The New Regulatory Focus On Liquidity Risk: Problems And Solutions-00-7302

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The loss of liquidity was not contemplated at all in the risk management models used across the industry, with the consequent increase of model back-testing failures. To give an idea of the impact of the liquidity component in these failures, we have observed in convertible bond portfolios three times the failures experienced by equivalent equity portfolios. The differential was entirely explained by the loss of liquidity in the convertible bond market, a market dominated by hedge funds that had to de-leverage their portfolios suddenly and all at once.

The combination of these events and the discovery that many monetary funds were investing relevant portions of their assets into illiquid instruments, such as ABSs, has increased the focus of regulators on Liquidity Risk.

Where the asset management industry is concerned, the most evident outcome of this new focus is reflected into the recent CESR recommendation for UCITS IV regulation (CESR/09-963, 28 October 2009). In this paper the CESR recommends the introduction of an ad hoc liquidity risk management process. Liquidity risk must be appropriately assessed, managed ...
... and monitored overtime for all the UCITS.

The recommended prescription is reinforced by the following article, where the regulator requires that management companies perform stress tests and scenario analyses to measure the impact of potential liquidity crises, similarly to what is done under current legislation for stress tests on market risks.

The introduction of Liquidity Risk is the biggest surprise of UCITS IV according to many practitioners, even if this recommendation has been preceded by similar initiatives by the FSA in the banking regulation and by the Italian Consob for illiquid instruments marketed to individuals, under the MIFID hat.

The surprise comes along with worries and unresolved questions on the implementation of these new rules and liquidity risk procedures. Market Liquidity Risk is still a gray area in the risk management research. In the remainder of the article we try to define market liquidity risk, explain where the implementation problems come from and propose a possible solution.

Market Liquidity Risk is the risk of losing a certain amount of money when we liquidate the positions held in a portfolio/fund. Assume for a moment that we can observe bid and asks for all the instruments that we hold in our portfolio, and that the size of these proposals is consistent with the quantities that we hold. Assume also that we are revaluing our portfolio using mid prices.

In this case the market liquidity risk is simply the cost of liquidating our portfolio at the observed bids (and asks for short positions), as measured by the distance between mid price and bid (or ask).

It may be easy to compute this loss for an equity portfolio, where bid/asks and volumes are available, both in normal and stressed times. It becomes much tougher to follow this approach when the assets held in the portfolio are bonds, illiquid bonds, OTC derivatives and the plethora of opaque financial instruments that can be found in abundance in many mutual funds.

We call this the Liquidity Risk Paradox: the information for calibrating liquidity risk models is available only for liquid instruments. In other words, we will never find the data that we need on illiquid instruments, where most of the Liquidity Risk actually lies.

For a long time it seemed that the problem did not have a solution and this explains in part why the risk management industry has never implemented a universal solution for measuring and managing market liquidity risk across all financial instruments, from equities to OTC derivatives, to illiquid bonds.

However, current technology and availability of data allows imagining new solutions. We have recently finalized one year of research and development for developing a new approach to liquidity risk.

The approach replicates the way market makers create the bid and ask of an illiquid product: they introduce in the pricing function of an instrument the bid and ask of the OTC derivatives that will be used to hedge the position, obtaining the equivalent bid/ask of the instrument.

The approach can be used for any financial instrument that links a pricing function to traded OTC derivatives, enlarging dramatically the set of instruments for which Liquidity Risk is computable, including opaque assets for which no price and volume information is available.

About the Author:

This article was written by Dario Cintioli on December 2009, he is the Global Head of http://www.statpro.com/portfolio_analytics/middle_office_analytics/risk_management.aspx and Complex Pricing at StatPro, a leading provider of portfolio analytics, data solutions, asset pricing services and http://www.statpro.com/portfolio_analytics/middle_office_analytics/risk_management.aspx for the global asset management industry.