Liquidity risk management in Asia
In Hong Kong, the regulatory focus is on establishing a liquidity management programme that is most suitable for a fund’s particular investment focus, while ensuring that funds have sufficient liquidity to meet investor redemptions (see appendix). Both the SFC and MAS guidelines are largely principles-based, however they will be enforced through regular audits and thematic reviews similar to the one conducted by the SFC last year where the regulator examined firms’ best execution efforts. The thematic reviews allow the regulator to examine each firm’s individual risk management approach relative to its specific business and risk profile. As of June 2018, the SFC have mandated enhanced reporting with respect to reporting liquidation profiles for authorized funds. This becomes effective from Q3 2018 reporting.
The MAS’ consultation (see box) was released in October 2017 and is similar in scope to the SFC’s regulation. An important distinction, however, lies in its treatment of money market funds, which have to hold minimum levels of liquid assets as well as maintain a weighted fund maturity of between 60 days for short-term funds and six months for all others.
Jurisdictions with significant fund management industries like Taiwan, China, South Korea and Japan have yet to release formal guidance on liquidity risk management. However, the convergence of global regulation and greater investor awareness is prompting a number of funds throughout the region to adopt liquidity risk management frameworks that conform to best practices.
Asset management companies, depending on their current approach to liquidity risk, will need to devote varying amounts of time and resources for compliance with the new guidelines. They will need to put in place firm-wide liquidity risk management policies that will serve as the yardsticks against which compliance will be judged under both the Hong Kong and Singapore frameworks. This will require a holistic assessment of firms’ current liquidity risk management approaches and the identification of functional and strategic areas that will need to be changed. Although firms in both Hong Kong only have a few months before the guidelines take effect, with expectations that the Singaporean regulator will imminently release their final wording around liquidity management, the breadth of the impending changes required will require significant preparation.necessitate a reasonably large amount of preparation.
According to the Tokyo-based head of operations quoted above, their current liquidity risk framework includes a generic policy document. However, this executive said that while they are watching regulatory developments closely, strategic or commercial changes are unlikely.
“I don’t think it’s going to change much of anything except for making sure we have certain thresholds in place that we can justify and not cross them. It won't change the way we manage our portfolios. It’ll just be a box to tick,” he said.
This is not a sustainable approach. Tas the SFC is requiring more stringent liquidity monitoring and reporting, especially for new funds. The regulator is looking at liquidity metrics for new product launches more closely and requiring that liquidity reports be included in marketing materials before it approves new funds. Furthermore, most investors, concerned about liquidity crunches during times of market stress, are preferring funds with transparent and well-defined liquidity risk management programmes.
To meet these requirements of regulators and potential investors, asset managers will need to imbue both front and back office functions with a culture of risk management that considers liquidity risk in most areas of their business. Firms will need to comply with their market liquidity frameworks as they construct portfolios or new structured products and then test them by performing liquidity stress tests and documenting the results.
Asset management firms will also need to be able create, aggregate and analyse large amounts of data. They will need to calculate the liquidity metrics the SFC will require through an analysis of the market for each product, historical redemption patterns and scenario analyses.
Bloomberg’s Liquidity Assessment Tool (LQA) is well placed to provide a complete solution for firms to do this by providing a quantitative snapshot of market liquidity across asset classes. It can:
LQA can provide key metrics including a liquidation cost, liquidation time horizon, expected daily volume, confidence measures for each output, and relative and absolute liquidity scoring.
Most instruments are traded OTC, so measuring liquidity for fixed income instruments is more challenging because of a lack of transparency in the market as most of these products are OTC. Bloomberg's pricing coverage means the LQA can provide a complete spectrum of liquidity assessments. The LQA provides clients with the flexibility to use Bloomberg data to generate liquidity reports and can generate these metrics in a flexible and granular fashion.
“Users can customise their metrics for their relevant jurisdictions. They can use the platform based on both their regulatory and marketing requirements. So the product is granular enough to help users create a number of different metrics that could facilitate compliance with multiple regulations and also their investor demands. Investors can ask different questions about liquidity and the product can be very quickly customised to produce different reports,” says Anthony Lee, a risk specialist at Bloomberg.
The LQA’s liquidity score — a relative liquidity metric — could be an important factor in designing portfolios, as it allows users to rank instruments within the same asset class or sector on the basis of their relative liquidity. This rule-of-thumb approach can allow users to quickly determine the liquidity profile of a portfolio’s components in the product design stage, as required by the MAS LRM guidelines.
According to Naz Quadri, Global Head of Liquidity Analytics for Bloomberg, the liquidity scores can play an important part in a portfolio construction exercise, allowing firms to comply with the SFC’s liquidity guidelines and also potentially create a more efficient portfolio.
“Firms can use the liquidity score to run different choices of securities that go into a fund and select the ones with, say, the highest score. So, when the portfolio manager looks to rebalance and trade in and out of these securities, the chosen securities are more likely to have lower round- trip costs, thereby increasing the alpha on the portfolio. It’s going to be cheaper for the manager to run this portfolio and, all other things being equal, potentially see better returns,” he said.
Stress testing
Stress testing is a significant part of all liquidity-based regulation. However, a challenge of running a proper stress-testing scenario involves inputting historical redemption patterns as well as expected redemptions. Redemption data is a key component of liquidity analysis under the new regulations. Yet, not all funds have maintained historical redemption data and estimating future redemption patterns can be challenging, especially in scenarios involving market stress.
According to Lee, generating reasonable redemption patterns is an industry-wide issue. LQA has developed forecasts for redemption scenarios, which can serve as a potential standard.
“Redemption data is specific to investor bases and it is harder to develop a one-size-fits-all solution. However, we can allow users to shift inputs to our model to create stress-test scenarios they can use to overlay on top of their standard historical redemption patterns to come up with a fairly realistic redemption-based stress test result. We have discussed this approach with the regulators and they seem to find it a reasonable solution to an industry-wide issue,” he said.
