With investment managers typically running multiple strategies, both onshore and offshore, across a range of asset classes, paying heed to regulatory rules has been a relatively straightforward affair.
Global regulations over the last decade have required financial institutions to become more prescriptive in terms of improving their trade compliance frameworks and enhancing pre-trade analytics. As such, most of the liquidity-related concerns in respect of Comprehensive Capital Analysis Review (CCAR) prescribed by the Federal Reserve Board, Solvency II, MiFID II, and liquidity coverage ratios under Basel III are essentially just rules from the regulator to adhere to.
Conversely, regulations such as the Alternative Investment Fund Managers Directive (AIFMD) on the buy-side, the upcoming Investment Company Liquidity Risk Management Programs rule – known as SEC rule 22e-4 – and prudent valuation regulations introduced by the European Banking Association for the sell-side, place an actual requirement on the end user to estimate their liquidity.
“With AIFMD, it is requiring fund managers to time bucket their liquidity and report those to the national regulators, but in my view SEC rule 22e-4 is probably the most challenging rule, to date,” comments Naz Quadri, Head of Liquidity Analytics for Bloomberg’s Enterprise Solutions business.
Twenty years ago, there was no consistency of approach in terms of how people viewed liquidity. Since the ’08 global financial crisis, the G20 have committed to rolling out an alphabet soup of regulations.
“They’ve become more challenging, to the point where, under SEC rule 22e-4, you’ve got the first mandated regulation around measuring, categorising, and reporting on liquidity,” adds Quadri.
This is putting pressure on financial institutions to closely track the distribution of liquidity throughout the month and categorise their liquidity into different buckets.
“PruVal is interesting. The EBA is asking the banks to give them details on their positions, which would have a liquidating horizon over 10 days for example, but also to give them an exit price for each position with 90 per cent confidence. To ask for a confidence level has real implications on how people design their liquidity models,” explains Quadri.
AIFMD and SEC rule 22e-4 are pushing liquidity risk management front and centre of trading strategies, placing much greater emphasis on ex ante risk. In theory this should help asset managers avoid getting caught out, should markets turn and their funds suffer a wave of redemptions.
To help with this firms such as Danske Bank Asset Management have adopted solutions such as Bloomberg’s Liquidity Assessment Tool (LQA) to measure and monitor liquidity risk across asset classes. Copenhagen-based Danske Bank Asset Management has more than EUR100 billion in assets under management. It uses Bloomberg LQA to measure and benchmark the liquidity risk of its fixed income and equity portfolio investments to meet its myriad regulatory reporting requirements.
Bloomberg LQA allows users to quantitatively and consistently evaluate market liquidity across multiple asset classes, including government and agency debt, corporate bonds, municipal bonds, global equities and ETFs. More asset classes are to follow by the end of 2017.
Four time buckets under SEC rule 22e-4
The technological prowess of liquidity risk management solutions like Bloomberg LQA is vital in supporting asset managers as they cope with regulation, of which SEC rule 22e-4 is the latest example.
It was passed unanimously on 13th October 2016 and impacts US open-ended mutual funds and ETFs. Commenting at the time, SEC Chair Mary Jo White said: “These new rules represent a sweeping change for the industry by requiring strong transparency provisions and enhanced investor protections. Funds will more effectively manage liquidity risk and both Commission staff and investors will receive additional and better quality information about fund holdings.”
“What the SEC is trying to achieve with this rule is for registered investment advisers to put in place a liquidity risk management process to define how they are managing their liquidity – reporting on order execution, reporting on breaches, etc. Secondly, they want the ability for firms, on a monthly basis, to categorise their holdings on a time basis, within four time buckets. And thirdly, alongside that time bucketing, to set thresholds,” says Quadri.
Briefly, the four time buckets are defined as follows:
1. “Highly liquid”
Positions that can be sold and settled within three business days;
2. “Moderately liquid”
Positions that can be sold and settled in more than three but less than seven calendar days.
The SEC asks funds to also consider “disposal”, i.e. classify the remaining positions that can be sold but not necessarily settled in current market conditions.
3. “Less liquid”
Positions that can be sold within seven calendar days but probably will need more than seven calendar days to settle.
4. “Illiquid positions”
Positions that will take greater than seven calendar days to sell.
“What is interesting about this regulation is, will clients be able to do monthly reporting on this? They are going to have to check for breaches, and check that going into the fourth week of the month their liquidity is in good shape. It’s quite likely that for mid-sized to large organisations, it will become a daily operational function,” suggests Quadri.
In many respects, SEC rule 22e-4 is the first explicit regulation to codify, or formalise, liquidity risk management.
Asked whether it could be viewed as too prescriptive, Quadri says that the SEC has been “fairly smart” in this respect and refers to three key pieces of wording.
When trying to figure out which liquidity bucket something should drop into, the rule states that it should be based on the amount of time it would take to liquidate “without significantly changing the market value of the investment”.
It is, therefore, up to the individual to determine how much cost they are willing to incur to liquidate a series of positions.
The second piece of wording is that they need to be able to do this under “foreseeably stressed market conditions”.
“The SEC is giving the nod to investment advisers that they need to consider stressed market conditions and will allow the individual fund manager to determine what they deem to be `foreseeably stressed’.
“The third piece of wording is that they don’t expect the investment adviser to liquidate their entire portfolio. They ask managers to look at redemptions that the fund would reasonably anticipate having. Imagine you have an ETF that has been running for a number of years that has, historically, had few investor redemptions. You would therefore base your categorisation on that small redemption rate.
“All of these wordings provide a degree of flexibility to investment firms,” explains Quadri.
Each of the four liquidity buckets are interchangeable, such that in the event of a market downturn, if a manager were about to hit their threshold limit in bucket four, for example, they could sell out and take a cost hit; or, alternatively, invest more in buckets one and two to change the overall percentage allocation across the fund. Whatever combination the manager wishes to take, such that their liquidity profile remains in compliance.
“The regulators are not mandating how to deal with a liquidity crunch. They are giving a mechanism for an investment firm to look at their portfolio and, by a set of rules, determine what their liquidity characterisation is,” concludes Quadri.
