Choices for cash deposits can include banks or brokerage firms, with each of these options for moving funds into cash instruments reviewed further below.
A bank’s balance sheet reflects customer deposits as both an asset and a liability because customers may withdraw at any time. A bank can do the following with customer deposits:
- Maintain cash to meet client withdrawal requests, which doesn’t generate any revenue for the bank
- Lend money for car or home loans and lines of credit, with any interest above what’s credited to checking and savings accounts resulting in revenue to the bank
- Invest most excess funds in US Treasury bonds (or some other similar, highly liquid investments) generating additional revenue to the bank
How Interest Rates Affect Cash Management at Banks
When interest rates rise, banks can earn more money from lending. US banking regulations also specify certain deposit coverage requirements to help maintain liquidity so that banks can meets customer withdrawal demands. A bank could face solvency problems if it holds bonds and bond prices fall because of rising interest rates. One prominent example of how interest rates affect banking is the closure of Silicon Valley Bank (SVB) in March 2023.
SVB invested their funds in long-term Treasury bonds when interest rates were lower. When prevailing interest rates rose very quickly, long-term bond prices fell, greatly decreasing the value of SVB’s Treasury bond holdings. This meant there were fewer bank assets available to cover deposits.
Concerned depositors moved quickly to withdraw larger amounts more quickly than they normally would. To cover the increased demands for withdrawals, the bank was forced to sell bonds at significant losses, which pushed the bank toward insolvency. SVB urgently needed to raise more capital but couldn’t do so quickly. Ultimately, the Federal Deposit Insurance Corporation (FDIC) stepped in when SVB didn’t have the cash they needed.
Brokerage firms that hold customer cash are subject to different segregation requirements than banks, and generally aren’t permitted to comingle the brokerage firm’s assets with client assets. While brokerage accounts aren’t insured by the FDIC, they’re members of the Securities Investor Protection Corporation (SIPC), which protects the customer securities of its members up to $500,000 (including $250,000 for claims for cash) in the event of a brokerage firm’s failure.
Most firms also carry private insurance well in excess of SIPC coverage to assure individual investors that their deposits are safe. If a brokerage firm were to fail, securities are safeguarded and are generally not at risk except due to significant fraud, or due to excessive margin debt. Brokerage firms do, however, keep much of their client cash balances in banks and those brokerage firms and their clients could therefore be affected by large scale bank failures.
Interest rates fluctuate, which means your time horizon and risk tolerance are likely to influence how you manage cash.
Below is some background on types of money market funds and alternatives.
Sweep Accounts Versus Traded Money Market Funds
This is the default money market linked to a brokerage account. Some sweep accounts may actually be FDIC-insured up to $250,000 since brokerage firms often use banks and subsidiary banks to park customer cash. Like bank checking and savings accounts, they don’t pay much interest.
Investors wanting to park large balances in cash should consider traded money markets or US Treasury management strategies. Neither are FDIC insured (traded money market funds and three-month Treasury bills are considered cash equivalents, though they’re technically still securities, not cash).
Even if a brokerage firm failed, traded money markets, Treasurys, and any type of security are protected under SIPC and any relevant private insurance, up to the relevant limits. Note that SIPC and private insurance don’t protect against any decline in value of a security. Instead, SIPC and private insurance protect customer accounts in the unlikely event of a failure of a brokerage firm. Brokerage firms are subject to segregation requirements that make client securities less likely to face much risk due to brokerage financial failures.
While there are several types of traded money markets, more generally speaking, money markets break into two types—taxable and tax-free.
Taxable traded money markets typically fall into one of three categories:
- US Government
- US Treasury
Prime money markets invest in all types of short-term securities such as US Government or Treasury securities, commercial paper, and corporate bonds. The underlying securities within the money market fund have maturities of 30, 60, or 90 days so bonds are maturing all the time allowing investors access with little to no concern for liquidity constraints.
Tax-free traded money markets can either be national or state-specific municipal funds.
- National municipal funds. These funds are federally tax exempt.
- State-specific municipal funds. State-specific funds are double tax-free for residents of the state associated with the fund.
For investors with balances over $1 million, yields on traded money markets can be 15 basis points higher.
US Government Treasuries: Fixed Income Securities
Investors once shied away from US Treasurys because of low yields, but they’ve become appealing with rising interest rates. Shorter term bonds now have higher yields than longer term bonds. This results in what’s referred to as an inverted yield curve. Inverted yield curves create opportunities for investors to structure their US Treasury Bond portfolios with a shorter average maturity.
Cash Management Strategies
A cash management strategy that investors should consider is one that combines several types of securities:
- Sweep money market funds for immediate access to cash
- Taxable or tax-free traded money markets as a means for parking cash with higher yields
- Laddered US Treasury bond portfolio
This approach offers liquidity, diversification, and the safety associated with the underlying investments.
Cash Management: Frequently Asked Questions
Below is a list of answers to frequently asked questions pertaining to cash management.
Are There Penalties for Liquidating US Treasurys?
There aren’t penalties but investors are subject to market conditions. If interest rates go up after purchasing US Treasurys, all other factors being equal, the value of the bonds will go down, and vice versa. Investors should pay attention to their liquidity needs and when funds will be needed they aren’t negatively affected by bond market fluctuations.
How Are US Treasurys Taxed?
US Treasurys are taxed at the federal level and exempt at the state or local level.
Is a Cash Management Account a Good Long-Term Strategy?
Cash management accounts are appropriate for investors with short-term cash needs or those looking to park funds before redirecting for longer term investing. Because of their fluctuating yield, they tend to be most attractive when interest rates are high.
Funds in these accounts ideally would be reinvested in diversified portfolios comprised of equities and long-term bonds with attractive yields.
How Do You Choose Between the Various Types of Cash Management options?
Cash management decisions should be made with an advisor who can help you plan for your time horizon and objectives.
Are Cash Holdings Risky?
Holdings in US Treasurys could be risky if the need for cash predates the maturity of the underlying bonds, especially if rates go up after the time of purchase, as with SBV. Holdings in sweep and traded money markets tend to be less risky as they’re always priced at one dollar per share. That price, however, isn’t guaranteed considering that there have been instances when the value of traded money market funds declined below one dollar.
We’re Here to Help
For more information on cash management, please reach out to your Moss Adams professional.