Inflation and interest rate spikes, the likes of which we haven’t seen in a generation, can cause serious market dislocations and liquidity crunches. Regulators around the world have taken notice. The increasing pressure of regulatory requirements around liquidity risk demands a more precise and holistic view of fund liquidity. The recently introduced Liquidity Stress Test program adds the concept of fund resilience and requires measuring fund to meet its obligations under normal and stressed markets.
One can argue that the long-term impact of regulation is positive, pushing the industry toward disclosure, risk mitigation and investor protection. But in the short term these new rules can cause significant friction as each additional regulation adds new layers of complexity and expense for asset managers.
Raising the Stakes
More than anything else, these regulations have materially increased the burden on asset managers, who must now employ robust quantitative capabilities to support an array of new calculations.
In the U.S.
In the EU
Whether they apply to global entities with multiple lines of business or a smaller fund with limited operational bandwidth, these regulations add up to an onerous list of new requirements for asset managers.
Regulatory Change Demands Adaptation
Computing a satisfactory time to liquidate figure for the whole portfolio is no longer sufficient as regulators now demand reporting on cost of liquidation and on expected / realized liabilities. In essence, regulators want firms to report on all the liquidity risks dimensions, such as: Market depth, Liability level, and Cost of liquidation. The combination of these three risks is then translated into a fund resilience indicator (RCR = Total liquid assets / liability). High RCR indicate that the funds are highly resilient and can meet the obligation.
Firms that were able to implement the full liquidity requirements (for both assets and liability) in a fully integrated fashion are now benefitting from additional risk management tools that provide a comprehensive view of the fund and its resilience to adverse cashflow events.
You can’t always sell what you want:
In normal market conditions, a fund that produces alpha tends to have less liabilities (redemptions) than a fund that does not provide positive excess returns. In normal market conditions, multiple liquidation strategies can be implemented because the bid-ask spreads tend to be tighter, reducing the liquidation costs. However, in a stressed market and global macroeconomic conditions, any given portfolio might be exposed to an increased level of liabilities as investor want to redeem positions to face increasing costs of mortgages and raising day-to-day expenses.
The increasing level of liabilities over a short period of time puts pressure on the market depth in a way that liquid instruments will become more liquid but at a higher cost of liquidation. As the liabilities increase in the short period. Illiquid assets, on the other hand, will become even more illiquid.
Consider what happened during the coronavirus outbreak. An ECB study found that in 2020 at least 215 investment funds suspended redemptions in March 2020. Real estate and bond funds were greatly affected by the liquidity crisis.
Further the study finds that funds holding illiquid assets, with large portion of retail investors have been more exposed during the liquidity crisis.
Funds that suspend payments to household investors face a reputational risk. Such suspension might cause runs on the fund and might even extend to whole AM firm, or even an entire economic sector.
Manage the investment and the investor:
Covid showed the importance of managing the liquidity profile of the fund, with particular attention for both portfolio positions and investor type. Institutional investors tend to be less emotional during market crisis compared to retail investors. Firms that analyze the liabilities streams and decompose them by investor type are in better positions to implement mitigating actions with special focus on communication during stressed market periods.
Communicating with institutional investors might be easier during periods like March 2020 as the institutional investor tends to be more literate and more aware of the risks faced by the investment. On the other hand, retail investors might be hard to communicate with due to scale and heterogeneous audience. Implementing a good communication program, based on simplicity and transparency helps in mitigating the risk of abnormal redemption risk.
Looking Ahead: The Future of RegTech
Given the scale and complexity of these regulatory requirements, perhaps it’s no surprise that even the largest and most advanced firms in the industry will struggle to build their own proprietary solutions. This path requires massive amounts of time and effort from development teams, diverting their attention away from profit centers to cost centers. All this makes a compelling case for outsourcing these functions to a third party with an established track record and the proven technology.
Correctly identifying a partner is crucial. From functionality to architecture to support to economics, asset managers must consider a long list of factors. The platform must combine quantitative capabilities with a range of customizable settings and API exports to streamline reporting. It should also be multi-asset, intuitive and easy to onboard, with a high level of integrability with other systems and diverse datasets, no matter where they originate.
The timing is right. This focus on risk disclosure doesn’t appear to be going away any time soon, so even funds that survived this wave will need to level up constantly to remain compliant. With the 18f-4 regulation and the proposed Alternative Investment Fund Managers Directive (AIFMD) updates causing industry-wide debate, asset managers have an acute need for transformative RegTech solutions.
This dynamic regulatory environment may put unprecedented pressure, but with the right approach, they can achieve compliance without sacrificing efficiency – and gain a competitive edge in the process.
Disclaimer: The information contained in this communication is for informational purposes only. Confluence/StatPro is not providing, legal, financial, accounting, compliance or other similar services or advice through this communication. Recipients of this communication are responsible for understanding the regulatory and legal requirements applicable to their business.