Importance of Liquidity for Functioning of Financial Markets

January 10, 2017

The global financial crisis highlighted the importance of liquidity in functioning financial markets. Pre-2008, market participants received easy access to readily available funding and were ill-prepared for events that transpired during the credit crisis. Failure to adequately assess and manage liquidity underpinned major market turmoil, triggering unprecedented liquidity events and the ultimate demise of Bear Stearns, Lehman Brothers and other financial institutions previously thought too big to fail.

Almost 10 years on awareness of liquidity risk has become the norm and its management essential to the viability of financial institutions. Looking ahead, effective risk management strategies and frameworks must address the major issues that compromised firms during the drawdown - liquidity should not be viewed as a short-term operational issue, but as a central component of long-term business strategies.

Market and Funding Liquidity

Market Liquidity incorporates key elements of volume, time and transaction costs (bid/offer spread). These dimensions equate to the amount of assets that can be sold at any time within market hours, with minimum losses and at a competitive price. Market liquidity can be difficult to measure depending on the asset type, whether the asset is fungible, and the time horizon to liquidate the asset.

Funding Liquidity (cash flow risk) is the ability to settle obligations on short notice. To do this cash can be raised by the sale of assets or new borrowing. Accurate and timely forward cash flow projections is crucial to effective liquidity management to maintain adequate funding. 

The Collateral and Liquidity Challenge

Since the crisis, bank supervisors have sought to mitigate possible future institutional illiquidity by adopting new requirements for banks to hold more high-quality liquid assets in proportion to the instability of their funding. Whilst market liquidity of an asset class can impact institutional liquidity, regulations that govern the activity of institutions can also play a role. Large banks perform a number of roles; acting as dealers, counterparties, and intermediaries involved in trading a wide variety of assets, including futures, bonds, and short-term secured borrowing and lending ("repo"). Most of these market-making activities have been historically regarded as low risk, hence the low-risk-based capital requirements. However, risk-based requirements may, over time, become biased towards underestimating. Supervisors have therefore increased the minimum amount of capital banks must hold against total assets. This is achieved through the supplemental leverage ratio (SLR), introduced by the Basel Committee in 2010.  Elsewhere, new regulations for derivatives and tri-party repo markets have forced substantial reform.

At issue is the role of high-quality (i.e., low-risk) collateral in financial markets and the impact of central bank asset purchases on the availability, and use, of that collateral in the open market. Several regulatory changes may be increasing the demand for these assets. Beyond new regulations on institutional liquidity, a lot of derivatives trading is migrating from the over-the-counter market to exchanges. These central counterparties use collateral requirements to manage their credit risk, so this additional trading activity may also be increasing demand.

Transaction Cost Analysis (TCA)

Given the volatility of financial markets and host of trading venues, market participants must factor in TCA as part of their total cost of doing business. The idea is to reduce transaction costs and improve returns - that can be difficult with the limited trading activity common to the bond market. Without a high volume of activity, it can be difficult to assemble the right combination of comparable trades and make meaningful comparisons around execution.  At the same time, changes in market structure and heightened scrutiny by regulators on best execution have added to the burden of proof on firms.

Unlike other risk factors, liquidity risk cannot be diversified away, but illiquidity generally occurs only for a short term: a security held to maturity has no liquidity cost. Given that, the asset manager can adapt the risk-return profile of the portfolio by strategically allocating certain assets to the illiquid strategy bucket e.g. private debt. Such a bucket helps boost the overall return of the portfolio by capturing an extra premium while offering potential diversification benefits. Swing pricing aims to protect the overall performance of the portfolio for the benefit of existing investors. Swing pricing is a mechanism by which the Net Asset Value (NAV) of a fund is adjusted upwards in the case of large net inflows and downwards in the case of large net outflows.

Regulation on Liquidity Risk Management Practices

The Basel Committee, the Committee of European Banking Supervisors and the Federal Reserve Bank have issued guidelines in an effort to establish sound, system wide liquidity management practices. Basel III introduced two key ratios – Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR), to provide guidance to banks to ensure short-term financing and long term financing remains resilient, which the Fed have also gone on to adopt.

The SEC, FCA and ESMA have outlined guidelines on liquidity risk management practice that funds should look to adopt. The SEC proposed a set of liquidity risk management requirements for registered open-end mutual funds and ETFs. The proposal is part of a broader SEC agenda to modernise the Investment Company Act of 1940 (’40 Act) and address perceived systemic risk concerns relating to the asset management industry. 

Managing Liquidity Risk – A New Approach

Liquidity needs to be managed on an ongoing basis. To do this effectively, firms are increasingly relying on technology providers that can provide a single integrated solution incorporating reporting, scenario modeling to support stress testing, data management and analytics. With advanced analytics, such as stress testing, scenario analysis and survival horizons, firms can capture and measure exposures that may impact their liquidity position.  Monitoring liquidity risk positions has increased the emphasis on automation and timeliness of data integration. Automated and customisable reporting that allows segmentation and tagging of positions based on the liquidity in your corresponding markets is also necessary. This information can be utilized to quantify and report liquidity risk at different levels of aggregation.

There is no one set model to manage liquidity. However, firms can benefit from an enterprise risk management framework that addresses market, credit and liquidity risk in a single integrated solution. As a leading technology provider of risk, analytics and trading solutions, Quantifi has strong liquidity risk management capabilities.

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