster and more complex environment, it also presents significant competitive advantage to those that can embed these systems and practices across their business.

A note on our 2023 Treasury and Trading operational survey

For the purposes of this review, we focused on the following broad functions:

Trade operations and control
Cash management
Liquidity risk management
Market risk management and hedging
Collateral management

It also became clear that while there were some high performers in the industry, we needed to look to adjacent industries to find true examples of leading practice across this range of activities. With this in mind, we expanded the interviews to include a range of Global & Regional banks, Asset Managers, Sovereign Wealth and Hedge Funds.

Summary conclusions

Whilst we will expand more on the results of this research in future blogs, in summary, insurance and pensions firms had significant opportunities for improvement across each of the broad functions we reviewed as compared to leaders in the sector and the adjacent industries. The key themes observed were broadly aligned to the following categories: