Liquidity is the misunderstood elephant in the room

Underpinning a series of recent market issues and events, liquidity could rear its head once again in the move to T+1, writes John Gubert, who points out that learning lessons from the past is critical in preparation for the reduction in settlement time.

Liquidity was the root cause of the Woodford Funds’ problems in the UK or the less controversial BlackRock action in deferring redemptions from its UK property fund. It is the reason for the UK pension fund stress as the sector battles with the good and the bad in Liability Driven Investments.  It has rocked the crypto sector with the collapse of FTX and the earlier Chapter 11 action of Celsius. It is an overhanging threat in all collateral based lending. And it is as key challenge as markets inevitably move to T+1.

Woodford was not the first fund to be hit with redemptions faster than they could create cash. After all, funds can only create cash by selling units to new investors, drawing on uninvested funds or bank lines or divesting. In reality the latter is the major element when a run occurs. And then all get to understand that fund valuations are tenuous and reflect a normalised market and not one with large overhangs of stock, in excess of normal market demand. In other cases, such as property funds, investors need to be aware that liquidity can be created through borrowing, but that is hardly optimal in troublesome markets.

The problem in UK pension funds was different. Rising interest rates hit market valuations. Paradoxically, the rise in interest rates also improved the solvency position of final salary schemes as it reduced the valuation needed to meet pension liabilities. But falling prices created demand for margin and the funds needed recourse either to emergency funding or bond market (for that was their primary investment pool) realisations. Final salary schemes in many cases have a higher value than their parent and so funding, usually with parental support, was far from simple to achieve. Hence the slump in market prices. The pension funds did not see themselves as requiring liquidity buffers as there was no possibility of mass withdrawals from members and they assumed they had premium assets. The whole market was wrong footed, not so much on real risk but on understanding the potential technical aberrations of their conservative approach to funding.

The issues in the crypto sector reflect a lack of scrutiny in a segment of the market that needs regulation. The collateral pools held by many crypto firms have been opaque and illogical. Yet the market has been blinded by the fear of missing out and omitted prudential analysis. The reality is that volatile investments, even if that volatility is marked by a sharp appreciation in their values, need to have conservative support. I would hate to hazard a guess at the amount of such support or its nature. However, intuitively, if, as in the case of Celsius, the investment value can soar from close to zero to $8,000 (to then fall to less than a dollar) the only sensible collateral is cash or genuine near cash (perhaps liquid US Treasuries) and this has to account for close to 100% of the outstandings at any time. In reality such a model is most likely unprofitable and that is no surprise! It joins a long queue of exaggerated and irresponsible valuations, including the mortgage markets in the US and elsewhere around the time of Lehman, country exposures especially in Mexico and the Argentine in the 1990’s and what was nicknamed the fallen angels in 2009-18 when on average each year $72 billion of investment grade bonds were downgraded to high yield.

All collateral lending is under threat of liquidity, and nowhere are the values at risk greater than in the settlement markets. The US has declared its intention to move to T+1 by 2024. It is inevitable that other markets will follow for investment is global and the US is a pivotal market, given it accounts for around 60% of world stocks. However, T+1 creates many challenges and much attention is focused on the operational challenges of complex transaction chains. These are a real challenge but the biggest will be the intraday challenge for moving cash and stock within the settlement period and mobilising the collateral needed for such activity. And learning from the lessons of the past, which tell us there will be a share slump short term greater than the maximum experienced to date, we need to prepare for a demand for material liquidity. And in share slumps liquidity dries up.

A serious modelling exercise is needed for history also says that short term liquidity crunches only become crises if there is no plan in place to alleviate them. In T+1, CCPs still have value and could be the centre for risk control or crises. Rule changes, as happened in certain metal markets, post the event are not a solution. Deep pocket arm twisting by Central Banks is an option, although it has reduced effectiveness by comparison to my early days in banking. Perhaps intraday debt supporting settlement needs to be for a longer period? Perhaps collateral pools need to be restructured or backed by cash stand-by lines. The solution will be costly. But, as we have seen in the past, the cost of doing nothing will be even worse!