From the September 2010 issue of Treasury & Risk magazine

Trading on Their Own

Big companies are still the ones most likely to execute trades in-house, even though new technology has made it easier to set up a trading desk.


When Eli Lilly & Co. announced its $6 billion acquisition of Imclone Systems in the fall of 2008--its biggest deal ever--the financial markets were collapsing and the outside funds in which Lilly had invested a portion of its cash were falling right along with them. Thomas Grein, treasurer and vice president of the Indianapolis-based pharmaceutical company, which had net income of $2.6 billion on $11.2 billion of revenue in the first half of 2010, says the company first started hiring outside managers in 2000. They provided Lilly with some additional returns in the first part of the decade, but the credit crunch of 2008 was less kind, he says, and one manager was especially troublesome.

"We harvested cash from that manager and a number of others so we would, first of all, be able to reduce debt requirements around the acquisition, but also because of [the investment managers'] performance levels," Grein says.

Since then, Grein's treasury has managed most of the company's cash in-house, investing directly in money market funds and especially commercial paper.

Plenty of corporate treasury desks were stung by external asset managers that put clients' money into investments such as auction-rate securities, which Wall Street described as highly safe, but which are now mostly underwater. Even money market funds, such as the venerable Reserve Primary Fund, shocked investors by "breaking the buck"--when the share price falls below the $1 mark--or threatening to do so.

Eli Lilly's three traders are also responsible for hedging the company's foreign exchange (FX) risk. They have, however, reached their trading limits. Grein says the company has exceeded $5 billion in cash and so plans to employ more outside managers, which it has identified but hadn't yet selected as of early August.

In fact, Eli Lilly is taking somewhat of a contrary approach. Typically, more cash to manage means more reason to establish in-house trading operations. Google, for example, has ramped up its in-house trading team from six staff members three years ago, when it had $11 billion in cash, to more than 30 today who manage $27 billion.

Large technology companies typically are cash-rich and have little debt, making them perfect candidates to establish in-house trading operations. Pharmaceutical and energy companies also fit the bill. And despite the economic downturn, most of these companies find themselves swimming in even more cash. Moody's Investors Service calculates cash at non-financial companies now totals $1.84 trillion, a 27% increase from early 2007, before the recession kicked into gear.

In addition, there's still plenty of Wall Street talent looking for gainful employment after brutal layoffs last year. And more importantly, technology has developed rapidly over the past decade, automating not only the execution of trades but their settlement and accounting.

These factors open the door for more non-financial companies to set up internal trading operations to manage their cash and trading needs at a lower cost than hiring outside managers.

"It's easier now than ever before to manage money and do FX trading in-house," says Jeffery Wallace, managing partner at Greenwich Treasury Advisors, noting that's especially the case for companies that have centralized their treasury operations. He adds, "Why pay an outside manager and tell them what you want them to do, when you can take the money, buy a very nice trading room, pay traders, and come out with a substantial profit."

So far, however, the strategy appears to remain the province of the big boys.

Aside from the biggest Fortune 100 corporations, companies are moving more cash to outside managers, says Craig Jeffery, managing partner at Atlanta-based consultant Strategic Treasurer. "There's definitely been a strong trend in short-term cash, where firms are using money market portals or having funds managed in separate accounts through outside managers," he says.

There are signs, however, that some less than super-rich companies see advantages to having at least one foot directly in the markets. Or at least some service providers have reached that conclusion.

IPC Systems, a Jersey City, N.J.-based trading system and network connectivity provider, has worked mostly with large banks and hedge funds to design platforms for trading and back-end settlement. Three years ago, it concluded there was growing opportunity to provide its services to non-financial companies setting up their own trading operations, in part because it was approached by a provider of networking equipment seeking exactly that.

Bart Bartolozzi, a senior product manager at IPC, declines to say how many non-financials use IPC's services to set up in-house trading operations, nor will he provide any names. He says, however, that after first targeting the Fortune 100, IPC has since set its sights a level or two below, on companies with highly entrepreneurial approaches to their businesses. Bartolozzi also points to global companies that must hedge risks stemming from changing values in currencies and commodities.

The math to determine whether building an in-house trading operation is cost-effective is straightforward. Mark Conner, who has run Baltimore-based Corporate Treasury Investment Consulting for three years and who previously worked with corporate treasurers for more than 20 years at major brokerage firms including Credit Suisse and Citigroup Smith Barney, says external investment managers typically charge 10 basis points as a starting fee. So farming out a $10 billion portfolio would cost approximately $10 million.

Assuming all-in compensation to staff at an in-house trading floor is $300,000 per trader, and the company hires 10 traders for a total cost of $3 million, the in-house solution costs only 3 basis points--a significant savings.

"If all you're doing really is hiring folks to get efficient execution, that's a very justifiable cost," Conner says. But he cautions that not only must companies hire experienced traders, but their management and their boards of directors should understand the investments and their risks.

"It's fine if the traders know what they're doing," Conner says. "But if management doesn't have a handle on it, the company is in for trouble." He notes the big losses Gibson Greetings and Orange County, Calif., suffered on derivatives investments back in the 1990s.

Brent Callinicos, treasurer at Internet search engine Google, agrees that it is less costly to trade in-house. He cautions, however, that it's critical to consider the anticipated rate of return on each type of investment and the resources required to invest in it.

Google invests in a wide range of fixed-income securities, ranging from Treasuries to corporate, government agency and emerging market bonds. In addition to executing short-term investments such as commercial paper and money market funds, Google's in-house traders handle bonds that carry a sovereign guarantee, such as Treasuries and government agency paper, of which the company holds about $18 billion. The fixed-income categories handled by outside managers--about $9 billion--are corporate debt securities, most municipal bonds and some foreign government bonds, Callinicos says.

The company's in-house trading staff also has the mandate to search out--and monitor--the best outside managers. While it makes sense to bring trading in-house whenever possible, Callinicos says, a treasury must have the systems, tools and people on the ground wherever relevant markets may open. "With sovereigns, we can hire a lot of people with experience in that space," he says. "We don't have to have people in London and Hong Kong."

When analyzing cash strategies, companies must also consider other likely needs for their cash, such as acquisitions. For example, in 2004, Microsoft used $32 billion of its $56 billion in cash to provide investors with a special one-time dividend.

Aaron Kessler, an analyst at San Francisco-based investment bank ThinkEquity, says investors may question why Google has chosen to retain such a large stash of cash. "It's probably better suited to buy back stock than to set up operations to manage their cash," he says.

Google did buy back shares following its $750 million all-stock deal to acquire AdMob this year, but it has announced no other plans for its cash. In the meantime, cutting cash management expenses by taking some of those responsibilities in-house is a strategy that's unlikely to find too many critics. And investors can hardly complain about their holdings of Google. The company went public in 2004 at $85 a share, and although the stock dipped below $300 when it weakened along with the rest of the market in late 2008, last month it was trading above $480 a share.

And nobody knows just what Google has up its sleeves. Managing cash in-house can give the company more control over its finances.

"Another reason we like in-house cash management is we can keep close tabs on our daily and weekly cash needs," says Grein at Eli Lilly, noting that the company has developed a cash forecasting process that lets it "tailor investments to exactly when we'll need that cash at varying times during the month."

Grein says Eli Lilly's in-house traders focus mainly on commercial paper while sometimes using money market funds. The company has some exposure to fixed-income instruments, such as mortgage- and asset-backed securities, but only through third-party managers with expertise in those areas.

Google's Callinicos has no plans to invest in equities, but says there are "numerous hedging tools for the portfolio--futures, options--that might make sense for us."

Google's software engineers worked with vendors to integrate a variety of applications, allowing data to flow from one to the other and giving treasury the ability to aggregate and monitor its exposures in near real time and see 98% of its worldwide cash in real time.

Google's traders mostly enter trades through Bloomberg but may use smaller platforms for niche securities. Ultimately, all of its positions, whether traded in-house or through outside managers, arrive at its custodian, State Street, whose portfolio and risk systems Google has integrated with its own software, as well as other third-party market information and trading systems.

On the FX side, Google uses FiREapps to collect and analyze data to determine what to hedge. It uses the FXall portal to execute and settle trades electronically through multiple banks, although large trades are still typically negotiated over the phone. The positions data are sent to storage and messaging provider Quantum Corp., which aggregates all Google's cash positions globally. That information then moves to Reval, whose risk management and hedge accounting services enable Google to maintain its positions.

"We do have many best-in-class third-party systems that speak to each other in FX, portfolio and cash management," says Callinicos. "Most of the IT heavy lifting occurred about one year ago, but we're not at an end state yet--there is still IT work to be done."

Callinicos, who joined Google as treasurer in 2007 after seven years as Microsoft's treasurer, agrees that new technology facilitates the establishment of in-house trading operations by non-financials and says applications related to FX are the most advanced. "They're great leveraging tools, but they're no substitute for the right people," he says.

Grein says Eli Lilly trades commercial paper over Bloomberg and money market funds through the SunGard Transaction Network--the latter adopted in the last few years. It uses FXall for its routine FX trades.

Most sizable companies have long traded FX in-house because the exposures being hedged, including production and supply chains, are highly sensitive. FXall's software lets users see bids and offers from multiple banks, rather than having to call each one separately. Even more importantly, it automates back- and middle-office functions and overall workflow that were prone to errors, eliminating the previous need for a trader to fax trade confirmations to all the company's legal entities on behalf of which the trade was conducted.

"Process improvements have helped the traders shift their focus from tactical responsibilities to more strategic projects, such as analyzing and executing business development projects," says Grein.

"Treasury used to be very operations-focused--how to move cash around from this account to that one," says Jud Murchie, an analyst at Boston-based Aite Group. "Technology has automated a lot of this and allowed treasury to become much more strategic."

One of the biggest challenges for treasuries at global companies is aggregating the company's asset values and risks across numerous bank accounts, external managers, time and demand deposits, and money sitting in subsidiaries around the world. Vendors such as Clearwater Analytics aggregate assets, reconcile them, and then generate consistent accounting, compliance and risk procedures on a daily basis.

Internal traders may enter transactions that overlap with those of external managers, resulting in concentration risk, says Courty Gates, Clearwater's CEO. "We're providing the trading team with visibility on their own activity, and for senior management we're providing an overarching view of the entire portfolio, whether internal or external."

"More visibility and real-time is definitely the goal and the trend among corporates," Callinicos says. "We leverage numerous companies, external managers, and third-party tools to make sure we have as much information as possible."

For an update on online trading, see Portals Open Trading Vistas.

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