Reviewing your liquidity arrangements

Hetal Patel of the IFoA's Finance and Investment Practice Area Board considers the shock to the financial system delivered by the COVID-19 global crisis from the perspective of institutional investment funds.

The Covid19 outbreak presented the greatest test for the liquidity arrangements of businesses, investors and individuals alike since the 2008 global financial crisis (GFC). As governments mandated shutdowns across the world, economic activity sharply contracted leading to dramatic falls in income that outpaced any corresponding reduction in outgo.

The gap resulted in an elevated demand for liquidity and funding at a time when assets prices were tumbling and financing costs were on the rise.

The financial system this time, however, appears to have coped with the liquidity shock much better than the GFC experience which was triggered by concerns of systemic credit risk. Central Banks were engaged, ready and – absence of the moral hazard of bailing out the credit failings of the financial sector – more willing to intervene to provide liquidity in targeted sectors such as government bond repurchase (i.e. ‘repo’) markets.

The financial sector as a whole was generally much better capitalised and able to continue to function through the turbulent period. Years of liquidity risk planning and balance sheet stress testing appear to have prepared firms well.

This note considers the perspective of institutional investment funds (IIFs), a broad term which we us to encompass insurance funds, pension schemes and other institutional funds such as endowments and sovereign wealth.

IIFs are supported by finance and investment practitioners including actuaries working in a range of functions such as treasury, ALM, investment strategy and risk management; often these roles will involve the measurement and or management of liquidity risk. In this context, we define this to be the risk that a fund, which may otherwise be solvent or well capitalised, is unable to realise assets in a timely way to meet its obligations as they fall due or can only do so by accepting a substantial discount to fair value.

As the first wave of the pandemic abates, market and liquidity conditions appear to normalise somewhat. Like the financial sector, IIFs appear to have generally ‘weathered’ the storm. However, we draw attention to following specific liquidity related challenges that were encountered:

• Diminished ability to trade in assets – the surge in (price) volatility resulted in a drastic reduction in market liquidity with transactions thinning out even in listed assets. Where trading was possible, the cost to IIFs of transacting increased considerably as reflected by wider bid-offer spreads.
• Suspension of property funds – the market volatility generally reduced liquidity in collective funds. Flows dried up or were often one sided, increasing the propensity for funds to be gated. Many collective property funds were suspended altogether due to material uncertainty around valuation of the underpinning assets.
• Sale of assets at depressed prices – in absence of large cash buffers, to the detriment of their beneficiaries, cashflow negative IIFs had to realise assets at depressed prices in order to meet routine outflows.
• Significant margin calls in respect of derivative positions – market volatility led to fierce swings in derivatives prices. This in turn generated the need for significant margin to be raised at short notice, mainly in the form of cash, adding to the liquidity strain.
• Operational challenges: the sudden move to expanded remote working, amongst other things, tested the ongoing ability of IIFs to manage their liquidity arrangements effectively.  

Actuaries and other practitioners should reflect on this experience, whilst conditions are more benign, to review and enhance the supported IIFs’ liquidity arrangements. We consider in more depth as follows.

1. The liquidity framework

Effective liquidity risk management starts with a comprehensive liquidity policy or framework. This should articulate the method for measuring, evaluating and managing liquidity of the IIF including specifying liquidity sources, liquidity requirements, target coverage ratios and their tolerances. It should also identify what stress testing is carried out.

It is important that the governance around liquidity management is clear and widely understood. Roles, accountabilities and delegated authorities should be well defined. This can facilitate management actions to be executed rapidly.  

Actions:

• Is the IIF’s liquidity policy comprehensive and up to date? It should comply with the latest regulatory and best practice standards.
• Review both the requirements and the eligible sources of liquidity. Do the haircuts applied to the liquidity sources need to be recalibrated? Has the risk that collective funds can be suspended/gated been adequately reflected?
• Do tolerances / thresholds for taking management action need to be adjusted?
• New stress tests that reflect the severity of the recent market experience should be carried out.
• Review the governance arrangements to ensure it remains valid, effective optimal.

2. Holistic investment and liquidity strategy

An orgainsation’s investment strategy is usually intrinsically linked to its liquidity or funding strategy as optimising one often constrains the other. For example a company may wish to retain maximum liquidity for prudence or flexibility. As a consequence, it is likely to adopt a conservative investment approach on its balance sheet which sacrifices the potential for higher return.

Moreover, for an IIF, both investment and liquidity needs should be determined in the context of the maturity profile and nature of the liabilities. For example, a With Profits Fund in run-off will have a greater ongoing need for liquidity than a closed-end investment trust and therefore is less likely to have an appetite for capturing the illiquidity premia offered by private investments.

Hence, in this way, liquidity requirements and investment objectives should be considered holistically and in the context of (liability) risk management.

Actions:

• Review investment policy to ensure that it is consistent and optimised given a certain liquidity objective. For example, this could involve modifying the investment strategy to generate a greater level of income thus increasing overall liquidity and potentially mitigating the need to realise assets in times of stress.
• Revisit whether the investment and liquidity objectives are appropriate given the nature of the IIF’s liabilities. In some cases a ‘cashflow driven investment’ (CDI) strategy, which better matches the liability cashflows and mitigates valuation and liquidity risk, maybe appropriate even at the potential expense of giving up higher expected return.
• Revisit the IIF’s investment framework rules to ensure it remains valid and effective through times of stress. This includes target allocation weights, tolerances, rebalancing rules and policies for managing contributions and withdrawals. In fast moving markets, where liquidity is thin, rebalancing to a target investment strategy may not be possible or can only occur at penal transaction cost.
• Consider the need for alternative sources of liquidity which potentially reduce the constraints on the investment arrangements – use of (internal or external) credit facilities, opening a repo programme with a counterparty bank where gilts can be pledged for cash.

3. Asset sales to generate liquidity

Many IIFs rely on the ability to sell down assets to generate liquidity, particularly where this is required to fund benefit payments. The recent experience demonstrated that this approach can run into difficulty in times of market stress. 

During the period of high volatility, market liquidity dried up even in listed assets. The market for trading credit practically disappeared as banks, the market intermediaries, didn’t have the appetite to warehouse inventory on account of a more onerous capital regime for such activity. In equities, liquidity was impaired outside of developed market blue chips. Where trading was possible, the cost to IIFs of transacting increased considerably as reflected by wider bid-offer spreads.

Transactions in unlisted investments such as property, unsurprisingly, thinned out as market participants sought to defer transactions decisions until listed markets stabilised, providing clearer indication of fair value.

Many IIFs access investments through collective open ended funds. As the market in the underlying investments became volatile and illiquid, so too did the performance, the cost and the ability to transact in such vehicles. In the case of property, many funds were suspended altogether preventing investors from investing into or more aptly withdrawing assets from these vehicles. This occurred because the funds’ appointed independent valuation agents invoked ‘material uncertainty’ around the fair valuation of the assets underpinning the funds. In the interest of collective fairness to a fund’s investors, the FCA rules require dealing to be suspended if there is material  uncertainty around 20% or greater of the underlying assets.

It is also important to note that whilst liquidity decreased, the need for asset sales to generate liquidity was accentuated to offset reductions in IIF income as companies in the equity portfolios announced dividend suspensions and property tenants sought rent relief.

Actions:

• Revisit the use of investments that exhibit little or no liquidity in time of stress. Does the additional return justify the extra liquidity risk? The latter usually is a function of the IIF’s need for liquidity and liability circumstances.
• Consider use of ‘liquidity scores’ for the asset portfolio and set maximum limits to restrict the use of illiquid investments to a prudent level.
• Revisit the appropriateness of the use of collective fund vehicles, including property, which come at the risk of being gated or suspended. This may well remain the most effective means for an IIF to access the investment exposure, however, sufficient stress testing should be carried out to understand the impact of fund restrictions on the wider investment and liquidity strategy.
• Where the liquidity strategy places reliance on portfolio income, to review its resilience given the recent experience with rent and dividends. This might indicate the need to diversify income sources or to target specific more resilient income sectors.
• Consider the appropriateness of holding a larger allocation for cash to serve as a liquidity buffer to mitigate the need to realise assets at depressed prices. This could either be an increase in the strategic weight or through a change in policy that permits a tactical increase in time of volatility and stress.
• Review the form of the cash holdings to ensure that, as well as meeting return objectives, it is sufficiently liquid and resilient to meet the IIF’s liquidity needs.
• Review the risk of any collective liquidity funds held being ‘gated’. For example, a homogenous investor base might indicate a potential demand for cash at the same time increasing the risk of gating. Consider the appropriateness of diversifying this risk by holding cash through multiple vehicles or in a segregated arrangement.

4. Derivatives related strain

IIFs, particularly pension schemes, make extensive use of derivatives to both hedge liabilities and efficiently implement strategy. This gives rise to another potential form of liquidity risk in the form of derivatives strain which arises when cash is required to meet margin calls or to crystallise losses on ‘OTC’ contracts (which may have been collateralised by non-cash assets or just not collateralised at all).

Late in March, at the peak of the market volatility, fixed income yields rose sharply as the market became concerned around increases in the supply in government debt to fund the fiscal stimulus measures. This move resulted in significant cash margin calls for IIFs. The strain was potentially compounded as typical synthetic equity positions and currency hedges also moved unfavourably.

Some IIFs invest in highly leveraged LDI or leveraged gilt strategies. That is, running a notional hedge exposure that is larger than the underlying cash invested or held. Leveraged gilt strategies are funded using repo agreements with a counterparty bank. Both magnify the potential cash strain from unfavourable market movements and in this episode created a potential liquidity challenge.

In the case of gilts, there is also the related issue of rollover risk - repo contracts are much shorter in term than the underlying gilts held and periodically need to be rolled over on uncertain funding terms. With the market illiquidity in March, and bank balance sheets stretched, funding costs spiked meaning that contracts were rolled on unfavourable terms. Funding conditions have subsequently eased particularly as the Bank of England intervened to target liquidity in this sector.

Action:

• Review liquidity arrangements and stress test to ensure that margin requirements can readily be met to an appropriate degree of confidence. In particular, review the structure of the cash holding arrangements to ensure that it is sufficiently liquid and resilient in times of stress to continue to meet margin calls at short notice.
• Take a holistic approach to risk and collateral management. Ensure that derivatives are structured to maximise the scope for the offsetting of collateral, potentially reducing any strain. This could also reduce operational complexity.
• Agree ‘collateral waterfall’ arrangements with the appointed collateral manager. That is defining how assets should be sourced at short notice to meet collateral requirements and in which order. Organising an effective arrangement can potentially reduce the cash held for margin call purposes.
• Review the exposure to repo rollover risk. Spread the maturity of contracts to diversify the risk of the IIF being exposed to a funding spike at a point or short period in time.

5. Interaction of operational and liquidity risk

Operational risk is generally speaking a distinct risk from liquidity. However, the Covid19 outbreak demonstrated how the two can overlap. Whilst businesses were prepared for the loss of their main office site as part of their disaster recovery planning, they were generally insufficiently prepared for the scenario that employees would be required to continuously stay at home en masse at short notice.

From a practical point of view, this made it more challenging for organisations including IIFs to effectively manage liquidity. For some, a lack of remote access to the full suite of systems and tools made it difficult to accurately monitor and measure liquidity and to take remediating actions. A particular area of challenge was in the management of derivative related collateral. Activity increased due to the price volatility in the underlying derivatives, however, the manpower, tools and processes required to support this remotely were somewhat restricted.

Action:

• Review IT systems architecture to ensure that vital tools to oversee investments and liquidity are available remotely.
• Ensure there are process are in place to enable management actions to be taken remotely. For example, agree with third parties such as fund managers to accept electronic rather than wet signatures on instructions.
• Review the preparedness of key suppliers in connection with management of the IIF’s assets and cash to work remotely. This would include fund managers, collateral managers and custodians.
• Ensure that critical teams are identified, adequately staffed and organised to minimise the risk of disruption due to multiple team members being unwell at the same time or only able to function at a reduced capacity due to the need to care for children or other vulnerable household members.

6. Cash as an opportunity source

Finally, liquidity is usually considered a risk to be managed; cash holdings are typically considered to be a drag on portfolio returns and therefore kept to a minimum. However, in times of volatility, cash can represent a source of opportunity providing capital protection and also provide the flexibility to quickly alter investment strategy as market conditions change. Hence, effective tactical use of cash can be a competitive advantage over peers.

 Action:

• Review governing rules and policies to ensure that an appropriate framework is in place for how cash holdings could be dialled up and down as required based on market conditions.
• Consider whether the current form of the cash holdings provides the optimum balance of return, capital stability and liquidity to be drawn at an appropriate notice period.
• Review the management process for rotating away from cash assets. Pre-defining triggers can facilitate timelier and more opportunistic execution.