PRMIA put on an event at MSCI on Wednesday, called "Innovations
in Liquidity Risk Management". Melissa Sexton of Morgan Stanley introduced the agenda, saying that the evening would focus on three aspects of liquidity risk management:
- industry practice
LiquidityMetrics by MSCI - Carlo Acerbi of MSCI then took over with his presentation on "LiquidityMetrics".
Carlo said that he was pleased to be involved with MSCI (and RiskMetrics, aquired by MSCI) in that it had helped to establish and define standards for risk management that were used across the industry. He said that liquidity risk management was difficult
- Clarity of Definition - Carlo suggest that if he asked the audience to define liquidity risk he would receive 70 differing definitions. Put another way, he suggested that liquidity risk was "a strange animal with many faces".
- Data Availability - Carlo said that there were aspects of the market that we unobservable and hence data was scarce/non-existent and as such this was a limit on the validity of the models that could be applied to liquidity risk.
Carlo went on to clarify that liquidity risk was different depending upon the organization type/context being considered, with banks obviously focusing on funding. He said that LiquidityMetrics was focused on asset liquidity risk, and as such was more applicable
to the needs of asset managers and hedge funds given recent regulation such as UCITS/AIFMD/FormPF.
The methodology is aimed at bringing traditional equity market impact models out from the trading floor across into risk management and across other asset classes.
Liquidity Surfaces - LiquidityMetrics measures the expected price impact for an order of a given size, and as such has dimensions in:
- order size
- liquidity time horizon
- transaction costs
The representation shown by Carlo was of a "liquidity surface" with x dimension of order size (both bid and ask around 0), y dimension of time horizon for liquidation and z (vertical) dimension of transaction cost. The surface shown had a U-shaped cross
section around zero order size, at which the transaction cost was half the bid-ask spread (this link illustrates
my attempt at verbal visualization). The U-shape cross section indicates "Market Impact", its shape over time "Market Elasticity" and the limits for what it is observable "Market Depth".
Carlo then moved to consider a portfolio of instruments, and how obligations on an investment fund (a portfolio) can be translated into the estimated transaction costs of meeting this obligations, so as to quantify the hidden costs of redemption in a fund.
He mentioned that LiquidityMetrics could be used to quantify the costs of regulations such as UCITS/AIFMD/FormPF. There was some audience questioning about portfolios of foreign assets, such as holding Russian Bonds (maybe currently topical for an audience
member maybe?). Carlo said that you would use both the liquidity surfaces for both the bond itself and the FX transaction (and in FX, there is much data available). He was however keen to emphasize that LiquidityMetrics was not intended to be used to predict
"regime change" i.e. it is concerned with transaction costs under normal market conditions).
Model Calibration - In terms of model calibration, then Carlo said that the established equity market impact models (see this link for
some background for instance) have observable market data to work with. In equity markets, traditionally there was a "lit" central trading venue (i.e. an exchange) with a star network of participants fanning out from it. In OTC markets such as bonds, there
is no star network but rather many to many linkages establised between all market participants, where each participant may have a network of connections of different size. As such there has not been enough data around to calibrate traditional market impact
models for OTC markets. As a result, Carlo said that MSCI had implemented some simple models with a relatively small number of parameters.
Two characteristics of standard market impact models are:
- Permanent Effects - this is where the fair price is impacted by a large order and the order book is dragged along to follow this.
- Temporary Effects - this is where the order book is emptied but then liquidity regenerates
Carlo said that the effects were obviously related to the behavioural aspects of market participants. He said that the bright side for bonds (and OTC markets) was given that the trades are private there was no public information, and price movements were
often constrained by theoretical pricing, therefore permanent effects could be ignored and the fair price is insenstive to trading (again under "normal" market conditions). Carlo then moved on to talk about some of the research his team was doing looking at
the shape of the order book and the time needed to regenerate it. He talked of "Perfectly Elastic" markets that digest orders immediately and "Perfectly Plastic" markets that never regenerate, and how "Relaxation Time" measures in days how long the market
takes to regenerate the order book.
Liquidity Observatory - Carlo described how the data was gathered from market participants on a monthly basis using a spreadsheet to categorize the bond/asset class type, and again using simple parameters from active "expert" traders. Take
a look at this link and sign up if this is you. (This sounded to me a lot like another "market
consensus" data gathering exercise which are proving increasingly popular, such as one the first I had heard of many years back in Totem - we are not quite
fully ready for "crowdsourcing" in financial markets maybe, but more people are seeing sense in sharing data.).
Panel Debate - Ron Papenek of MSCI was moderator of the panel, and asked Karen Cassidy of Morgan Stanley about her experiences in liquidity risk management.
Liqudity Risk Management at Morgan Stanley Wealth Management - Karen started by saying that in liquidity management at Morgan Stanley they look at:
- Operating Capital
- Client Behaviour
Since 2008, Karen said that liquidity management had (maybe unsurprisingly) become a lot more rigorous and formalized, being rule based and using a categorisation of assets held from highly liquid to highly illiquid. She said that Morgan Stanley undertake
stress testing by market and also by idiosyncratic risk over time frames of 1 month and 1 year. As part of this they are assessing the minimum operating liquidity needed based on working capital needs.
Karen added that Morgan Stanley has a broker-dealer structure that separates out retail from institutional. In wealth management they have aroun 6 million clients, with $14B in debits and $7B in credits, and look at spikes in cashflow needs up to $2-5B.
They are expending a lot of effect currently on data collection and modelling given that their data is specific to a retail broker-dealer unit, unlike many other firms. As such they have little data as yet for times of market stress. They are also looking
at metrics around financial advisors, and how many clients follow the financial advisor when he or she decides to switch firms.
Hedge Fund Liquidity Risk - Hilmar Schaurmann of Fortress Investment Group said that hedge funds look at
- Fund Liquidity
- Position Liquidity (relevant to Carlo's LiquidityMetrics)
Hilmar said that minimum cash flow needs and liquidity risks were very fund-type specific, for example with macro funds mostly holding very liquid assets in stark contrast to funds investing in complex structured products. Also that these needs were dependent
upon margin payment needed and on investor redemption modelling.
Looking less at the fund and more at the fund portfolio position, Hilmar said that (maybe counter-intuitively) liquidity risk is more relevant for the liquid part of the trading book, since these instruments may become illiquid (I guess illiquid assets are
already illiquid is the logic). Illiquid assets tend also to have their funding more aligned with their inherent liquidity constraint. He said that hedge fund risk management should aim for the transparency of liquidity risks based on issues that start small
but through contagion spread to the wider market.
Business or Regulation Driving Liquidity Risk Management - Ron asked Karen what were the drivers of their processes at Morgan Stanley. Karen said that in 2008 the focus was on fundability of assets, saying that the FED was monitoring this
on a daily basis. She made the side comment that this monitoring was not unusual since "Regulators live with us anyway". Karen said that it was the responsibility of firms to come up with the controls and best practice needed to manage liquidity risk, and
that is what Morgan Stanley do anyway.
She added that Morgan Stanley were however in conversation with FED and SEC on contingency funding (sounded like some "internal model" approval exercise). She added that in general the industry was over-funding and funding too long in response to regulation,
and that funding would be at lower but still pragmatic levels in the absence of regulatory pressure. Like many in the industry, Karen thought the regulation had swung too far in response to the 2008 crisis and would eventually swing back to more normal levels.
Hilmar said that regulation had had an effect on liquidity risk management at hedge funds, but for example Form PF was more a report/measurement than a guide to better liquidity risk management. He made the interesting point that in the hedge fund industry,
the "real" regulators were the investors themselves.
Carlo added that he had written an unintentionally prescient academic paper on liquidity management in 2008 just prior to the crisis hitting, and he thought the regulators certainly arrived "after" the crisis rather than anticipating it in any way. He thought
that the banks have anticipated the regulators very well with measures such as LCR and SFR already
In contrast, Carlo said that the regulators were lost in dealing with liquidity risk management for asset managers and hedge funds, with regulation such as UCITS being very vague on this topic and regulators themselves seeking guidance from the industry.
He recounted a meeting he had with BaFin in 2009 where he told them that certain of their regulations made no sense and he said they acknowledge this and
said the asset management industry needed to tell them what to implement (sounds like the German regulator is using the same card as the UK regulators in keeping regulations vague when they are uncertain, waiting for regulated firms to implement them to see
what the regulation really becomes...).
What Have We Learnt Since 2008 - Karen said that back in 2008 liquidity was not managed to term, funding basis was not rigorous and relied heavily on unsecured debt. She said that since then Morgan Stanley had been actively involved in shaping
the requirements of better liquidity risk management with more rigorous analysis of counterparties and funding capacity. Karen said that stronger governance was a foundation for the creation of better policy and process, and she was involved in meetings on
governance at least twice a month. She said that regulators were receptive to new ideas and had been working with them closely.
Ron suggested that regulators for the hedge fund industry are a "friction" in slowing change, for instance the recommendations for changes to Form PF still the same despite the form coming out in 2012. Hilmar said that prior to 2008 most hedge funds were
single prime, but post crisis had gone multi-prime. He said that term funding was treated much more rigorously, for example in long term funding for CDO/ABS assets. A lot more attention was also being paid to counterparties, where an idiosyncratic issue can
spread to being systemic very quickly. He cited the August 2011 example around the relationship between weak European banks and weak European sovereigns how the two groups weakened each other and in doing so widened the issues and associated concerns. Hilmar
added that hedge funds now effectively get charged for tail risk, something that they did not have to face pre-2008.
What will be the effect of CCPs on OTC markets? Carlo said that when executing a large order, you have the choice between executing 1) multiple small orders with multiple counterparties or 2) a single large block order with one counterparty.
In this regard, the equity and bond markets are very different. In lit equity venues, the best approach is 1), but in the bond markets approach 2) is taken since the trade information is not transparent to the market.
Obviously equity markets have become more fragmented, and this has resulted in improve market quality since it is harder to get all market information and hence the market is less resonant to big events/orders. Carlo added that with the increased transparency
proposed for OTC markets with CCPs etc will this improve them? His answer was that this was likely to improve the counterparty risk inherent in the market but due to increased transaparency is likely to have a negative effect on transaction costs (I guess
another example of the law of unintended consequencies for the regulators).
Hilmar added that when markets become illiquid then you become naturally blind given that there is no data to analyse, hence historic analysis and modelling is weakened as a result similar to issues with being over reliant on volatility and VaR under normal
market conditions. He proposed that managers needed to think ahead more, looking for linkages between events and markets, such as say the effects of an economic slowdown in China on the German export industry, and how these events may produce contagion and
Audience Questions - there then followed some audience questions:
LiqidityMetrics extrapolation - one audience member asked about transaction cost extrapolation in Carlo's modelling. Carlo said that MSCI do not extrapolate and the liquidity surface terminates where the market terminates its liquidity.
There was some extrapolation used along the time dimension however particularly in relation to the time-relaxation parameter.
LiquidityMetrics "Cross-Impact" - looking at applying LiquidityMetrics to a portfolio, one audience member wondering if an order for one asset distorted the liquidity surface for other potentially related assets. Carlo said this was a very
interesting area with little research done so far. He said that this "cross-impact" had not been detected in equity markets but that they were looking at it in other markets such as fixed income where effective two assets might be proxies for duration related
trading. Carlo put forward a simple model of where the two assets are analogous to two species of animal feeding from the same source of food.
Hedge fund redemption restrictions - Hilmar was asked whether restrictions placed by funds to halt/limit investor redemptions would happen again at the next crisis. Hilmar first responded by commentating that this was effectively a very
novel form of term funding but said that investors were now very wary (and aware) of this practice.
Long and short position liquidity modelling - one audience member asked Carlo what the effects would be of being long or short and that in a crisis you would prefer to be short (maybe obviously?) given the sell off by those with long positions.
Carlo clarified that being "short" was not merely taking the negative number on a liquidity surface for a particular asset but rather a "short" is a borrowing position with an obligation to deliver a security at some defined point, and as such is a different
asset with its own liquidity surface. Hilmar commented that in credit markets liquidity varies with position and in a crisis longs need to cover which would be favorable for those shorting.
Changing markets, changing participants - final question of the evening was from one member of the audience who asked if the general move out of fixed income trading by the banks over recent years was visible in Carlo's data? Carlo said
that MSCI only have around two years of data so far and as such this was not yet visible but his team are looking for effects like this amongst others. He added that the August 2011 weak banks - weak sovereigns in Europe was visible with signals present in
Good food and good (really good I thought) wine put on by MSCI at the event reception. Great view of Manhattan from the 48th floor of World Trade Centre 7 too.