Planning for tighter liquidity risk management rules
Problematic valuations have heightened need for liquidity
Liquidity risk management has been in the headlines recently, driven by regulatory concerns that another liquidity crisis similar or worse than the one endured in 2008 is inevitable.
ESMA has been the key proponent in Europe publishing various notices including new Liquidity Stress Testing Guidelines that come into effect on 30 September this year requiring fund managers operating under UCITS and AIFMD to ensure liquidity stress testing processes are effective and timely.
The need for realistic liquidity management and ongoing review of both portfolios and investor profiles is mandatory.
The ongoing coronavirus situation has served to emphasise the regulators' fears surrounding liquidity and while volatility is a necessary part of a manager's trading philosophy for many investors, the extremes seen over the last few months have prompted many to move to redemption and the dreaded flight to cash and other cash equivalents in order to weather the storm.
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During these uncertain times managers should have already reviewed how best to manage liquidity in their funds. There are two key aspects to liquidity; the portfolio and its contents and the composition of investors in the fund.
To address the new requirements, managers should consider, among other aspects, the following key points:
• Ensure regular and appropriate liquidity profiling on the portfolio is being carried out. Also clearly define thresholds or limits where escalation may be required.
• Ensure appropriate and regular stress tests are being conducted and the tests themselves are reviewed to allow for more relevant tests to be introduced as and when required.
• Have the relevant governance committees operating within the firm and at fund level oversee and sign off on the results of the tests. Documentary evidence is vital here. Furnish your depositary with the outcome.
• Trends are more important than 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.
Liquidity analysis is not just centred around the portfolio. The composition of the fund's investors is another key element and will assist in managing liquidity.
While the use of a nominee company can mask the underlying breakdown of investors, certainly in the alternatives space, many managers will have a good understanding of their investor base.
Whilst the use of redemption "tools" such as gates will offset a run of redemptions, this tool does not ultimately stop a fund having to suspend if it simply cannot service its exiting investors.
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A manager should therefore be closely monitoring its investor profile looking at the percentage of the fund held by each investor, typical redemption levels together with the ongoing highest level where applicable.
The assumptions should be stressed based on a multiplication of factors increasing the downside affects. Again, consider the trend as well as the date of the review.
What causes some confusion among managers is the requirement around reverse stress testing and what this actually means. There is not a one-size-fits-all answer here as the threshold will vary by fund strategy.
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