Over the past few months, we have experienced significant market fluctuations due to market instability caused by geopolitical issues, surging inflation rates as well as drastic market events. This has urged risk managers to shift their thought process to a more pro-active approach rather than a reactive one, with an increased focus on liquidity risk management from all other pillars of risk.
Market Uncertainty has also prompted regulators out there to focus more on the management of liquidity risks and on the importance of anticipating liquidity stress events through liquidity stress testing. This was also made a key focus by several national competent authorities, especially the European Securities and Market Authority (“ESMA”) who introduced guidance on Liquidity Stress Testing (LST) in late 2020.
From a risk management perspective, these guidelines truly came at the right time, these allowed license holders to prepare and anticipate future shocks on their portfolios. This allowed for Risk Managers and Portfolio Managers to be better prepared on dealing with liquidity stresses. The ESMA LST guidelines served as a reminder on the importance of analysing past shocks and anticipating future possible shocks through the use of both redemption and investor analysis.
From a historical perspective, one should be analysing past historical redemptions in order to gauge whether a portfolio can meet a plausible redemption scenario from past events under similar, yet typical market conditions. From a hypothetical perspective, one should be analysing the investor base by anticipating potential future redemptions. This can be assessed by looking into the type of investor, investor concentration as well as the geographical location of the underlying investor. Close attention needs to be put on these factors as they could serve as early warning indicators of what could trigger potential redemption shocks to the portfolio at hand.
Nevertheless, we can always try to pre-empt as much as possible future stresses, but there will always be some things beyond our control. This leads me to another important element, that whereby the Risk Manager’s involvement throughout the entire portfolio lifecycle. The Risk Manager, where possible, should be involved at the initial stages where the Offering Documentation of the Fund is still being drafted, that way we can ensure that the Fund is being structured with appropriate liquidity mechanisms to avoid unforeseeable stresses in the future. These mechanisms should be tailor made to the fund’s underlying target pool of potential asset classes. Case in point, a private equity or real estate fund should be structured very differently in terms of liquidity mechanisms when compared to those funds which invest in plain-vanilla instruments.
Hence, why a lot of thought should be put in place pre-emptively to ensure liquidity risks are mitigated and controlled as much as possible before there is a chance of such risks materialising. Some mitigants and controls one could design their portfolio with at fund set up stage are lock in periods, designing the fund as closed-ended where necessary or putting in place redemptions fees, applying deferral of redemptions, adjusting the dealing frequency as well as applying hard and/or soft liquidity related disclosures or thresholds to manage liquidity better.
At RMC Wise, our risk management team is well-versed in ensuring that your fund is appropriately structured with suitable liquidity mechanisms. Moreover, our team can assist you in designing and running your liquidity stress tests in line with the applicable regulation.
Stephanie Borg Caruana
Senior Risk Associate, RMC Wise Limited