Rationalising liquidity risk

It is not surprising that liquidity risk has risen up the agenda for executives in the investment industry. Regulation and banks’ retrenchment from market-making activities have fundamentally changed market liquidity conditions. In a new State Street survey (see box) more than half of respondents said they are spending more time in conversations with senior management about liquidity compared to a year ago.

Challenges in managing liquidity risk can have far-reaching consequences for any financial institution. Our research revealed that 30 percent of respondents said portfolios had become less liquid in the past two years. For fund managers looking to anticipate liquidity flows, especially in times of heightened market volatility and potential event risk, this creates a need for new technologies and expertise.

Reflecting this challenge, more than three-fifths of respondents cited current market conditions as impacting their investment management strategy, with almost a third rating this impact as significant. The increasing complexity of investment portfolios can make it difficult to see the full picture of portfolio liquidity — especially when these exposures are allocated across multiple funds, asset classes and third-party managers.

State Street 2016 Liquidity Survey

Longitude Research surveyed 150 asset managers, including 50 hedge funds, and 150 asset owners in June and July 2016. This global survey extended to 14 countries 300 institutional asset owners and managers in June and July 2016.

Of those surveyed, 150 were asset owners, including pension funds, insurance companies, and endowments and foundations, and 150 were asset managers.

These included 40 hedge funds. The global survey extended to 14 countries worldwide.

Approximately 35% of respondents were based in the Americas, 40% in Europe, and 25% in Asia Pacific.

Consequently, both managers and investors are now focused on upgrading both their liquidity risk measurement frameworks and reporting. They are taking concerted measures to improve the liquidity profile in their portfolios to cope with decreased market liquidity.

What are the challenges for investors and managers when measuring and reporting amid the new liquidity conditions? How can they gain a deeper understanding of their liquidity risk to help shape their investment strategies going forward?

A clear view on liquidity risk

Asset managers and the funds they manage for the end-investors are just one segment in a broader market that influences liquidity dynamics. Other participants also have  a major  influence on market liquidity, such as sovereign wealth funds, pensions funds, sell-side funds and central counterparties. Market liquidity  is therefore a result of the interaction and regulation affecting all those players   The manager acts as fiduciary for the fund and its investors in an agency capacity. Flows in and out of an asset class by a fund will therefore be primarily driven by the investor’s willingness and appetite to invest in that given asset class.

Despite the fact that many institutional investors and managers are conscious of the need to measure and report liquidity at both the security and fund level, they find it difficult to do so in practice. Some 42 percent of all respondents in the State Street survey said they faced either a significant or moderate challenge in reporting their liquidity position to their boards or to the regulators. The situation is exacerbated by the need also to understand redemption patterns under both normal and stressed conditions.

Some investors and managers will need to completely overhaul their systems for measuring and reporting liquidity risk. The State Street survey highlighted that a significant number of respondents — 44 percent — plan to invest in improving their risk-reporting capabilities.

Making risk analytic tools work for you

Attaining a real-time and granular view of liquidity risk is needed to comprehensively report portfolio positions to investors, regulators and other stakeholders. But this insight is also critical to investment decision-making. Investors require a holistic and firm-wide view on liquidity, to understand where their exposures might be concentrated. And the liquidity characteristics of the underlying assets (i.e., understanding the exposure on a position level) should always be considered by investors.

By doing so, managers may be able to minimize the impact of market shocks on portfolios by assessing the effects of changes in costs and liquidity, valuing portfolios and asset classes as well as optimizing solutions to meet the institution’s liquidity and capital needs. Getting these processes right will enable better communication around liquidity to all stakeholders.

Another key priority for any liquidity risk measurement framework is being able to stress-test key risk measures, including various measures of liquidity, across different market conditions, using both historical and forward-looking insight.

Powerful risk analytics will be vital to help investors understand a fund’s investment strategy and portfolio positioning, and how managers navigate a changing liquidity environment. Keeping investors well-informed may reduce the likelihood that they will withdraw money from funds at times of heightened market volatility.

A new roadmap for liquidity risk management

Only by understanding, measuring and reporting liquidity risk are investors and managers able to manage the liquidity profile of their investment portfolios in the increasingly dynamic way that market conditions demand.

The changed market environment requires investors and managers to develop a holistic approach toward viewing their liquidity positions, particularly across today’s complex multi-asset portfolios. As our research underscores, many are already investing in a combination of advanced analytical tools, sophisticated risk modelling capabilities, and systems to report in near real-time on changing liquidity conditions.

 

David Suetens is international risk officer for State Street Corporation

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