With highly volatile markets becoming the norm, it is important that buy-side firms have a solid and robust liquidity risk management program in place, according to Confluence.
In its recent thought leadership paper “Liquidity Shortfalls and Record-High Market Volatility Call for More Stringent Stress Testing, Monitoring and Reporting”, Mattia Prati, Global Head of Technical Sales Support, and Chantal Mantovani, Product Manager for RegTech and Fixed Income Analytics, Confluence, argued that the asset management sector has been the focus of significant regulatory reforms in the US and EU, and most recently, strengthening asset-side liquidity requirements and requiring the use of liquidity management tools.
“The need for asset managers and service providers to remain compliant with new and evolving regulations is more relevant than ever,” they said.
On August 19, 2022, the SEC put into effect Rule 18f-4 under the Investment Company Act of 1940, requiring regulated funds to implement programs that include risk guidelines, stress testing, back-testing, internal reporting and escalation, and program review elements. More recently, the SEC proposed enhancements to its open-end fund liquidity framework under Rule 22e-4 which would enhance how funds manage their liquidity risks, require mutual funds to implement liquidity management tools, and provide for more timely and detailed reporting of fund information.
In addition, the SEC is looking to improve the resilience and transparency of money market funds under Rule 2a-7 by increasing minimum liquidity requirements, removing the ability of funds to impose liquidity fees and redemption gates when they fall below certain liquidity thresholds, requiring certain money market funds to implement swing pricing, and enhancing certain reporting requirements to improve the Commission’s ability to monitor and analyze money market fund data.
According to the authors, the different market and financial crises in recent times have demonstrated that, under fairly unpredictable circumstances, the liquidity of traded instruments can nearly vanish.
There is no doubt, they said, that the pace of financial regulation has increased markedly over the past decade requiring fund managers to measure and report on the actual liquidity of the instruments in their portfolios and the length of time it might take to sell them.
“While it is usually possible to get out of a position, the question is how long it will take and how much it will cost,” said Prati and Mantovani.
“Liquidity shortfalls and market volatility are causing regulators to enact stringent liquidity testing, monitoring, and reporting regimes,” they added.
According to the paper, firms need a comprehensive risk management process to ensure compliance and flexibly shift to different adaptations of rules, without increasing operational costs and continuing to communicate with stakeholders.
“However, many firms are limited to spreadsheets, disparate databases and generic risk engines,” commented Prati and Mantovani.
They said that regardless of the regulatory jurisdictions a firm need to: measure liquidation costs across different market conditions and monitor time to liquidate trends; apply historical and/or statistical stress scenarios including reverse stress testing; monitor the cost of liquidation, time to liquidate and liability analysis across different market conditions and time horizons; analyze investor behavior and liability time series; and provide industry-standard output to multiple regulators, regardless of the type of data and analysis required.
“In addition to meeting evolving regulatory requirements globally, asset managers, fund managers and service providers need a comprehensive liquidity risk analysis solution,” they said.
They added that navigating uncertain market and regulatory waters is “no easy task”, but identifying the right regtech partner can make all the difference.
“By prioritizing data, automation and integration, asset managers and service providers can be ready for future compliance requirements, more easily weather market disruption, and growth their business profitably,” Prati and Mantovani concluded.
