Managing liquidity in uncertain times

This article was written by Fergus Trenholme, Liquidity Risk Specialist, and Christian Benson, Regulatory Affairs Specialist.

Against the backdrop of geopolitical and economic turbulence and the need to carefully manage liquidity, fund managers operating in the European Union (EU) are increasingly aware that well-defined data strategies can no longer just be an afterthought. Yet, sparse data and a patchwork of legislative requirements are holding back key policy goals as well as industry efficiency.

As the EU seeks to refresh the legislative framework for the fund sector through the review of the Alternative Investment Manager Directive (AIFMD) and market supervisors turn their attention to fund liquidity resilience, the European fund sector will need to consider how best to manage the evolving data requirements that this new landscape will require.

Liquidity as a regulatory concern

Over the past decade total investment fund ownership in Europe has grown to €15 trillion from €6 trillion in 2010, and this has fed into a growing regulatory focus on the fund sector. During this period, events such as the demise of Woodford Investment Management (June 2019) have illustrated the importance liquidity risk management at the firm-level, while major events like the onset of the Covid-19 pandemic (March 2020) and the outbreak of war in Ukraine (February 2022) required the industry to actively assess and manage liquidity through extreme stress scenarios. In response, work is underway at the international supervisory level to explore potential reforms to liquidity management, with recent initiatives in the EU and UK including:

• March 2021: ESMA publishes results of the 2020 common supervisory action regarding UCITS liquidity risk management.
• June 2021: The Bank of England and the FCA conclude their joint survey on liquidity management in UK open-ended funds.
• November 2021: The European Commission published proposals to review the Alternative Investment Funds Manager Directive (AIFMD).
• February 2022: ESMA proposes reforms to improve resilience of money market funds (MMFs).
• March 2022: ESMA and the national European supervisors (NCAs) conclude that there is room for improvement in fund liquidity stress testing.
• April 2022: The International Organization of Securities Commissions (IOSCO) seeks feedback on market liquidity issues affecting corporate bond markets.
• May 2022: UK authorities release discussion paper on MMF reform and FCA publishes guidance on UK MMF Regulation.

Liquidity scene setting

Historically, fund liquidity reporting requirements have been typically treated as a compliance exercise with no real impact on fund performance. Yet as market structure has developed it has become clear that certain firms are realizing competitive gains through their reportable liquidity metrics. This has led to two different approaches with some firms taking a more compliance-focused “tick-box” approach to EU fund requirements while others adopt a more performance-focused and holistic approach.

Liquidity mismatch and LMTs

Liquidity mismatch remains a challenge for both the market and policymakers, as this can lead to situations where investor demand for their money back is not satisfied by the fund’s ability to sell its holdings. This mismatch between redemption terms and the liquidity of the fund’s assets has the potential to become a systemic risk. Ensuring firms have access to a full range of measures to manage fund liquidity, known as liquidity management tools (LMTs), is a key tenet of the AIFMD review currently going through the EU’s legislative process. LMTs typically include:

• Swing pricing mechanisms to ensure that the investor entering or exiting the fund supports the cost of liquidity to limit first mover advantage;
• Redemption notices to provide fund managers additional time to gather cash necessary to pay redemptions;
• Side pockets that allow managers to set up dedicated fund for certain asset that become especially illiquid or hard to value when a particular market segment deteriorates.

European policymakers are currently in the process of revising the AIFMD to introduce rules to harmonize the use of LMTs across Europe and enhance their supervision.

Liquidity measurement in bond trading

The bond market is an interesting example of an OTC market where accurate liquidity measurement is difficult, as most bond trading occurs in a relatively small proportion of the total active issue market. This consolidation of trading in a small universe of instruments means that it is hard to obtain accurate assessments of liquidity measures for most of the market, as large segments of the market may only trade on an infrequent basis.

As an analogy, consider the case of an antique car last bought many years ago. You most likely would not find an existing list of prices being offered by potential buyers, but if the car were to be brought to auction it would likely sell in line with estimates. Bloomberg tries to answer the same challenge with securities which may seldom trade in the secondary markets with our market liquidity solution, LQA. This allows market participants to evaluate the likely ease and cost of meeting client redemptions under both prevailing and stressed market conditions.

Reporting and data standardization

When completing regulatory filings, funds often encounter a wide range of data complexity and subjectivity that ranges across simple descriptive data, calculated data, and more complicated data that requires the use of analytical tools. The high degree of interpretability and firm-specific bias involved in fund reporting has prevented a more standardized view of the market emerging.  Reported measures can be considered to span four broad data categories with varying degrees of complexity:

1. Accounting
2. Calculated
3. Derived/implied
4. Modelled

For example, within the “modelled” category, there is little consistency between managers as two funds with the same fund could report different liquidity profiles as a result of inherited model biases. This lack of standardization and consistency in reported data has led to some of the problems in liquidity management that are prevalent today. With experienced traders and compliance officers looking for tools that determine the true liquidity risk of a trade, policymakers are seeking to improve the consistency of liquidity reporting from similar funds to enable a more holistic and accurate view of the market.

Conclusion

As European legislators works toward an amended version of the AIFMD and market supervisors and central banks step-up their work on market liquidity issues, the regulatory environment for the fund sector is set to mature over the coming years. To ensure success in this changing environment, firms should prepare to adapt and strengthen their data strategies accordingly.