Is there a need for a standardised approach to assessing liquidity?
Doctors are armed with standard medical tests and tools for diagnosing patients. Fund managers looking to measure liquidity, on the other hand, are not so well equipped. Defining an industry standard for measuring liquidity is complex, largely due to differences in liquidity based on investment strategy and the size of the fund, with the latter driving the size of average investment positions. Market participants continue to look for a global independent measurement of liquidity that suits both large and small investors.
Markit recently partnered with the TABB Group to gauge the current liquidity environment through a survey of mostly portfolio managers and traders across the buyside and sellside. Survey participants overwhelmingly indicated that their biggest concern is a large scale macro crisis disrupting liquidity. This makes sense given that past liquidity crises typically had at least one major macro event sparking the crisis. Data also indicated that 60% of participants believe that liquidity for US corporate bonds greater than $20m in market value has decreased in the past 18 months, while only 8% indicated that liquidity has improved for all round lot trades. We were surprised to see that only 60% of respondents indicated internal risk managers requested a documented liquidity assessment and 40% received requests from regulators. Lastly, over 70% of respondents indicated that they measure liquidity based purely on their investment team's expertise, which some may find too subjective.
Liquidity metrics and scores calculated from millions of daily parsed quotes and TRACE/MSRB data can help investors better quantify their liquidity risk. The ability to exit a position with minimal price impact is important to many market participants. We have observed that customers want a better understanding of their liquidation timelines in order to better plan exit strategies and properly set fund investors' expectations on redemptions. Properly designed liquidity metrics in combination with investment team expertise could help drive a fund's redemption policies and decisions around whether redemption delays, swing pricing, redemptions in kind or intra-fund redemptions should be mandated or offered based on the fund's liquidity profile.
The latest IMF Global Financial Stability Report highlighted Markit's Liquidity Score as a composite measure of liquidity, given that the data is sourced directly from banks, dealer runs, books of record and repository data venues. Multiple data sources gauge the search cost component of liquidity through a combination of traded and quoted depth, bid-ask spreads and trade volume data. This culminates in a liquidity score ranging from 1 to 5, with 1 being the most liquid.
While every patient is unique, doctors do have a set of standard tools for assessing their health and medical risk. Similarly, there needs to be a set of standards that fund managers can use to measure liquidity risk for their unique fund structure and complex. As evidenced by the TABB Group survey, the top three most useful liquidity metrics are TRACE corporate bond data, dealer intraday bid/ask quotes and the frequency of dealer quotes. In our view, a liquidity measurement should take into account all three metrics. Similarly, we believe the data that sits behind a bond level liquidity curve should include observable TRACE trade data and derived data to estimate the cost and time to liquidate a given position based on holding size.
Fund managers can build a liquidity risk management program by layering investment and risk team expertise on top of a combination of standardised liquidity metrics and scores and internal fund data, such as investor concentration, fund and industry level inflow and outflow data, fund complex cash flow and portfolio concentrations.
Kiet Tran | managing director, global head of Pricing Data
Tel: +1 212 931 4392
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