This Q&A is taken from a webinar recently hosted by Quantifi, OTC Partners and BlackRock. The participants shared their perspectives on the importance of liquidity in the functioning of financial markets and the increasing regulatory pressures on buy side firms to ensure strong liquidity risk management practices are being carried out.
- Antonello Russo, Director- Risk Management, BlackRock
- Rahul Patel, Senior Business Consultant, Quantifi
- Sol Steinberg, Founding Principal, OTC Partners
What would you say is the main cause of liquidity change in the marketplace?
AR: There have been many secular reasons as well as changes in regulation and in particular, with the impact of the financial crisis we have been experiencing incredibly low levels of yields. This has resulted in a change in the behaviour of investors; the appetite for assets with a lower liquidity profile has increased and become more mainstream, at the same time changes in regulations that caused a difference in the way the markets behave.
On the fixed income side, the market relied on a broker-dealer’s ability to intermediate fixed income trades using an inventory of securities. As balance sheets have become much more expensive to maintain, the appetite to behave in this way has actually changed. Going forward, the expectation is that the fixed income market may end up becoming more similar to the equity market, where brokers simply intermediate transactions on behalf of end investors. I think the problem is that this shift is not happening fast enough.
There are also a number of changes being driven by regulations, in particular MiFID II which is aimed at increasing the visibility of transactions, flows being traded and traded prices. These changes are the result of the events of 2008 and the way regulators and monetary authorities have reacted to those events. These changes are likely to cause a considerable change in the way the market behaves.
The reduction in interest rates and growing appetite for investors to own yielding securities has seen an incredible increase in the issuance of debt. The size of outstanding issuance has become much higher and this, combined with the reduction in secondary market turnover, is resulting in much thinner markets and may be the precursor of liquidity shocks.
Will exchange traded derivatives ever gain enough liquidity to match the current liquidity in the OTC markets, for example rates?
SS: When we look at the exchange traded versus the OTC market, we have to recognise the origins and the fundamentals behind them to understand what the future could entail. Exchange-traded derivatives were first launched for several asset classes, to provide various different exposures. These were new products.
When these exchange traded derivatives first started out they had a lack of industry wide participation. As with all new products, the industry is open to exploring them as possible good solutions and lower cost alternatives than existing means of trading. However, as these products are illiquid, they typically require a ‘big bang’ type event to encourage industry participants to start trading them. A certain threshold needs to be crossed for industry participants to feel that the product is adequately liquid enough for them to change their existing behaviour.
“It is very difficult for end users to change existing behaviour. Just because there's a better mousetrap or a better way to gain a certain type of exposure it doesn't necessarily mean that the end users will fully migrate to the new way."
Sol Steinberg, Founding Principal, OTC Partners
It is very difficult for end users to change existing behaviour. Just because there's a better mousetrap or a better way to gain a certain type of exposure it doesn't necessarily mean that the end users will fully migrate to the new way. Financial market participants are accustomed to doing a trade the way they did it yesterday. If a trade was relatively successful, they will continue to prefer their existing behaviour rather than look at new and potentially more cost effective alternatives. Ultimately a generational shift and a new presence in the financial markets is the only way that we are going to have a wholesale replacement for the exposures that we are getting in the OTC market.
Exchange traded derivatives have been relatively successful; the functionality features and ease of use of these products are exceptional and the liquidity is still gathering in certain pools to support these products. Nonetheless it is going to take more behavioural changes for these products to ever potentially surpass the OTC suite. When we do have that generational shift, I predict that these products will surpass the OTC suite but we are talking many years from now.
What additional technology solutions could benefit you in handling liquidity conditions and managing the quality risk?
RP: Liquidity needs to be managed on an ongoing basis. This demands a new approach to liquidity risk management I support the idea of a single enterprise solution, incorporating reporting, scenario modelling to support stress testing, data management and analytics. A single solution reduces the complexity of dealing with multiple applications and having an open modular framework gives you the flexibility to adopt various features. This allows firms to handle various aspects that surround liquidity risk management without compensating their level of data quality. Another key benefit is that it lowers total cost of ownership (TCO) as you reduce complexity and risks associated with multiple integrations because you are not dependent on other applications in the event that they may fail.
There is no one set model to manage liquidity. However, firms that adopt a single framework that addresses the market, credit and liquidity will be able to manage risk based with an integrated view of all the risks impacting their portfolio.
How has regulatory requirement put pressure on how funds manage their Liquidity, internal model vs regs?
AR: There is a lot of focus by regulators on liquidity and this has become a lot more explicit. For example, I can see how my own behaviour has changed as liquidity risk management has become integrated into the day-to-day process. There are also very explicit requirements; liquidity stress tests have to be carried out and reported, so they have to be explicitly defined. Regulations are requiring asset managers to identify, quantify and report liquidity profiles and a tiering approach is now being proposed by major regulators as a way to identify the liquidity of portfolios.
I have seen a more open discussion within the regulatory community about taking the liquidity of investment strategies into consideration. Something which may be beneficial is having an increased focus on the risk of asset-liability matching and on liability consistency. We have seen in the past certain funds investing in real estate assets and offering a liquidity profile which one may not associate with those type of assets. I think it is healthy to have a discussion whereby one understands exactly the type of liquidity profile which is being offered and how realistically it is going to pan out in such strategies.
“There is a lot of focus, by regulators, on liquidity and this has become a lot more explicit. For example, I can see how my own behaviour has changed as liquidity risk management has become integrated into the day-to-day process."
Antonello Russo, Director- Risk Management, BlackRock
There is also a much more explicit understanding of which liquidity terms one should offer on various strategies and which extraordinary liquidity provisions should be defined on certain funds. There is now a better understanding of these provisions and the factors influencing these requirements. In the past, these provisions were considered something that would never be invoked, whereas nowadays I think one has to take into consideration that every now and again redemptions in kind actually may end up being used. In summary, focus on liquidity risk management is not only explicitly driven by regulations requiring liquidity quantification, stress tests and reports, but also by a permanent change in behaviour by institutions.
Will the introduction of MiFiD II regulations next year improve market liquidity for most buy-side participants?
AR: One of the aims of the new regulations, in my opinion, is to achieve greater transparency around trading of unlisted, and in particular fixed income, securities. One way to achieve this is represented by the requirement to report trading activity, including OTC transactions, in order for volume and traded prices data to be aggregated and disseminated into the market.
This may certainly result in more predictability and increased liquidity, but it is crucially dependent on how these requirements are implemented in practice. Its implementation may make it more or less effective, or even cause new risks. There may also be exemptions to the general rule, which may be fully justified and make the implementation more beneficial and conducive to greater liquidity, but may also reduce its effectiveness.
Could you comment on issues related to analyzing / managing organic liquidity (e.g., how much in flexibility options might be granted implicitly via investment in p.e. / infrastructure funds versus via publicly-traded equivalents; solvency risk modelling for publicly traded credit exposure; etc.)?
AR: If I understand the question, this is related to the possibility of achieving intra-term liquidity for investment in assets with an intrinsic very long investment horizon and no organic intra-term liquidity or intra-term cashflow generation.
I believe it is important to ensure that any portfolio’s liquidity terms are sensibly set and consistent with the underlying investment assets liquidity profiles. One may want to consider various avenues to turn one’s investment assets into cash, ahead of the final maturity for such assets, but needs to be realistic about doing this. It may be achieved via secondary market transactions, or listed closed-ended funds, or through extraordinary liquidity provisions, but one needs to consider that achieving liquidity through these means may come at material discount to the “fair” value of the investment assets, or imply a very long lead time to realise the investment (and probably both a material discount and an long lead time).
Is the OTC really as liquid as we believe when you consider just how many bespoke products are now out there?
SS: When we look at the OTC product suite we see that the amount of activity, volume, transaction size, and outstanding notional massively dwarf any other asset class by a great deal. At current count there is a 3T of net exposure and 700+ Trillion in notional exposure. So, yes the liquidity is there, and hasn't dissipated in close to 25 years.
The answers above represent the personal opinions of the participants and do not reflect their employer’s positions.
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