Advantages and Disadvantages of Diversification Strategy in Finance
For treasury managers of cross-border businesses, managing liquidity risk is one of the top priorities, and diversification is widely considered a safe, sensible strategy.
Diversification, in a nutshell, entails spreading investments, assets, or funds across various currencies, financial instruments, or institutions to decrease risk associated with global operations and improve cash flow management.
However, as with each strategy, diversification comes with its advantages and disadvantages, and treasury managers must be aware of how to offset any potential issues arising from their diversification strategies.
In this article, we explore the advantages and disadvantages of diversification strategy in the context of liquidity risk management, especially when applied to cross-border operations.
Understanding Diversification in Liquidity Risk Management
Let’s start by breaking down two key terms - diversification and liquidity risk - and understand them in the context of treasury management.
Treasury managers use diversification as a strategy to minimise risk by spreading assets across different currencies, financial institutions, and instruments. In practice, this allows the company to access liquid cash faster and meet short-term financial obligations and unexpected demands consistently, regardless of market conditions or geopolitical climate.
Liquidity risk, on the other hand, is a critical concern for treasury managers as it means that the company may not be able to meet its short-term financial obligations because of lack of access to liquid assets.
With every diversification effort, companies try to:
Advantages of Diversification Strategy
Diversification serves as a cornerstone strategy in cash and liquidity management as it brings some significant benefits relating to risk mitigation, improved liquidity, operational flexibility, and even higher returns.
1. Risk Mitigation
The first and probably most important advantage of diversification is the ability to achieve risk reduction - primarily those relating to currencies and financial institutions.
For businesses operating across multiple jurisdictions, sending and receiving funds in more than one currency, diversifying assets can allow them to minimise fluctuations of a single currency and offset any currency risks. It’s generally good practice to open accounts, even if only virtual accounts, in each currency your business operates in, regardless of whether it’s for receiving, sending, or holding funds.
Additionally, diversification of funds across multiple financial institutions minimises the impact of dependency on one financial provider. Unfortunately, loyalty to one financial provider with all your funds, even if spread across different financial instruments or currencies, carries serious risks. Banks may temporarily or entirely suspend their operations, raise their fees, or even shut down, as we’ve seen with the examples of SVB or Volt Bank. This puts businesses in an impossible position whereby in the short term they cannot access their funds or perform core business operations, and in the long term, they may be impacted financially or reputationally. Maintaining relationships with banks in different countries ensures continued access to funds regardless of circumstances.
2. Enhanced Liquidity
Improved access to liquid cash is one of the main goals for treasury managers. By keeping funds in multiple currencies across multiple financial institutions, global businesses are in a better position to access cash in the desired local currency for various operations instead of relying on costly and slow currency conversions. The speed of access to cash is particularly important if the business wishes to capitalise on business opportunities and meet supplier needs in different geographies quickly.
3. Operational Flexibility
Another often overlooked advantage of diversification is the flexibility it offers for global businesses. With their assets spread across multiple currencies and financial institutions, they are able to quickly respond to the needs of their various subsidiaries, stakeholders, suppliers, or customers without reliance on costly and time-consuming international transfers. The added benefit of this flexibility is reduced operational cost - since transfers can happen in local currencies and potentially even along local payment routes, the cost of the transfer will be significantly cheaper as it will not involve costly currency conversion and intermediary banks.
Lastly, should any of the banks they are using go through downtime or temporary suspension of operations, they can continue their business as usual because they are not dependent on just one financial institution, so any transfer can be sent from another bank.
4. Potential for Higher Returns
While maximisation of returns is not the primary goal of treasury management, a well-executed diversification strategy, including a diversified portfolio, can bring higher yields. Thanks to holding assets in different currencies, treasury managers can take advantage of interest rate differences and market fluctuations and optimise cash positions while at the same time maintaining good liquidity levels.
5. Growth opportunities
With a well-diversified treasury and flexible financial operations, businesses can take advantage of a faster time to market and explore new markets or verticals for business growth. Having access to multiple currencies and an established relationship with financial institutions in various regions reduces the time wasted on compliance processes when entering new markets and gives an undeniable, competitive advantage.
Disadvantages of Diversification Strategy
While diversification offers numerous benefits, it’s important to understand the disadvantages of diversification strategy. These relate mostly to complexity, increased cost of maintaining multiple banking relationships, and potential for reduced efficiency.
1. Increased Complexity
The more currencies and financial institutions are used to diversify your treasury, the more complex and disjointed your financial ecosystem will be. In order to manage it, your business will need to either expect treasury managers to take on extra manual work to consolidate, reconcile, and report data across all currencies and financial institutions (which can also be unreliable due to the ever-changing nature of finance and forex fluctuations) or rely on treasury management systems which frequently, albeit not always, involve a steep learning curve and some issues with implementation. Additionally, the tasks related to managing, consolidating, reconciling, and reporting on cash position and treasury across all accounts and currencies may be pulling the treasurers away from more important, strategic tasks such as strategy and forecasting.
2. Higher Costs
Linked to the increased complexity is also the increased cost of implementing and maintaining a diversification strategy for your treasury. Firstly, maintaining relationships with multiple banks and financial institutions means accruing and paying fees with each and every one of them. Those fees can include account monthly maintenance fees, required minimum balance, and insufficient fund fees. When multiplied across several financial institutions, these can make a serious dent in a company's bottom line.
Another aspect worth considering is that while maintaining multiple accounts in multiple currencies is a great method to diversify currency risk, frequent currency conversions even between own accounts can lead to substantial transaction fees, especially if the business is making more, smaller transactions.
3. Currency Risk
While diversification can mitigate some currency risks coming from over-reliance on one currency, on the other hand, it exposes the business to FX risk on more fronts. The more currencies a business has, the harder it may be to determine the true value of liquid assets at any given time. Additionally, accurately forecasting currency movements across multiple markets becomes increasingly challenging, as does implementing effective hedging strategies.
Best Practices for Implementing a Diversification Strategy
In order to maximise the advantages and minimise the disadvantages of diversification, treasury managers should consider the following best practices:
How Fyorin's Solution Can Help Diversify Your Liquidity Risk
Fyorin's platform lets you unify your treasury in one place, giving you a 360-degree overview of your cash across all institutions, currencies, and subsidiaries. Our technology was built on top of a robust network of global financial institutions allowing your business to easily diversify liquidity risk:
Interested in seeing how Fyorin can help your diversification strategy? Get in touch by sending an email to [email protected] or book a free demo.
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