Fund Managers Want Combined Liquidity Exposure
Large asset managers are moving from monitoring liquidity risk within individual funds to measuring the combined exposure across all their funds according to State Street Global Exchange.
State Street Global Exchange is the business within State Street Corporation, the custodian, asset servicer and fund manager, which helps the firm’s clients use new technology and data analytics.
Mark McKeon, head of product management and analytics at State Street Global Exchange, told Markets Media: “A lot of fund managers have reviewed liquidity within the portfolio manager function on a fund-by-fund basis but large firms now want to look at combined exposure across all their funds.”
He continued that State Street initially developed a multi-asset funding liquidity framework to meet the liquidity requirements of UCITs IV, the European Union regulation covering certain investment funds, which not only measures the liquidity of the assets but also incorporates the liabilities.The regulation does not specify how fund managers should address liquidity risk but the State Street system provides redemption profiles under both normal and stressed conditions, and updates the necessary coverage ratios.
“In the past five years the client base has extended,” added McKeon. “There is a lot of demand from US mutual funds following the SEC consultation, which is being looked at by other regulators and asset managers in Europe and Asia.”
The US Securities and Exchange Commission’s proposals include requiring mutual funds and exchange-traded funds to hold a greater cushion of assets that can be easily sold during stressed market conditions – such as a minimum of cash or cash-like investments that can be sold within three days – and for them to tell investors how many days it would take to sell their holdings.
Liquidity has become a hot topic since the financial crisis as regulators have made banks have cut their balance sheets and leverage. Banks have reduced their market-making activities, and market participants have claimed that it has become harder to trade corporate bonds in particular.
This month the Financial Conduct Authority published a paper on the UK regulator’s review of the revolution of liquidity in the UK corporate bond market between 2008 and 2014. The regulator analysed more than 6,000 bonds that were active between August 2011 and December 2014, and about 400 bonds from November 2007 to August 2011.
The FCA said: “On the basis of a series of widely accepted liquidity measures, we document that there is no evidence that liquidity outcomes have deteriorated in the market, despite the decline in inventory of dealers in this period. If anything, the market appears to have become more liquid in recent years. We also document that there is little evidence that liquidity is having a larger effect on bond spreads now than a few years ago.”
The paper said that UK primary dealers held approximately £400bn of inventories on their trading books in the middle of 2008 which fell to £250bn at the end of 2014 on the basis of regulatory returns. However, the regulator argued that a fall in inventories did not imply a reduction in liquidity in the market.
“All the measures of illiquidity show a remarkably consistent pattern: they start from reasonably low levels at the beginning of our sample (2008 Q1), then increase for the subsequent quarters when the financial crisis hit, and subsequently decline to a very low level by the end of 2011, remaining stable ever since,”said the FCA.
The regulator acknowledged that its results do not imply that liquidity will always be there when needed as there was considerably less liquidity in 2009 and 2010, when markets were stressed, than either before or after this period.
“Further, it is likely that a similar pattern will emerge in the future if the markets were to experience periods of extreme stress,” added the FCA. “Therefore, our results should not be misinterpreted to imply that there are no risks associated with liquidity.”
JR Lowry, head of State Street Global Exchange for Europe, Middle East and Africa, told Markets Media: “We have seen reductions in transaction volumes on some of the trading platforms that we operate so liquidity is a concern. People are worried that when interest rates rise there will not be enough liquidity for them to change their bond positions.”
McKeon said clients are interested in peer comparisons on the State Street platform and the firm is adding data on fixed income and additional sources in Europe and Asia to enhance the platform further.
In Europe the MiFID II regulations covering financial markets in the region are due to be implemented. McKeon added: “For MiFID II we have venue analysis and best execution solutions in the US which we will push into Europe.”
Lowry said: “State Street has developed a capability to monitor liquidity over the last five years but it is early days for the industry. The debate will continue on how best to measure liquidity and how best to provide useful information.”
David Lawton, director of markets policy and international at the FCA, said in a speech at the Financial Risk International Forum in Paris this month that the regulatory discussion in the last two years has intensified around the role of asset managers, and others controlling private pools of capital, for investment purposes.
One reason for the increased regulatory focus is the growth in size of the asset management industry which may make them more systemically important. The IMF has estimated that the fund management industry intermediated assets of $76 trillion, or 40% of global financial assets, last year.
Lawton said the Financial Stability Board and the International Organisation of Securities Commissions have identified five potential structural vulnerabilities of funds – the possible mismatch between the liquidity of fund investments and the terms and conditions for redemptions; high levels of leverage within certain investment funds; operational risk challenges in transferring investment mandates from a fund manager in a stressed condition to another manager; securities lending activities of asset managers and funds; and the potential vulnerabilities of pension funds and sovereign wealth funds.
At the beginning of this month, the FCA published the findings of a review of a number of large investment management firms on how they managed liquidity in their funds. The FCA found areas of good practice in applying the EU rules which apply to funds for liquidity risk management across a variety of market conditions. The UK regulator raised positive steps that can be taken to better manage liquidity risk including upfront disclosure to investors about liquidity risk; subscription and redemption processes that are designed with the fund’s investment strategy in mind; regular assessments being made of liquidity demands; gathering price data from varied sources; and stress testing of portfolios and possible redemptions in light of a range of market conditions.
“It is important in any analysis of where we are today not to look back at the pre-2008 period as a golden age that we need to get back to. That is definitely not the right benchmark,” Lawton added. “Secondly, it is not clear that current liquidity conditions have deteriorated to a point where serious structural issues have arisen (for example, excessive volatility, or prices not reflecting the fundamentals of supply and demand, or a discontinuation of markets). Nor, if there has been any deterioration, what role financial regulation has played.”
However Lawton continued that it is possible to imagine scenarios in which a trigger event (such as a sudden, unexpected increase in central bank rates) or losses at one fund could cause knock on effects for other firms and broader falling asset prices.
“A key vulnerability being discussed is the ability to manage fund redemptions in an orderly way, particularly in the context of post-crisis market conditions, including liquidity,” added Lawton. “The picture of the systemic risks is still being drawn through the work of the FSB, IOSCO and others.”
Featured image via Shane Farnsworth/Lightstock<
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