The New Edge in Investment Performance: Liquidity Management

September 10, 2015

Erik Vynckier, CIO Insurance at AllianceBernstein was guest speaker at Quantifi’s breakfast briefing, which took place 9th September 2015, at The Mercer, London. Erik shared his knowledge and experience under the theme ‘The New Edge in Investment Performance: Liquidity Management’.

Insurers and pension funds are nowadays bearing the brunt of the liquidity risk in the financial system.  Whereas the corporate bond market has grown fourfold since the credit crunch, inventory at the trading desks of the banks has declined.  Additionally, Basel III dis-incentives banks from the repo-business.  

Long-term investors are eager to acquire illiquid, higher yielding portfolios including residential and commercial mortgages, infrastructure loans and mid-market corporate loans.  Initial and variation margin for essentially all derivatives, and clearing for most, point to potential sinks of liquidity from the balance sheet.  Liquidity (and illiquidity) of assets and liabilities have become both underutilised return generators and poorly monitored risk factors.

Given the negative impact on portfolio liquidity and on portfolio returns of sub-optimal collateral management it is imperative that the buy-side improve its collateral practices.  Collateral management should become an integral part of asset-liability management of insurers and be incorporated in the strategic asset allocation methodology. In terms of new Basel 3 rules on bank capital and liquidity, one potential implementation of the leverage ratio includes banks’ intermediation in the repo markets in the balance sheet total.  This could limit banks’ willingness and raise costs for maintaining their brokerage operations in the repo markets.  No longer finding cost-effective counterparties for repo activity could further limit an insurer’s capability to secure liquidity when needed, forcing the insurer to orient asset allocation to very liquid but low yielding bonds as a precaution.

 


 

"Systems have to be updated to this end, e.g. with additional stress scenarios and Monte Carlo simulation capabilities to enable better planning and optimisation of collateral."

 


 

For an insurer, the issue of hedging and collateral should be incorporated into the product development cycle: any new product should be tested for potential derivative trading and collateral issues.  Variable annuity plans which, for example, provide a guarantee on a fund investment are not only be difficult to hedge with low tracking error but also cause problems as to where collateral can be sourced from to support the hedging. Collateral management is no longer just a securities services task.  It has impact on front office decisions and has strategic relevance for balance sheet management and for product development.  Front office software today normally lacks the necessary reporting on collateral availability and cost and also does not sketch future potential liquidity and collateral needs.

Systems have to be updated to this end, e.g. with additional stress scenarios and Monte Carlo simulation capabilities to enable better planning and optimisation of collateral. The right software vendor could capitalise on this business opportunity.  It could be speculated that the historic split between “front” and “back” office operations (and software systems) is no longer the most suitable business model.

Is the buy-side prepared?  Can technology help?

We have gone more and more into electronic trading and settlement as well as software tools for portfolio and risk management. That's another one-way street and every new client or regulatory request piles more pressure onto technology. The sell-side tends to look after their technology needs in-house while the buy-side often sources from solutions providers. Even very sophisticated asset managers might buy superior vendors systems that they could not build on their own. More and more collateral is involved: anyone using derivatives requires collateral so that they don't sit indefinitely on counterparty risk. Hence liquidity management has now come to the fore.

There should be a dose of realism amongst CEOs that their financial institutions do not necessarily have unique quantitative risk or software development skills compared to the best of the sector. The difference between successful and failing financial institutions lies more in the culture of the organization and the engagement of the people running the business than in the quantitative risk management software or hardware per se. The best organizations will recognize their limitations and set up effective cooperation with the specialist vendor ecology to achieve best-in-class tools.

 

Recommended Whitepapers

Identifying Liquidity Risk for Financial Stability
Buy-Side System Requirements
Buy-Side Risk Analytics, Chartis RiskTech Quadrant®
Measurement and Management of Counterparty Risk