RISK MITIGATION

Mitigating liquidity risks should consist not only of preparing liquidity buffers as a counterbalance, but also requires a fundamental review of risk factors and their alignment with the risk policy of the firm. This is not straightforward as the risk factors a firm is exposed to may not be immediately visible, especially where securitisation and derivatives are involved.

It may be necessary for a firm to map all the assets or risk factors underlying the assets under management to fully understand risk exposure and potential concentrations. An in-depth review of actual risk factors including; links with the firm's main customers, sensitivity and concentrations of key assets to those factors and potential correlations among assets, clients and portfolios are all fundamental to defining the appropriate stress scenarios of each firm.

Each firm must engineer its own individual response and counterbalancing framework in the context of its own exposure, exposure of its clients, and the nature of the business and then align it with the approved risk policy.

The appropriate prevention and management of liquidity problems should involve a tight monitoring of concentrations. Banks are traditionally structured to monitor and hedge concentrations within their lending books, thus focusing on funding risk. Buy-side firms are normally required and equipped to monitor and diversify their concentrations within portfolios, therefore preventing market liquidity risk.

Challenges arise when both the buy- and sell-side need to tackle cross-asset concentrations to similar risks, when the concentrations are hidden by the derivative nature of the instruments, when funding can be disrupted as a result of market movements changing the value of collateral and when all are impacted by their counterparty's failure to properly handle those risks. It would be difficult to predict all business scenarios that can result in disruptions of this sort as they tend to result from unexpected correlation and volatility movements due to unforeseen events. It is possible, however, to tightly monitor exposure concentrations of all kinds - internal and external - as they point out the vulnerabilities of a firm (internal) and even the ones of the entire industry and financial markets (external).

Liquidity (or the lack of) arises from concentrations

Wealth generating markets such as stock exchanges or real estate aggregate liquidity based on the perceived value of the assets traded. Zero-sum game markets, such as futures and options, match customers so that one trader's gain is the loss of another. One macroeconomic role of the former is to absorb or regurgitate liquidity; the latter is a hedging tool for operators with matching exposures to risk factors such as fluctuations of commodity or currency prices, for example.

A key element to maintaining wealth-generating markets in balance is the different timeframes to which investors operate. What one perceives as a short-term opportunity to sell an asset is seen as a long-term investment by others. The exposure derived from the various investments leads to hedging with zero-sum game markets such as futures and options. Hedges are always arranged for the short term, or rolling from tenant to tenant, due to the risk profiles and settlements they require. Zero-sum markets do not drive trends but can dramatically amplify the short-term price fluctuations of the underlying investments they are derived from.

Speculative bubbles tend to inflate when a large majority of investors trade in a single direction regardless of a timeframe. Risk concentrations form at that point and are particularly likely to trigger liquidity problems as everyone becomes a short-term trader and may exit in panic when the bubble bursts. In fact, a definition of a stock market crash is "the day everyone becomes a short term trader."

While it would not be possible to predict where and when the next bubble will be created, there are tools to help monitor the build-up of risk concentrations and the associated liquidity risks.

Monitoring concentrations as they build-up

The key to understanding a firm's vulnerabilities is to uncover the actual risk factors to which it is exposed. For instance, a firm holding a portfolio of securities exposed (directly or indirectly) to commodity prices would have only a partial view of its risk exposure by solely running simulations on equity prices. The potential impact of the underlying commodities on the equities also has an effect. Simulating prices of the underlying equities is fraught with difficulties as it relies on many assumptions, such as the covariance of the equity versus underlying price returns, the impact on the market volatility and liquidity of extreme market movements, correlations within the industry and so on.

In other words, considering the impact of liquidity risks requires the monitoring of risk exposures at their roots, as much as possible. Each firm should, therefore, embark on identifying all root-risk factors, monitor the concentrations they build-up and add radical correlation changes in their scenarios.

Price movement and volumes traded give precious indications of potential concentration build-ups as they point out the degree of emotion in which securities or financial instrument are traded. A well-balanced market where buyers meet sellers in steady volume tend to return normally distributed prices and profit and loss (P&L) changes, on both short- and medium-term. Before a market loses its balances and experiences a massive drawdown, some typical distortions are often noticeable, such as directional volumes imbalance, unexpected changes in correlations, unusual standard deviations, among others. Simultaneously, news releases related to such a market tend to accelerate, new sources of information appear, and the market sentiment tends to point to a single direction. The market liquidity may actually be at its highest at such point, but the market gets vulnerable.

The answer is in transparency: from open model, open data and open analytics

The impact of volatility and correlations on market liquidity is massive and complex. The unpredictable nature of correlations under stressed conditions makes models less reliable. The interaction of volatility, liquidity and correlation is three-dimensional and non-linear. Simulations based on history can be misleading too, since financial markets typically suffer from remedies or structures derived from a previous crisis to the effect that the next crisis will be different from previous ones.

It is possible, however, for analysts to keep tracking the effects liquidity (expressed in market depth); volatility (implied) and correlation have on each other and relate those observations to news as it breaks on a real-time basis. For example, one can define several categories of news related to oil prices and set up systems for machine-readable news to automatically trigger records of price changes, volatility, impact on correlations, on credit, credit correlation and so on. It sets the base for an exploratory forward-looking approach that can supplement a quantitative statistic-based analysis

As the sound management of such sensitivities and the capacity of the risk managers to pre-empt on those risks will be eventually rewarded or punished with liquidity implications, we can conclude that the most important aspect of the new risk management is transparency. Not only the transparency of pricing models, but also the clarity of processes, counterparty relationships, connectivity and IT setup, regulatory compliance and the adequacy of the overall framework with the shareholders' appetites for risk.