The financial crisis that began in 2008 was one of the biggest shocks to the global financial system since the 1930s, and the resulting regulatory reform efforts have been widespread. One area of particular focus has been market liquidity; regulators around the globe have established new rules intended to ensure sufficient liquidity, which we define as the ability to buy or sell a position at or near its current value, in times of stress. As a result of this focus, fixed income market liquidity in particular is in the spotlight given the focus on global central bank actions with regard to interest rates.
“If U.S. interest rates begin to systematically increase in the future, there’s a concern we could see outflows from fixed income funds,” says Rob Haddad, Vice President of New Product Development at ICE Data Services. “Fund directors are actively preparing for a range of scenarios given the potential impact of redemptions and how they could impact fund liquidity. In addition, regulatory obligations have increased the capital requirements for banks, meaning their ability to have an active role in providing liquidity is constrained in ways that it was not during prior market events.”
Concern about market participants’ ability to effectively manage liquidity risk is being stoked by a combination of factors, including: a multi-year decline in dealer inventories; a sharp increase in the supply of outstanding debt instruments (with no comparable increase in trading volume); proliferation of riskier, less liquid instruments such as leveraged loans; and anticipation that future interest rate increases could trigger a flight from fixed income assets. In effort to ensure sufficient management of liquidity risk, the SEC has proposed a new set of rules aimed at bringing transparency to liquidity risk management. These rules include requiring each portfolio asset to be classified by one of six liquidity groups based on the fund’s assessment of the number of days needed to convert the fund’s position in that asset to cash “at a price that does not materially affect the value of the asset immediately prior to sale.”
Fixed Income Participants React To the SEC’s Proposed Liquidity Rules
In a March 2016 survey, ICE Data Services asked 133 financial industry professionals, including risk and compliance offers, investment managers, treasurers, and individuals responsible for valuation oversight, for their thoughts on key aspects of the SEC’s proposed liquidity rules. On key questions, their responses were fairly unified.
Regarding the final SEC liquidity risk management rules, please share your opinion on the following:
However, in response to being asked how a “material” price departure would be defined, we received a broad range of replies, shown in the pie chart below, underscoring that there’s a wide range of interpretations regarding materiality of price changes.
When liquidating a security, what would you consider to be a "material" price departure from the security's current price? (i.e. all price movements below this amount are considered acceptable).
See our comment letter to the SEC regarding the need for clarity around liquidity rules.
Manage Liquidity Risk with ICE Liquidity IndicatorsTM
To add clarity for market participants and offer the ability to accurately measure liquidity risk across fixed income securities, we developed an independent Liquidity Indicators service that taps into our array of market intelligence, including our evaluated pricing information, and generates key liquidity measurements through innovative statistical methods. The primary goal of the Liquidity Score we generate is to reflect how likely a security’s price is to be impacted by current and future expectations market liquidity. Importantly, the methodology used by ICE Liquidity Indicators to “solve” for liquidity is uniform across asset classes, making it simple to compare liquidity for a given bond or structured security. The development of ICE Liquidity Indicators was spurred by the global focus on efficient management of liquidity risk in the fixed income market, including the new regulations proposed by the SEC.
ICE Liquidity Indicators provide a multitude of quantitatively driven liquidity risk metrics – including both Projected Days to Liquidate and Projected Market Price Impact. Additional analytics include projected trade volume capacity, projected future price volatility, active trading estimates, stress scenarios, portfolio-level liquidity profiles, back-testing simulations, and relative liquidity scores across a universe of securities on a uniform scale. The below screenshot provides a glimpse of the how the number of projected days to liquidate a sample portfolio of municipal bonds behaves under an assumed target market price impact setting of 1%, and alternatively, how this projection changes when the target market price impact is adjusted to 5%. As expected, as the tolerance for acceptable price departure from current price increases, projected days to liquidate decreases to align with a wider acceptable price impact.
ICE Liquidity Indicators are designed to support firms’ liquidity risk management needs during all economic cycles, at both the security and portfolio level.
Learn More About ICE Liquidity Indicators