Liquidity Risk Management – The Times are Changing


A lot has been written about liquidity risk management, driven by regulatory pressures but also due to fears that a liquidity crisis similar to or worse than 2008 now seems inevitable.

ESMA and the SEC, for instance, are both being vocal on the issue, having previously insisted that fund managers adopt appropriate liquidity stress testing arrangements.

ESMA’s new Liquidity Stress Testing Guidelines, published in September 2019, come into effect in September this year, and will require managers to take an ever closer look at their liquidity risk profiles.

The ongoing Coronavirus situation has heightened the importance of liquidity risk management, as performance stutters and managers face redemption requests. In response, more firms are now ramping up their cash or cash equivalent positions.  Liquidity risk management is now key to fund survival.

So what should investment firms be thinking about?

  • Carry out regular and appropriate liquidity profiling on portfolios and define clearly any thresholds or limits where escalation may be required.
  • Ensure appropriate and regular stress tests are being conducted and that the tests themselves are reviewed to ensure the process is adequately tailored.
  • A risk/liquidity/pricing committee/Board must oversee and sign off on the results of the test. Documentary evidence is vital here. The findings need to then be shared with a depositary.
  • Trends are just as important as a snapshot of the situation – ensure the results are presented to enable an ongoing assessment to be made.
  • Be prepared to amend the Liquidity Management Policy to reflect necessary changes to the level and type of tests performed together with the risk appetite of the firm.

However, the whole liquidity scenario is not just centred around the portfolio. The composition of the fund’s investors is another key element. While the use of a nominee company can mask the underlying breakdown of investors, especially in the alternatives space, most managers should have a good insight into who their clients are.

Although the use of redemption “tools” such as gates will offset a run of redemptions, this does not ultimately stop a fund from having to suspend if it cannot service its exiting investors.

A manager should therefore be closely monitoring its investor profile by looking at the percentage of the fund held by each investor, typical redemption levels together with the ongoing highest level where applicable. These assumptions should also be based on a multiplication of factors increasing the downside effects.

What has caused some backlash among managers is the discussion around reverse stress testing and what this actually means. There is no a one size fits all answer here as the threshold for a fund pursuing a global macro strategy will be totally different to a hybrid credit fund. Essentially, the reverse stress test is the worst case scenario. It therefore needs to be designed to capture the relevant data points and risk parameters that directly impact the fund’s strategic objective. This may include moves in base rates, FX, indices, credit ratings and any other relevant input which, either individually or as combination of some or all, would have a detrimental effect on the fund’s liquidity profile.

Ultimately, liquidity management together with stress testing should now be considered as a compulsory requirement. It needs to be based on appropriate data, robust modelling and effective methodologies.

Coronavirus has resulted in some extreme issues but few managers would have included such a worst case scenario in their prior stress tests. Many core portfolio securities, such as airlines, hospitality services and travel companies have seen significant rises in volatility and the valuation of these assets may prove challenging. If the valuation is problematic, it follows their liquidity may also have declined indicating it is not just the small cap securities that experience such issues.

Managers may need to train their personnel in the understanding of liquidity measures as this is not a tick box exercise. Regulators may well be engaging fund boards, risk managers and other individuals to explain the measures a fund has in place and how they are interpreting the output. The clock is running down to 30 September to ensure all policies, procedures and training are in place. At a minimum, regulators are likely to insist managers, including their boards, become more transparent about their funds’ liquidity terms and their ability to meet redemptions during distressed market conditions.

This article first featured in HFMWeek: