Liquidity risk is not important until it is. And then it becomes the only thing that matters.

Fund managers can no longer ignore liquidity risk management. Over the past few weeks we have heard and read the news on Neil Woodford’s Equity Income Fund and how it ploughed funds into illiquid assets. On 3rd June, the fund was closed to redemptions which left thousands of investors locked in the fund for at least 4 weeks. The issue is not that the fund was investing in illiquid assets – UK funds are allowed to invest up to 10% of its assets in unlisted assets. The issue is did Neil Woodford and his team understand the liquidity risk associated with these assets, moreover, did they have the appropriate liquidity management framework in place in order to facilitate the event of significant redemption risk.

The incident highlights the risks of liquidity mismatches when open-ended funds invest in unlisted assets while offering investors daily access to their money. Mark Carney, Governor of The Bank of England, pointed out that “$30 trillion of global assets are held in funds that promise daily liquidity to investors despite investing in potentially illiquid assets”. Woodford isn’t the first fund manager to run into liquidity problems. In 2016, after the UK voted to leave the European Union, the country’s largest real estate fund froze almost £9.1 billion of assets as investors rushed to get their money out. M&G Investments, Aviva Investors and Standard Life Investments all suspended redemptions from their funds devoted to illiquid property assets. In the US, Third Avenue Management, a mutual fund company founded by Marty Whitman, managed as much as $26 billion in 2006. In 2015, it was hit hard when its Focused Credit Mutual Fund imploded whilst investing in junk bonds.

Liquidity risk regulation has moved to centre stage as regulators have been looking for some time at factors that lead a fund to suspend dealings. The International Organization of Security Commissions, in February 2018, issued its final report on ‘Recommendations for Liquidity Risk Management for Collective Investment Schemes’. Prior to that in 2016 the US Securities and Exchange Commission had released the 22e-4 Rule on Liquidity Risk Management Programs. In February 2019, the European Securities and Markets Authority issued a paper to provide recommendations on how investment funds can manage liquidity risk. Whereas in the UK, following a review of principal firms in the investment management sector, on 20th May, the FCA, set out a number of significant shortcomings including a lack of effective risk frameworks. These included failures to adequately assess liquidity risk.

What is liquidity risk?

Liquidity refers to the ability to execute transactions with limited price impact and tends to be associated with low transaction costs and immediacy in execution. An asset is considered liquid when fund managers are able to buy or sell it with little delay, at low cost and at a price close to the current market price or fair value. Liquidity is multidimensional depending on a variety of factors including market structure and the nature of the asset being traded. Both the level and resilience of liquidity are important for market participants. Changes in market structure increase the fragility of liquidity.

Unfortunately, no single metric fully captures all relevant aspects of liquidity, making it difficult to assess liquidity conditions across markets or within a fund. Many factors may impact the liquidity of an asset, which can be measured by different modelling approaches. Because of the multifaceted nature of liquidity, a three-dimensional approach should be used to estimate asset liquidity risk, based on:

• Quantity: How much are we trying to sell?
• Time: How long do we have to sell an asset?
• Cost: How much liquidation cost or discount to fair value are we willing to accept?

Liquidity risk management – A look at the tools available

Liquidity is typically better at lower quantities, with more time to sell and with lower costs. That said, expressing liquidity in a uniform way can be challenging, as any asset liquidity metric needs to take all three dimensions into account. Data challenges create further complications, such as the lack of security-level market activity data needed to model the liquidity of over the counter (OTC) instruments.

An effective liquidity risk management framework helps safeguard the interests of investors, maintain the orderliness and robustness of funds and markets, and reduce systemic risk, all in the support of financial stability. A strong liquidity risk management framework pays attention to governance, measurement and monitoring, contingency planning and product suitability, supported by best-in-class liquidity risk monitoring tools and systems.

To fully capture the multifaceted nature of liquidity risk, key risk measures should incorporate both time and cost dimension of liquidity risk by using dynamic, market databased inputs when analysing sources of liquidity in portfolios. In addition, the analysis should focus on estimating funding liquidity needs coming from redemptions. The availability and quality of the data required should be taken into consideration when selecting key measures to be used in the framework and reporting. Available key liquidity risk measures include:

Asset liquidity risk

• Assessing the percentage of a fund’s net asset value that can be liquidated and made available to investors as cash over a specified time period, at an acceptable discount to fair value, or liquidation cost.

Funding or redemption liquidity risk

• Estimated percentage of a fund that could be redeemed in a defined time period.
• Historical redemption rate patterns.
• Funding profile, including investor concentration and other investor characteristics.

Additionally, the liquidity coverage ratio (LCR) is a central measure bringing together asset and funding liquidity risk to estimate whether an open-end fund has adequate sources of liquidity — that is, liquid assets that can be converted into cash — to cover liquidity needs, such as investor redemptions, in normal or stressed market environments.

Finally, the importance of liquidity risk stress testing should not be overlooked. The aim of stress tests is to improve risk analysis to highlight the limits of risk measurement and management strategies. In particular, they flag up the consequences of, or conditions that might lead to, extreme scenarios, highlighting risks that have not been considered by the investment team. Liquidity stress testing and scenario analysis covering both asset and funding liquidity risk is an important part of an effective liquidity risk management framework and should focus on historical and hypothetical scenarios.