Should We Be Paying More Attention To Liquidity Risk?

In November 2012 Paul Amery wrote a blog saying that liquidity risk was something regulators had next on their agenda. Fast forward nearly two years and it seems that the European regulator is now starting to grapple with it.

ESMA (European Securities and Markets Authority) published a report on “Trends, Risks and Vulnerabilities” this Wednesday 3^rd September with a large chunk focusing on liquidity risk.

Initial findings show that liquidity risk increased in the second quarter and looks set to continue its upward trajectory.

The report also found that while aggregate liquidity appeared ample, its distribution was uneven across markets. It reported that: “Both this unevenness as well as dependence on monetary policy support are important factors in determining liquidity risk.”

There are also possible reasons as to why liquidity may have been augmented. ESMA cites anticipation about possible policy responses to continued disinflationary trends to have augmented liquidity.

But what does this mean and should we be worried?

Liquidity risk is the risk that a security or asset cannot be traded quickly enough in the market to prevent a loss and is fast becoming talked about in the exchange traded fund space. It is defined under UCITS as “the risk that a position in the UCITS portfolio cannot be sold, liquidated or closed at limited cost in an adequately short time frame and that the ability of the UCITS to [repurchase or redeem its units at the request of any unit-holder] is thereby compromised;”

Why should we be concerned about liquidity risk?

One of the issues in relation to liquidity risk and exchange traded funds is if investors were to start making redemptions in niche market ETFs. In a worst case scenario event, what happens here – should there be liquidity issues – is that, investors won’t be able to get their money out and will lose it.

However, where is this liquidity risk?

Ben Seagar-Scott, director investment strategy at BestInvest argues that in particular we should be looking at physical ETFs.

He explains: “What synthetic ETFs do is shift the liquidity risk exposure away.  This will happen increasingly as use of ETFs is likely to grow as we get into more niche markets. Liquidity risk is a problem in physical ETFs. With synthetic ETFs you swap the counterparty for liquidity risk – so it becomes the bank’s problem (so long as the bank doesn’t go bust), but in physical ETFs then the investor is exposed to liquidity risk – so, what happens if there are redemptions all at once?”

his raises a valid point.

But one lawyer who wished to remain anonymous said that it is actually synthetic ETFs that could be more of a problem. They say that “With synthetic funds you can create false liquidity because it uses a swap…. And is something investors need to be aware of.”

 

Another market commentator, who also didn’t want to be named, adds that you have to clearly establish where the liquidity risk sits before you can pick out physical ETFs. Does the liquidity risk sit with the swap provider? The ETF owner? The bank? The investor?

They said: “There is no example of a stock loan failing because they are priced mark to market.”

This raises levels of confusion and a smidge of worry for me. It’s clear that there is an issue, but quite possibly no one knows exactly what it is.

Who else is looking at liquidity risk?

Encouragingly though UCITS IV has made some effort in addressing liquidity risk.  A note from Deloitte says that under UCITS IV, “UCITS must explicitly address liquidity risk, going beyond the cover rules set forth in previous UCITS regulation. However, neither detailed regulatory guidelines nor meaningful and recognised market practices have emerged.”

IOSCO also addressed liquidity risk in a consultation in April 2012 where it made the point that collective investment schemes (funds) differ fundamentally from banks in that “maturity transformation” (borrowing short-term and investing long-term) isn’t an inherent part of the business.

It also appears that ESMA is now on the case as well. So perhaps it’s just a debate that needs thrashing out?.

Until such time, we are left with ESMA's report, which gives us a good view on what is going on in the market, which according to ESMA’s report, looks something like this:

-          The risks related to a snapback and subsequently arising demands from asset reallocation increased.

-          Liquidity measured in sovereign bond markets was stable.

-          In equity markets, a brief deterioration early in the quarter highlighted the potential for disruption.

-          Bond market volatility remained inversely related to maturities.

-          Sovereign bond bid-ask spreads: Bid-ask spreads were broadly stable across the EA. A degree of convergence continued, however, with those of the three largest EA sovereigns reverting back to end-2013 levels. A downward movement was particularly noticeable for one sovereign exiting an adjustment programme.

Regardless of all of this, it is clear that we probably should be mindful of liquidity risk, especially now regulators are shining the light on it again.