The future of liquidity risk management

Liquidity risk management has been a key concern for hedge fund managers trying to navigate the economic and political turmoil of the pandemic. So, what can they expect in future? A return to the pre-pandemic status quo, or a full transition into digital liquidity risk management?

The future is real-time

In an article published by Citi Bank¹, Elizabeth John, Citi’s head of market management and trade solutions for Europe, the Middle East and Africa (EMEA), as well as Czeslaw Piasek, head of EMEA liquidity risk management services and treasury solutions, say real-time transactions involving around-the-clock clearing and settlement systems, will become the new normal. They were both optimistic about the prospect of new technologies transforming how we manage capital, liquidity and risk – for the better. Treasurers will be able to manage liquidity 24/7, but this will demand new approaches to managing liquidity risks^1.

Technology could drive innovation by reducing costs

By the early 2030s, ultra-high-frequent trading, machine learning and big data are expected to be widely adopted and these technologies may help hedge fund managers reduce costs while improving overall efficiency.

Global alternative assets may still be the second-largest alternative asset classes

According to Citi Bank’s report¹,global alternative assets could have an expected value of more than $4 trillion by 2025. While volatilities expected to persist in 2022, hedge fund investors are optimistic about generation alpha in various secular themes, such as the growth of innovation in biotechnology and a more inclusive financial services sector in emerging markets.

Alternative assets tend to be less liquid and subject to less regulation than traditional markets, yet recent regulatory changes in the US have allowed private alternative asset markets to open up to individual investors that meet certain criteria².

Whatever investment vehicle is chosen, the liquidity must match that of the underlying security – otherwise there may be too much liquidity risk. Verdence Capital executive director, Matthew Andrulot, says he looks for 'a ladder of liquidity'³ when choosing alternative assets for his portfolio. Investment company KKR & Co president and co-chief operating officer, Scott Nuttall, whose firm focuses on private equity but also has platforms in hedge funds, says markets 'typically overvalue liquidity and simplicity'³, which is why he favours 'illiquidity and complexity'.

Environmental, social and corporate governance (ESG) becomes a KPI

It’s likely that hedge fund managers will start dedicating more attention in the integration of socially responsible investing, climate change policies and sustainability. This should be a prudent response to the growing demand for ethical funds from investors and policymakers.

However, in another article, which you can find here, we discussed the scepticism surrounding ESG and how this is a big challenge for hedge fund managers. The Chartered Financial Analyst Institute (CFA) recently launched an ESG certification, while the United Nations lists 17 Sustainable Development Goals (SDGs).

All this sounds promising, but the challenge for hedge fund managers lies in creating like-for-like comparisons of ESG credentials – bearing in mind the differences in reporting standards and frameworks across various jurisdictions. Many investment managers are also hesitant to recommend funds that are labelled as ‘ESG’ unless they can see reliable data to validate these claims within eco-conscious investing.

Is the rise of ETFs a concern for hedge fund liquidity risk management?

Assets in exchange-traded funds (ETFs) doubled between 2016 and 20204 and exceeded $10 trillion by the end of 2021. But some investors are worried – or at least cautious of the liquidity risks that could accompany this increase.

However, ETFs are still susceptible to market volatility. Even though they’re highly sophisticated when it comes to diversification, it doesn't make them immune to normal jumps and swings in the market. The volatility depends on the type and size of the market your ETF is tracking⁵. For example, if your fund tracks the S&P 500, it’s probably going to be a lot more stable than one that tracks a specific sector in a high-growth, volatile, emerging economy.

Of course, there are no guarantees, and we can only rely on past performance* as an indication of what might happen in future.

Key liquidity risks in hedge fund ETFs used for hedging purposes

While the common perception is that ETFs are generally safer than single stocks due to their diversification, they’re not totally immune to risks, and liquidity remains one of the main ones.

Capital gains distributions require shareholders to pay capital gains tax, whereas a more tax-efficient method would be to retain those capital gains and invest them
The price of ETFs doesn’t always match their underlying value, so investors may end up paying more than the value of the portfolio’s underlying stocks or commodities
ETFs are often linked to benchmarking indices, which means investors hoping their funds will outperform the market may need to adjust their expectations

Liquidity risks with cryptocurrency

New regulations which permitted German funds – specifically Spezialfonds for institutional investors – to put up to 20% of their assets in cryptocurrencies, sparked fears of greater liquidity risks there.

Why are some worried about what’s happened in Germany?

The rule change in Germany enables institutional investors to include a high-risk, speculative asset in workplace pension funds, which has raised some eyebrows. In an article (published in August 2021)⁶, Fitch Ratings warned that liquidity risks would increase if volatility triggers trading breaks for cryptocurrency ETFs. The American credit rating agency says this would compromise investment managers' abilities to meet redemption requests and other obligations.

Cryptocurrencies could increase short-term liquidity risks

Anyone who has invested in (or is at least familiar with) cryptocurrencies, will know that they’re extremely volatile even when compared to traditional high-risk portfolios with 90% equity allocation. This means if you decide to withdraw your money in the short term (i.e., within one or two years), you may end up losing significantly more than you put in.

While individual funds, like high-growth tech companies, can be just as volatile (if not more so), the risks are magnified with cryptocurrencies in the absence of mature regulations designed to protect investors.

Crypto volatility between late 2021 and early 2022

By August 2021, the market capitalisation of cryptocurrencies was estimated to be over $2 trillion – more than double the amount at the end of 2020. This is despite the economic disruption and turbulence of the pandemic and lockdowns.

But, in early 2022, bitcoin's volatility became difficult to ignore, even for the most enthusiastic crypto investors. Dubbed the 'crypto meltdown'⁷ by some, the value of the largest cryptocurrency plummeted by over 40% between November 2021 and January 2022.

By January 2022, the value of the overall crypto sector fell by more than $1 trillion compared to its all-time high of almost $3 trillion in November 2021 (according to Coinmarketcap)⁸. To put that into perspective, the S&P fell 49.17% during the late 2000's economic crisis – but that took place over 17 months between October 2007 and March 2009.

The fact that bitcoin's value has fallen by a comparable margin in a much shorter timeframe is a significant liquidity risk for hedge fund managers who are already investing in this space.

Other digital liquidity risks hedge fund managers should bear in mind

In a September 2021 report titled 'Digital Assets: From Fringe to Future'⁹, BNY Mellon declared that digital assets have already entered the mainstream, but there’s a need for these to be integrated into the traditional ecosystem, for example, with an equivalent level of liquidity risk management.

In a recent report titled 'Future Ready Payments 2030'6, UK Finance in conjunction with PwC discussed the need for liquidity optimisation and made the following recommendations

Improve liquidity arrangements for domestic retail, wholesale and cross-border payment market infrastructure
Achieve the above by integrating regulation, process and enhanced systems
Improve liquidity efficiency between multiple payment and securities settlement systems

The pandemic has accelerated the digitalisation of financial services

Covid-19 has driven more demand for digital advice, which is becoming a popular alternative to traditional face-to-face counselling, and interest in digital assets like cryptocurrencies has also risen sharply. Soon, much of the decision-making involving liquidity risk management in banks will be done by prescriptive analytics, machine-powered forecasting and AI.

This is an exciting development, but investors – both retail and institutional – will want to know (a) how this impacts their investments from a risk-reward perspective and (b) how this technology will benefit them as the customer?

Choosing a prime broker with long-standing relationships with Tier 1 banks will also ensure hedge fund managers have access to the best real-time reporting.

Past performance is not an indication of future results.