The liquidity risk has been one of the most neglected risk during the years prior 2008 in the Asset Management industry. Since this period, liquidity has been a great challenge for Regulators, Financial Associations and Asset Managers:
- To formalize and manage its impacts within the risk management process;
- To monitor it, source it, and optimize it through the rigorous execution process;
- To input it within the investment process.
But today, where do we stand on these topics? There is very little data, no metrics that are disclosed to the investing public. We hear about liquidity, illiquidity, liquidity risk, illiquidity, liquidity without any simple communication or any descriptive item… Due to its multidimensional aspect, it remains a blurred notion. So, let’s start getting first more clarity with the following definitions:
- What does illiquidity mean for an asset? The difficulty/inability/impossibility of initiating/liquidating a strategic or tactical position, due to normal or stressed market conditions (volumes traded in the market, market depth, bid-offer spread, price resilience, speed of execution…) and to their own characteristics (newsflow on the issuer, quantity of securities held/to be bought,…). What would be the best concepts to identify liquidity, to set up metrics to qualify it and to monitor it?
- What does liquidity risk mean for a fund? « It is true that in the “good times” it seems almost non-existent, and that it is not an easy risk to define and fully understood ». Liquidity risk would be defined as a liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units: in other words, the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.
But the investor clients can wonder how liquidity is identified and defined (according to dimensions, concepts…) by Asset Managers? What are their induced metrics to qualify it? What are their guidelines to manage such risk and the means employed to optimize liquidity on the asset side and the investor protection on the liability side?
WHAT’S UP ON THE ASSET MANAGERS’ SIDE ?
Due to the lack of disclosure on liquidity measurement from Asset Managers, investor clients can question themselves how Asset Managers qualify an asset as liquid and manage their liquidity risk? How do they upgrade their liquidity access in the markets and hence fund assets liquidity? How do they update their communication on this topic within the mandatory reports?
LIQUIDITY RISK MANAGEMENT ENHANCEMENT
Thus, how asset managers can reduce the liquidity mismatch between assets liquidation and liabilities outflows?
Asset-based measures : the principle is an assessment of the consequences at the overall level of the fund and not a security-by-security approach. A fund may hold less liquid securities or instruments as long as it does not generally impair its ability to comply with its regulatory obligations to redeem units and other financial commitments. The manager defines the methodological approach that seems most appropriate for regularly measuring the level of liquidity in the fund’s assets: the measures in assets are generally based on various approaches such as liquidity scoring, liquidation time, the cost of liquidation…
You’ll find here after some asset liquidity measures and visualizations.
The graph above describes the monthly changes of the Portfolio Liquidity Score during Q1 2018: the higher the score is, the more illiquid the portfolio becomes. With those scores, through normal and stress market conditions, the portfolio is not very liquid.
In the above chart, we can discover the repartition of positions according to their scores (corresponding to the Portfolio Liquidity Score of 3,46 in the histogram): no score 5 here.
Here, same portfolio but under stressed market conditions (corresponding the Portfolio Liquidity Score of 3,94, close to the illiquid threshold): no score 2 here.
Here, you can observe the progression of portfolio liquidation in time.
Liability measures and liquidity stress tests : the manager defines the most appropriate approach for measuring the risk on the fund’s liabilities. The manager estimates redemption scenarios at different maturities (one of which corresponds to the frequency of subscription/redemption). These scenarios may be based on historical elements (history of subscriptions / redemptions of the fund) or hypothetical items (eg exit of the largest client(s), exit of a class of stakeholders …).
The liquidity stress tests are mainly aimed at measuring the fund’s ability to cope with increased liquidity requirements without affecting the principle of equal treatment of shareholders. It is desirable to launch two types of simulations (other types of simulations may be implemented elsewhere):
- Simulation of atypical redemption requests occurring in a simulated context of drying up the liquidity of the fund’s assets;
- Simulation of increased liquidity requirements (margin calls or financing).
Regulatory requirements and practices vary in different jurisdictions. While the degree of sophistication and the definition of what is to be considered “liquid” varies, in most cases, asset managers monitor liquidity on the asset side on a frequent basis. There are a number of techniques (diversification, eligible assets, limits on illiquid assets, liquidity buffers etc.) and tools (both for day-to-day liquidity management and also for use during stressed markets conditions that are specific options that alter the redemption conditions) available to fund managers to aid in the management of liquidity needs.
So why not upgrade your own liquidity risk management, based on more sophisticated one, to get a competitive advantage over the peers?
UPDATING LIQUIDITY ACCESS OF ITS ASSETS
How to measure and improve your liquidity access to the markets? Thanks to tools to visualize its own liquidity in the markets, and to some elements to reinforce it.
Each investor, each entity has its own liquidity grade because of its ranking among banks, its way of understanding the Best Execution and the tools put in place to feed it: a very good liquidity means that the investor benefits from a top ranking, an excellent understanding and use of Best Execution, a technology that feeds it and market skillset. It comes down to more knowledge, more independence, and therefore more latitude to address the market and better deal.
From a pre-trade point of view, what does the investor need?
- To know what the instrument is quoting.
- To valuate what the instrument is worth for the desired size.
- To source the desired size to be traded.
From a post-trade point of view, what does the investor needs?
- To check if the trade caters the Best execution.
- To monitor the liquidity of asset classes and TCAs.
Liquidity could be assimilated as opportunity and immediacy: it won’t wait for the investors due to market conditions. To benefit from it, the investors must react as quick as possible and to be well prepared to such action: the trading team is the last input the Asset Managers should take care in order to insure their own liquidity.
The team is in charge of managing the market liquidity risk (the Fund Manager is managing on his side the portfolio liquidity risk) for each step belonging to the deal (pre-trade, trade, and post-trade). The Trading Desk is becoming, more and more, a market intelligence team managing big data resources, feeding in that way a big stake of the liquidity risk management process.
Finding the necessary liquidity for the PM is one of the first objectives of an execution desk: traders should be disciplined, fast, well-informed (products, markets, counterparts, axes, market intelligence…) and they should care about market impact done by trades: the weaker it is, the better it is for the trust, the reputation and the future deals. The market could be resilient, but the less noise the traders do, the better it is for everyone.
Liquidity is not only a general state of a market, it’s also the qualification of Asset Managers’ own ability to trade what they need for their portfolio at time t, whatever the market conditions: there’s not a single market liquidity for the whole market, but each investor has his own liquidity defined by his strengths and weaknesses. If we take the four dimensions applied to liquidity, each investor will manage according to his own process, his own technology, his own skillset.
If we must prioritize the four dimensions, here is the ranking:
- Depth traducing the market capacity to absorb purchase and sale orders for huge amounts: the related questions to this are which counterparts are providing such depth, and how could the investors know the specific instruments they bid/offer with such depth ?
- Width traducing the market charges to deal : how could the investors try to trade with the thinnest bid/offer spread relative to the sizes ? Or how could he consider his trade details are fitting the Best Execution ?
- Immediacy meaning the shortest piece of time to trade: how could the investors synthetize the previous dimensions and information to trade as fast as possible not to lose the opportunity targeted in the market? The more time the investor spend on his deal, the more noise there will be (and hence, more stress).
- Resilient traducing market ability to recover quicikly its pre-trade state: how the investor contemplates the way he traded, his own dealing methodology? The less noise, the more discreet the investor is, the more resilient the market is.
So why such a risk is not more presented and valuated in the mandatory reportings required by MIFID 2 (as KIIDS) and PRIIPS (as KID)? What is already done and described about liquidity within prospectus, DICI, Monthly Reportings? Few words about liquidity risk during abnormal market conditions, or no indicator…
The next step should be to well disclose it to clients. Investors are constantly told to ensure their funds are diversified, liquid and have strong risk management guidelines. But if Asset Managers are not able to share relevant and clear information about their funds liquidity, how investors can challenge them on their ability :
- To monitor it ?
- To use it in their execution ?
- To measure and manage it within their risk management process ?
IOSCO, in its final report « Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration » (01/02/2018), has challenged Regulators to require from Asset Managers the appropriate disclosure, in the fund’s offering documents, of the following details:
- The significance and potential impact of the liquidity risk on funds and its investors;
- A summary of the liquidity risk management process;
- The tools that may be employed to address these risks.
Particularly for tools, regulators should require asset managers to provide greater transparency to investors by disclosing the following:
- Descriptions of the liquidity risk management tools;
- Explanation of when the tools may be used;
- The tools’ impact on the fund and investors;
- Any other risks to investors.
A further step should be to supply more frequently fund holdings. The aim is not to front-run Asset Managers but the clients get hence more upside in their own asset allocation and risk management monitoring (as a look-through operation): to avoid any overlap due to overexposure to an issuer, a sector, risky or less than usual liquid assets. Dealing with portfolio holdings disclosure, the US have embrassed this opportunity since 2004.
Asset Managers could publish such information (or longer historicals than the outstanding ones) based on conditions as lagged periods (2 weeks, 1 month, 1 quarter…) or dedicated firstly to clients with access and then to the public… Portfolio holdings disclosure is a key ingredient in informing, educating and protecting investors, which, in turn, lifts confidence and attracts assets to the financial system. Asset Managers may think about it.
ANY INTEREST ON THE INVESTOR CLIENTS’ SIDE…
Are you so sure to invest in one or more liquid vehicles? What information do distributors furnish to clients? If there is little information provided on the liquidity measures of vehicles (and their components), how do clients to challenge Asset Managers to this inherent risk?
Today, all-risk scales incorporated into the distribution reports are only focus on market and credit risks: why liquidity risk is not appearing with the same interest? Today, most of the Metrics used for the selection of investment vehicles or financial instruments focus mainly on historical or expected returns and the potential market and credit risk: therefore elements linked to the directional side of the asset. But whatever the directional performance and the revenues received, the calculation of the investment Total Return should also take into account the ability to enter into/exit from a market: ie qualify liquidity via one or simple measures to implement. So the maximization of Total Return requires liquidity management and optimization (minimization) of its cost.
If the investor clients are able to qualify, within Collective Investment Schemes, liquidity thanks to metrics, they can introduce the liquidity premium concept in their fund selection process. But what is the liquidity premium? The liquidity premium compensates investors for investing in assets with low liquidity: why it shouldn’t also be applied to indirect investment vehicles as Mutual Funds, UCITS and ETF?
Hence, from an investor point of view, what is the point to own less liquid vehicles if they don’t generate higher returns within a same expertise/spectrum? Smart Liquidity could bring to investors more explanations and clarifications about liquidity metrics and liquidity risk management for a dedicated investment vehicle, and hence the elements to compare Collective Investment Schemes.
TO CONCLUDE, WHY NOT DELIVERING MORE INFORMATION, AND THUS TRANSPARENCY, ABOUT LIQUIDITY OF INVESTMENT VEHICLES?
What would be the benefits of such work for Asset Managers?
- Be able to set up an asset liquidity measure, an asset/liability liquidity metric and follow-up the liquidity risk management within the investment structure. The goal is to optimize the costs of managing portfolio liquidity and its allocation;
- Be able to improve the liquidity approach/access to better trade in the financial markets, and thus to reduce the execution costs (#BestExecution, #TCA);
- Be able to communicate to clients on vehicles liquidity (MIF2 Information and Protection of Investors and PRIIPS) and to get a competitive advantage over the peers.
What would be the added-value of such work for Investors?
- Be able to measure and qualify vehicles liquidity/liquidity risk management in the selection process (#FundHoldingsDisclosure);
- Be able to challenge the Asset Managers and to compare them over the peers.
THE SMART CONTENTS can support your entity to optimize liquidity issues through execution, allocation and risk management topics, and help investors to get more insights about liquidity risk management on potential investment solutions. Do not hesitate to contact us and ask for our Liquidity Metrics Reporting (White Paper).