The new liquidity guidelines have nuances that can leave a market practitioner scratching their head. The ESMA Final Report on the ‘Guidelines on Liquidity Stress Testing in UCITS and AIFs’ is a well thought-out document designed to raise the industry to a minimum level of appropriate practice regarding liquidity stress testing and risk management. Yet several points in the level 2 text are puzzling.
For example: “Hypothetical scenarios could include rising interest rates, credit spread widening, or political events.”1 There are certain parameters that the industry has accepted as drivers of liquidity of financial instruments - namely that liquidity is a function of size, timing and price and that factors such as bid-ask spreads, volatility and market accessibility are variables that impact liquidation costs or timing. These are supported throughout numerous academic studies and highlighted in the ESMA paper per my last blog.
The question, is why interest rates and credit spreads should directly impact liquidity. Let’s say that a particular vanilla fixed rate corporate bond trades today at par. The ICE Data Services’ Liquidity Indicators service is going to provide a Projected Trade Volume Capacity (PTVC) which is the foundation of our approach to liquidity. For background, this metric will provide a modelled estimate of how much volume of that instrument could be borne in the market in one day, given a specified market price impact - broken down between an active portion (as driven by historical trading activity) and a potential surplus portion (driven by the potential for an instrument to transact even when not historically available - in other words, think of a “museum piece” or highly desirable holding that is already mostly placed with buy-and-hold accounts). So let’s say that the PTVC for this hypothetical bond is $1MM per day at a few cents less than par. That’s the baseline estimate. I get why the PTVC might no longer be $1MM if bid-ask spreads widen, or if price volatility increases 20-300%. But why would that figure move if interest rates rise? For example, let’s assume interest rates back up 50bps and credit spreads simultaneously widen another 50bps such that the fair value of this bond is now 92. Guess what? The market can still bear to transact $1MM per day. We could even suggest there may be new market entrants and potential buyers of the instruments at the higher yield.
In conclusion, interest rates and credit spreads are critical factors when assessing the fair value pricing of a financial instrument - but they don’t necessarily have a direct impact on liquidity. Perhaps ESMA are referring to “hard” assets such as real estate, where these factors impact affordability, the transacting universe, and would reasonably be expected to affect liquidity.
1 Page 37 of the ESMA adopting release, section v.1.8