Liquidity risk: What's lurking under the tip of the iceberg?

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15 October 2019
Cubillas Ding

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Liquidity is the hidden risk that when it fully reveals itself, threatens the survival of a firm. In the United Kingdom, notwithstanding ongoing the Brexit proceedings, we are undergoing a period in the global economic cycle where we are starting to hear more occurrences of liquidity events, for instance: Reyker, Woodford Equity Income Fund, and H2O Asset Management (part of Natixis), to name a few in the investment management industry. I will refrain from commenting about company-specific circumstances, but just to say that all of these firms ran into trouble because of challenged liquidity and cash flow obligations, in large part due to hard-to-trade assets.

As such, I have been reflecting on how the investment industry can better facilitate and enhance different aspects of liquidity risk assessments, portfolio transparency, and funding/execution liquidity.

On one hand, this is a significant challenge we are faced with. There are certain types of markets that are inherently illiquid - technology can better connect/aggregate buyers and sellers, reduce friction associated with investment activities, but it does not natively create demand; Illiquid markets tend to be lacking in transparency and availability of (usable, hydrated) data. This is made worse by the withdrawal of sell-side dealer liquidity from certain markets. At the same time, electronification associated with deals and trades is growing but not necessarily beyond conventional equity and fixed income assets. In short, the scale of the challenge is akin to scientists attempting to predict and stop icebergs from breaking off glaciers and melting away under conditions of global warming and climate change !

On the other hand, I am also tempted to believe that advances in next generation digital technologies, analytics and AI/machine learning (buzz words, I know), can play a role to help model, monitor and discern the "critical cracks in the fund glacier", at least with sufficient notice before an iceberg actually "breaks off ". But, where and how? I have been reflecting on a number of examples where new technologies can help.

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