Recent financial crises have demonstrated that unpredictable circumstances can cause liquidity to nearly vanish. In response, regulators across the globe have developed new rules to ensure liquidity remains stable across markets worldwide. What are these new regulations and what goals are they looking to achieve? How are current events affecting liquidity? We sought to answer some of the most frequently asked questions regarding liquidity today.

How is the current Brexit situation affecting liquidity in the EU and worldwide?

liquidity - quoteThe implications of Brexit are broad, ranging from FX volatility to counterparty risk. Organizations are looking to put strategic initiatives in place to find liquidity in a period of high uncertainty, factoring in the higher funding costs registered for the UK corporates.

When asset and funding liquidity risks come together, a liquidity spiral can develop, with falling asset prices possibly prompting banks to reduce their supply of credit, thus causing further falls in asset prices. Contingency measures have been put in place by the EU in case the UK leaves without a deal. These include, primarily, the recognition of UK clearing houses as the cleared liquidity may start concentrating in a smaller number of clearing houses (as these may move and merge), thereby increasing the systemic risk in the EU.

What are the main differences between the US SEC initiative on liquidity risk and the Liquidity Stress Test (LST)?

The main differentiators are found in the asset classes that regulators focus on and the time to liquidate classification. The SEC focuses on all registered open-end investment companies (ETFs are also included and to some extent underwriters of unit investment trusts as well) but excludes money market funds and closed end funds.

ESMA also diverges from the SEC initiative in the classification of positions: seven quantitative bands for ESMA (less than 1 day, 2-7 days, 8-30 days, 31-90 days, 91-180 days, 181-365 days, and more than 365 days) compared to four qualitative buckets for the SEC initiative (highly liquid, moderately liquid, less liquid, illiquid).

What are the underlying goals for both the SEC initiative and the Liquidity Stress Test?

Both ESMA and SEC initiative have mandated a new set of rules aimed at quantifying liquidity risk in a more structured and standardized way. With the specific focus on the risk that a fund could not meet redemption requests without significant impact on the remaining investors in the fund, the new rules require a fund to: monitor liquidity risk across different market conditions, monitor time to liquidate trends, and analyse redemption simulations and liabilities scenarios.

How is liquidity viewed in the EU compared to the US/worldwide?

The recent global crisis highlighted the need to inject liquidity and loosen monetary policies worldwide. Different procedures are applied between the EU and US as well - on the one hand because of the substantially different ratio between the outstanding bank credit and the outstanding bond issues and on the other hand because of the higher conservatism of the European Central Bank (ECB) compared to the Federal Reserve.

Such structural differences mainly lead the ECB to prefer directly supplying self-liquidating collateralized emergency liquidity to banks rather than to engaging in longer-term open market purchases. Consequently, both the monitoring of liquidity and redemption stress testing became of utmost importance within the overall risk management framework.

How does one establish a relationship between the market impact that is calculated for all the instruments in the portfolio (regardless of the trading venue) and the time-to-liquidate in order to assign asset classes into the relevant buckets prescribed by the regulator?

The new rules aim to reflect the traditional three dimensions of liquidity: cost, time, and volumes. When measuring liquidity risk it is simple to calculate liquidity if bid-ask and volumes are available. The challenge arises when regulators regularly ask to calculate liquidity for illiquid assets while the data required for calibration is only available for liquid instruments.

Unfortunately, the current methods in place for measuring liquidity are unable to give the necessary detail for the most opaque and illiquid instruments, which is where the measurement of liquidity risk is mostly needed.

StatPro has introduced a universal approach based on liquidity scenarios that can cover any financial asset (equities, bonds, OTC derivatives, etc.) using a homogeneous and consistent approach. This is divided into five different components: fair bid-ask value, nominal outstanding, market cap, % ownership, payoff complexity. All components are calibrated across three default liquidity scenarios: normal, stressed and highly stressed market conditions.

How is the relationship between liquidity risk and time-to-liquidate established? Beyond the use of bid-ask and volumes, there are a number of different methods that can be applied. StatPro’s current approach is in relative terms and aims to identify a sample of liquid assets and compare the liquid sample against a fixed number of samples that represent the main categories and asset classes. Benchmarks tend to have a similar average but the shape of their distribution indicates that equities are more sensitive to percentage of ownership, whereas bonds with low nominal emissions tend to be buy-and-hold. Each benchmark may be used as a reference against the categories assigned to each asset class, finally producing metrics such as min/max/average/standard deviation of the market impact.

Starting from the metrics computed for the benchmark, users may determine the first boundary in terms of time to liquidate. Since benchmarks are considered liquid by definition, a set of ratios may be defined based on the assumption that the average market impact of the benchmark is equal to one day to liquidate.

Conclusion

While the issue of liquidity may be approached differently depending on the region or market, the importance of liquidity risk management cannot be understated. Firms need a platform that enables them to meet new regulatory requirements and can combine both a quantitative and qualitative approach to create an accurate representation of how the market handles liquidity.

Will your firm be able to satisfy the requirements for the Liquidity Stress Test (LST)?

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