LIQUIDITY ANALYSIS AND RESERVES TRANCHING WAIFEM Regional Course on Optimising Reserves and Foreign Exchange Management for Income Generation Accra, Ghana, May 11 – 15, 2009 Lamido A. Yuguda, CFA, FCA Foreign Operations Department Central Bank of Nigeria Abuja, Nigeria

RESERVES MANAGEMENT OBJECTIVES § Preservation of capital § Maintenance of adequate liquidity § Maximization of return within tolerable risk limits.

LIQUIDITY § What is liquidity? An asset or a portfolio of assets is liquid if it has the following qualities: – Can convert to cash quickly – Low transaction costs to liquidate – Does not move the market upon liquidation

RATIONALE FOR HOLDING LIQUIDITY § Ensuring that the portfolio is sufficiently liquid to meet disbursement needs as and when they fall due. § Minimising the cost of acquiring liquidity when disbursements out of the portfolio are made: § Selling a bond when bond prices are down, the unrealised losses translate into realized § Breaking a deposit prior to maturity, implies cost in terms of foregone income on the deposit § Reputation risk…an indication of poor liquidity management on the part of the central bank.

LIQUID INSTRUMENTS § § § § § §

Overnight Deposits Term Deposits Certificates of Deposits Treasury Bills Repos Reverse Repos

THE COST OF LIQUIDITY • Liquidity has a cost in terms of foregone income • Liquid markets and instruments pay less than less liquid markets and instruments • However, the cost of lack of liquidity can also be enormous as indicated. • Consequently, only liquidity needed to meet known and contingent disbursements should be kept. The balance of reserves should be invested to earn a reasonable return.

WHAT IS RESERVES TRANCHING? § Tranching refers to the process of segregating international reserves into multiple portfolios (tranches), each reflecting specific objectives. § A common structure consists of three portfolios: § Working Capital § Liquidity portfolio § Long-term portfolio

§ Each of these portfolios may be either single or multi-currency according to the composition of the central bank’s reserves

TRANCHING SHOULD BE BASED ON • • • •

Transactional needs Liability immunization Providing confidence to markets Generating income to offset cost of carrying reserves

TRANCHING CONSIDERATIONS • • • •

Investment Horizon Liquidity Requirements Risk tolerance Return considerations

TRANCHE APPROACH TO RESERVES MANAGEMENT Goals

Benchmarks

Long term wealth

Full maturity index, equities

Buffer tranche

1-3 index

Liquidity / currency Increasing reserves

3 month bills / cash Reserves

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KEY STEPS IN RESERVES PORTFOLIO TRANCHING § Forecast/anticipated disbursements § Estimates of unknown disbursements § Unknown disbursements are based on observed historical trends. § The key issue is to balance the conflicting objectives of liquidity and return

TRANCHING OF RESERVES § A common structure consists of three portfolios: § Liquidity Portfolio § Short-term portfolio or Liquidity Buffer § Long-term portfolio or Investment Tranche

§ Each of these portfolios may be either single or multi-currency according to the composition of the central bank’s reserves. § Each may be managed against a specific benchmark.

TRANCHING OF RESERVES

Liquidation of assets

Liquidity Tranche

Liquidity Buffer

Investment Tranche

Investment of excess cash

TRANCHING OF RESERVES

Investment Tranche: Excess Reserves Liquidity Buffer: Estimated Support

Liquidity Tranche: Minimum requirement

LIQUIDITY PORTFOLIO § Objective: § To manage known and high probability foreign currency cash payments and inflows § To manage cash positions arising from day to day reserves management activities.

§ Liquidity Portfolio serves as the link between reserve assets held in other portfolios and net demands for foreign exchange cash (which can be net outflows or inflows).

LIQUIDITY PORTFOLIO §Surplus accumulation of cash in the liquidity portfolio can be used to purchase assets for the other portfolios, so increasing their size. §Return achieved—less than other longer term portfolios §Benchmark could be a particular target ( for example three month LIBID) or the yield of short-term government securities

LIQUIDITY PORTFOLIO: TYPES OF INSTRUMENTS Bank Instruments •Time Deposits •Certificates of Deposits •Bankers Acceptances •Overnight placements •Call accounts •Current accounts •BIS deposits

Govt Instruments Treasury Bills Floating rate notes Repos/Reverse Repos

Credit Instruments

Other Instruments

Commercial Paper

•Derivatives •Forward Rate Agreements

LIQUIDITY OF MARKET INSTRUMENTS

3mth Time Deposit

3mth CD

3mth CP

3mth T-Bill

No Liquidity

Good Liquidity

Average Liquidity

Ample Liquidity

LIQUIDITY PORTFOLIO: HOW INSTRUMENTS ARE QUOTED Discount Basis

Interest Bearing

Treasury Bills Discount Notes BAs Commercial Paper

Floating Rate Notes CDs Agency Securities Commercial Paper

LIQUIDITY PORTFOLIO: REPURCHASE AGREEMENTS § Characteristics of Repurchase Agreements: – Collateralised lending contracts – Repurchase Agreement (repos) – Securities are lent to a counterpart against cash/securities. – Reverse Repurchase Agreement (reverse repo or resale) – Securities are borrowed from counterpart against cash/securities – Interest is paid on the collateral. Typically the rate is set below the rate on bank deposits because repos are effectively a secured loan whereas bank deposits are unsecured loans. – Supporting infrastructure – legal agreements, defined credit lines with counter parties, settlement and control arrangements, etc.

LIQUIDITY PORTFOLIO: REPURCHASE AGREEMENTS

Repos

Investor is borrowing cash

Reverse Repos

Investor is Lending cash

Go for lowest rate offered Go for highest rate offered

Remember: Follow the cash. The value of a repo depends on Whether you are borrowing cash (lending securities) or lending cash (borrowing securities)

SHORT-TERM PORTFOLIO OR LIQUIDITY BUFFER § Short-term Portfolio: § Objective is to hold assets designed to meet contingent demands for foreign exchange liquidity. § Consequently, preservation of capital will be an important consideration in the portfolio, so that its benchmark will have a relatively short duration. § Nevertheless, it will still be possible to incorporate a return target for the portfolio, typically by setting a benchmark duration greater than that of the liquidity portfolio.

SHORT-TERM PORTFOLIO OR LIQUIDITY BUFFER § Composition: – Treasury Bonds and Notes – Agency Securities – Treasury bills – Repurchase agreements – Reverse repurchase agreements – Time Deposits

LONG-TERM PORTFOLIO OR INVESTMENT TRANCHE § Long-term Portfolio: § Objective is to generate an acceptable level of return; designed to contribute most to the overall return objectives for the entire reserves portfolio. § Benchmark will have longer duration than the other portfolios.

LONG-TERM PORTFOLIO OR INVESTMENT TRANCHE § May be invested in any of the instruments on the allowable list including – – – –

deposits with BIS Repos Treasury notes and bonds High credit quality agency securities, preferably bullets (those with embedded call options difficult to manage) – Etc

MULTIPLE BENCHMARKS? § The liquidity buffer and the investment tranche may be managed against different benchmarks § Relative return, tracking error numbers for each may be monitored § However, total portfolio return, both absolute and return can be calculated internally and monitored.

REBALANCING TRANCHE SIZE § Specify upper and lower band for each tranche § Decide on rebalancing rule § Rebalance tranch size

CONCLUSION • Central banks emphasize liquidity in the management of their portfolios • Liquidity has a cost , there is therefore need to balance liquidity with the need to generate return for the central bank • Portfolio tranching is one component of liquidity management strategy

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