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How to Manage Liquidity Risk in the Post-Lehman Era

Published October 03, 2018

Financial market liquidity is highly correlated with investor confidence and market conditions, as we saw when liquidity dried up following the collapse of Lehman Brothers in 2008. Ten years on, it is incumbent upon asset managers and other market participants to ensure they have the best possible risk management tools in place to avoid or mitigate a potential liquidity crunch if another crisis hits.

In the months and years after the Lehman collapse, central banks injected multiple rounds of liquidity into markets via accommodative monetary policy and extraordinary measures such as quantitative easing. This helped restore market confidence and created a wealth of opportunities for investors (i.e., asset owners) and third-party asset managers whose assets under management ballooned in size in aggregate, driven by a combination of inflows and favourable investment returns across asset classes.

The unintended consequences of this monetary-driven liquidity, however, were significant inflows into riskier, less liquid asset classes as more investors chased returns in a lower yield environment. If these inflows were to reverse abruptly, perhaps due to changes in monetary policy, there could be a significant impact on liquidity.

 

Liquidity Deterioration

While many liquidity resilience metrics show that the long-term picture of market liquidity is mixed, liquidity has deteriorated on certain measures compared to before the global financial crisis. This is especially true for bonds.

Bond trading turnover has been declining over the past decade. This is due to the crowding out of active managers and other secular trends that have lowered the ratio of trading activity per unit of bond outstanding. Simultaneously, market liquidity and depth have diminished as measured by average trade size and price impact, further discouraging active managers from trading. Banks have significantly reduced their role as intermediaries as regulations have pushed up the cost of market making. This can be evidenced by the staggering drop in dealer bond inventory after a decade of deleveraging.

Asset Managers’ Responsibility

As banks have withdrawn from market making, asset management companies have taken on more responsibility for managing liquidity. This has captured the attention of regulators and investors who have focused on the potential mismatch between the promised liquidity terms of open-ended funds with daily dealing and the liquidity of the underlying assets in these funds. Regulators are concerned that, during periods of market stress, significant redemptions from funds with similar investment strategies might cause them to sell their underlying assets into a falling market. This would lead to a price and illiquidity spiral, and the potential contagion could cause not only liquidity issues for individual funds, but also broader systemic issues across financial markets. Investors who wished to redeem units during such periods might find they could not, while those remaining in a fund might have to bear costs related to redemptions by others.

In light of this, it is important to understand the wide range of established liquidity risk management processes and tools that asset managers have at their disposal to manage and mitigate liquidity risk for their funds and products, in both normal and stressed market conditions. State Street Global Advisors recently published a paper on buy-side liquidity risk management best practices in the Journal of Risk Management in Financial Institutions that can be accessed here.  

The paper describes what we have learned over the past five years while building out liquidity risk management framework, including best practices developed to meet both fiduciary and regulatory responsibilities. A comprehensive and robust buy-side liquidity risk management framework should incorporate strong governance, real-time measurement and monitoring processes, as well as contingency planning and product suitability reviews, supported by best-in-class liquidity risk monitoring tools and systems. By having such a framework in place, we aim to ensure that we are able to manage situations that might otherwise affect broader market liquidity and our clients.

Disclosures

The views expressed in this material are the views of Sebastjan Smodis through the period ended September 24, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

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