Nearly half (48 per cent) of respondents to a survey by State Street Corporation and the Alternative Investment Management Association (AIMA) say that decreased market liquidity is a secular shift that is here to stay.
Regulations stemming from the 2008 financial crisis, coupled with historically low interest rates and slow rates of growth in the global economy, have constrained the ability of many banks to perform their traditional roles as market makers, which in turn has impacted broader market liquidity conditions.
More than three-fifths of the survey respondents say current market liquidity conditions have impacted their investment management strategy, with nearly a third rating this impact as significant, and are reassessing how they manage risk in their investment portfolios.
More broadly, they are adjusting to an environment of less liquidity in which trading roles have been transformed, new market entrants are emerging, and electronic platforms and peer-to-peer lending are changing the way firms transact their business.
“Increased regulation and the pressure to manage costs have significantly changed market liquidity conditions,” says Lou Maiuri, executive vice president and head of State Street’s Global Exchange and Global Markets businesses. “The new liquidity paradigm is causing many players in the investment industry to think again about the fundamentals: what roles they play, where they invest, and how they transact their business.”
While there is no one-size-fits all strategy for balancing risk and return in the current market environment, investors and managers are adapting to the new environment by focusing their efforts in three areas.
Firstly, the liquidity shift has serious ramifications for investors globally. They are seeking to develop the right strategies and tools to help them succeed in this complex new environment. This includes improving the way they measure and report on liquidity risk, and reassessing how they manage risk in their investment portfolios.
Some 42 per cent of all respondents say the changed market conditions are making it more challenging than before to report their liquidity position to their board or regulators, while 44 per cent of respondents plan to invest to improve their risk-reporting capabilities.
Secondly, investors and managers are shifting their allocation strategies to take account of new liquidity conditions. While more liquid fund vehicles such as ETFs, UCITS funds and 40 Act funds have been gaining ground, a holistic strategy that balances risk with return across the whole portfolio is critical.
Fifty three per cent of asset managers and asset owners are planning to add more liquid investments to maintain exposures, while 44 per cent are increasing the size of their cash allocation against future liabilities or redemptions.
Thirdly, the new market liquidity conditions are inspiring many players in the investment industry to invest in new solutions and platforms such as peer-to-peer lending that provide alternative sources of liquidity, with 49 per cent saying the role of non-bank institutions as liquidity providers will grow and 42 per cent say that this growth will come from hedge funds.
Nearly half (47 per cent) meanwhile, say hedge funds may play an important role in providing liquidity in more volatile markets.
“With liquidity likely to remain top of mind for years to come, now is the time to find the strategies, tools, and solutions that will make a sustainable difference in the new investment climate,” says Maiuri.
“Hedge funds and other asset managers are responding to more challenging market liquidity conditions by increasingly seeking out new opportunities, including taking on a more prominent role as market-makers, providing new sources of finance to the real economy, and lending their support and expertise to improving liquidity risk management,” adds AIMA CEO Jack Inglis (pictured).