The main liquidity risk factors before the Covid-19 pandemic

Although liquidity risk management has changed since the pandemic, we explore the main risk factors hedge funds need to consider to understand how these changes are impacting investors.

What is liquidity risk?

There’s always a risk that a business or individual will be unable to meet their payment obligations, or only meet these obligations at excessive, often unforeseen costs. This is known as liquidity risk.

What is risk management?

Traditional liquidity risk management involves managing short-term cash-flow risk (e.g. the risks of not being paid on time by clients) and long-term funding risk, such as a private investor or venture capitalist pulling out of your business.

Liquidity risk management before the pandemic

The hedge fund sector in the UK’s been exposed to a great deal of economic, financial and political turbulence since 2016.

The UK’s delayed exit from the European Union on 31 January 2020 took place on the same day the country recorded its first case of Sars-CoV-2 – a novel coronavirus that would soon sweep the world, sparking the biggest global health crisis in more than a century.

It would be easy for hedge fund managers to blame most of the recent market turbulence on the economic and financial impacts of the pandemic and government-mandated lockdowns.

For example:

In the spring of 2020, the FTSE 100 posted its largest quarterly fall since Black Monday in 1987.1 Yet, even by the end of January 2022, after a stronger performance in 2021 (+14.3%), the index was still slightly down on its value compared to two years earlier.2

During the lockdowns, many sectors of the economy, like hospitality, were essentially closed for months at a time. UK government borrowing soared in response to income-support schemes like furlough and the Self Employment Income Support Scheme (SEISS) grant.

However, it’s not wise to ignore hedge fund liquidity risk factors predating the pandemic.

Brexit and the 2008 credit crisis were two of the main liquidity risk factors for hedge fund managers, but they’re still as relevant as ever.

Regulatory risks post-Brexit

Last year, UK hedge funds were forced to stop using the UCITS passporting mechanism which gave them access to the 27-nation EU trading bloc, without having to relocate staff or hire them locally.3 This was directly linked to the UK’s departure from the EU. At the end of the transition period on 31 December 2020 – when freedom of movement officially ended – this ‘loophole’ enabled hedge fund managers to continue receiving and delivering EU-related orders, offer investment advice to clients in the EU and, crucially, raise capital from European investors.

But rules on trading within the EU have tightened.

One financial regulation lawyer quotes on the news site Financial News London said the ability of hedge fund managers to hire authorised firms to host them in Europe 'is basically evaporating'. But the issue is that, in the absence of clear guidance on what the UK's departure from the EU means for fund managers and their businesses, they’ve had to launch 'temporary Brexit solutions', a London-based legal adviser quoted in the same news site, described.

Not all managers have adopted this approach, however. One compliance officer at a hedge fund said he would not sanction their use in his firm, although other hedge funds feel they have little choice but to use this loophole in order to retain access to the EU’s vast market.

What about liquidity mismatches?

During the 2008 crisis, hedge fund investors became increasingly conscious of how their capital was being managed and their redemption options. Subsequent regulations have tried to identify and mitigate potential mismatches between the liquidity afforded by hedge funds and the redemption terms they offer to their investors.

Investors generally find it easier to access their capital these days – but restrictions on redemptions may be mutually beneficial for both parties. For example, preventing mass redemptions in short time periods can protect the stability of the fund and the financial sector more broadly.

Which other types of liquidity risks that existed before the pandemic are still relevant?

Funding liquidity risk

When a business or individual are unable to meet their short-term obligations, this is typically referred to as funding liquidity risk. In this situation, a company’s at risk of defaulting on its outstanding bills.

Market liquidity risk

This is also known as asset illiquidity – when exiting a position becomes difficult. For example, if a large number of people want to sell prime real estate at the same time, the urgency of these transactions can increase the liquidity risk for fund managers. If the asset can be sold over a longer timeframe, the liquidity risk is reduced.

On the other hand, if a fund manager struggles to sell an asset, this can reduce its market value or make it difficult to determine its intrinsic value.

ETF liquidity risk

Some investors have sounded the alarm over ‘illiquidity risks’ that can be associated with exchange-traded funds (ETFs). The liquidity risk of ETFs increases when the securities’ trading volume is very high or if the investment environment is volatile. Investors may also find it harder to sell ETFs that are illiquid, or struggle to sell them at their desired price.

Liquidity risk measurement

To identify and prepare for a possible liquidity crisis, hedge funds need metrics for measuring these types of liquidity risks. Partnering with a prime broker gives you access to the tools and technologies you need to do this. For example, smart order routing (SOR) technology gives you access to deep liquidity and the best prices on various dark and lit venues.

Probably the most obvious – and arguably the most important liquidity risk measurement – is cash flow forecasting. This needs continuous adjustment to take into account recent changes in the business or the market which could (a) affect the profitability forecast and (b) require senior management to adjust the overall strategic direction of the business.

Financial ratio analyses

These allow you to monitor your current liquidity risks based on your hedge fund's past performance. You can use this information as an indicator for future performance and to adjust your operational and financial strategy to optimise your revenue.

The quick ratio will help you see how your hedge fund will meet its short-term obligations, while the current ratio will look at your hedge fund’s ability to repay its short-term obligations from its short-term assets.

As the world moves on from the past two years, we examine how these liquidity risk factors changed during the pandemic and the UK’s exit from the EU.

Date de publication: 2022-07-13T17:25:02+0100

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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