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  • Writer's pictureWilliam Webster

Should Treasury make money?

The role of a treasury has changed dramatically over the past four decades. It used to be about making money, which was a lot easier because markets weren’t efficient. There were wide spreads, customers weren’t knowledgeable, and arbitrages paid well. (Hands up who can remember the 10 basis points free lunch between futures and swaps). This was an era when greed was good.

Today it’s different. Trading rooms that were full of noise have fallen silent. The easy profit opportunities are gone, regulations are tight, and risk mitigation is now the focus.

The choice

This means that your expectations of treasury need to be clear.

Do you want it to be a profit centre or not?

Whilst this isn’t a binary question, there are two distinct approaches.

The first is using treasury to efficiently manage the balance sheet without taking much risk. This is where you use the market to hedge and give up the bid-offer spread because you are the customer.

The second is having Treasury as a profit centre, but that is easier said than done. A significant challenge is to unravel how money is made. In truth, revenue streams are so mixed up that it’s almost impossible to see what’s going on.

Revenue sources

It reminds me of the trader who told me that he was going to lose his job because the “system” couldn’t allocate the high coupons he received to his P&L, but at the same time debited funding costs. If simple stuff like this goes on, there is absolutely no way you know what’s happening.

Then there’s the dealer who told me how he loved his new job. Everyone had to come to his team to deal with anything under two years; this captive no-risk franchise facilitated bumper profits and bonuses for the desk. No wonder other parts of the bank mistrusted treasury.

Maybe proper transfer pricing is the answer, but that’s a can of worms. Every approach I’ve seen is flawed in one way or another. It’s a great theory that doesn’t work in practice.

Where's your edge?

However, the real risk occurs when you don’t have any reason why a competitive market would pay you to transact. In this situation, if you insist on making money, dealers will oblige, and there’s only one way to go. That’s to push the boat out in terms of risk. Here I’m talking about credit, interest rate, liquidity, and basis risk. With the most stringent limits in place, it is quite amazing how enterprising dealers can become when pushed. Even when you aren’t breaching limits, the risk is there.

I recall a Treasury that hedged a Gilt portfolio with swaps and then, at an opportune time, unwound the trade to make a significant gain. The Board was outraged. Why? Because they realised that this profit had come from risk-taking, and none of it showed up in their reports. So, there you have it, the more you push, the greater the risk.

This means proper oversight and a curious, questioning approach are essential. If something seems too good to be true, it probably is, underscoring the need for a knowledgeable second line of defence that can tactfully probe what’s going on and get to the bottom of it.

The biggest risk, however, is behaviour, not of traders but of management. Business cycles come and go, and so does risk-taking. 1987, 1992, 1998, 2008, and 2020 all have one thing in common – market disruption. It can come from anywhere and can lead to anything, and it’s almost inevitable that when these things happen, you are least prepared because there’s nothing like a period of benign conditions to lull you into a false sense of security. We used to joke about the EM traders increasing their profit and limits year by year. They would go down for the biggest sum ever when the cycle turned, and it did.

If you want the treasury to make more, be satisfied you can answer these three things:

1. Why should the market pay you to trade?

2. What is the real source of money?

3. How good is the second line?

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