BGN Entrepreneur

The credit crisis has been accompanied by a contextual reduction of liquidity in all asset classes. For certain asset classes, such as asset-backed securities, liquidity has entirely disappeared, but even for popular instruments such as convertible bonds and corporate bonds, the destruction of market depth has been severe.
The loss of liquidity was not contemplated at all in the risk management models used across the industry, with a consequent increase in model back-testing failures. To give an idea of the impact of the liquidity component in these failures, we have observed in convertible bond portfolios three times the failures experienced by equivalent equity portfolios. The differential was entirely explained by the loss of liquidity I the convertible bond market, a market dominated by hedge funds that had to de-leverage their portfolios suddenly and all at once.
The combination of these events and the discovery that many money market funds were investing relevant portions of their assets into illiquid instruments, such as ABS, has increased the focus of regulators on liquidity risk.
Where the asset management industry is concerned, the most evident outcome of this new focus is reflected in the recent recommendations from Cesr, the Committee of European Securities Regulators, for the regulation of Ucits IV funds. In this paper, Cesr recommends the introduction of an ad hoc liquidity risk management process, adding that liquidity risk must be appropriately assessed, managed and monitored over time for all Ucits.
The regulator wants management companies to perform stress tests and scenario analyses to measure the impact of potential liquidity crises, similar to current legislation for stress tests on market risks.
The introduction of liquidity risk is the biggest surprise of the Ucits IV proposals, according to many practitioners, even if this recommendation has been preceded by similar initiatives from the UK’s Financial Services Authority in the arena of banking regulation and from the Italian Consob for illiquid instruments marketed to individuals, under the Mifid hat.
The surprise comes alongside worries an unresolved question as o the implementation of these new rules and liquidity risk procedures. Market liquidity risk is still a grey area in risk management research.

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