The PwC ALLERT Report

The recent financial crisis highlighted that the importance of Liquidity Risk Management, as well as the severity and swiftness with which this risk can materialise, had been severely underestimated by the industry, markets and regulators alike.

What the regulator requests

Regarding the Asset Management industry, both UCITS IV and the AIFMD include the concept of Liquidity Risk in their guidelines. CESR’s (now ESMA’s) level 2 and level 3 guidelines (issued in the context of UCITS IV) clearly emphasise liquidity risk by mentioning it right after market risk in the description of the risks that at least should be covered by the Risk Management Process (RMP).

The Commission Directive 2010/43 EU (transposed in Luxembourg in both the Règlement CSSF 10-4 and the CSSF circular 11/512) also specifi es that the Management Companies must use an appropriate Liquidity Risk Management process (including stress tests) in order to guarantee the right for shareholders to redeem their shares. The proposed AIFM Directive dedicates a full paragraph of its global framework to Liquidity Risk Management.

How liquidity impacts investment funds?

Asset side

Also called market/product Liquidity Risk, the asset liquidity risk arises when transactions cannot be conducted at quoted market prices due to the size of the required trade relative to normal trading lots.

Liability side

The liability liquidity risk arises when the fund cannot meet redemption payments or is able to do so only with such an investment deviation that it could originate claims from the investors.

How to approach liquidity risk in the investment fund industry?

How to monitor and manage the portfolio liquidity risk?

Asset side

The common liquidity indicators used to assess the liquidity of the securities (Average traded volume, bid-ask spread, LVaR, etc.) suffer from different drawbacks.

Therefore, instead of relying on single indicators, PwC has extended the scope of liquidity indicators and selected sound liquidity indicators:

• Average traded volume/% of shares held
• Stale prices
• Credit ratings – LOT
• Number of market/Number of pricing providers
• Bid-ask spread
• Stressed bid-ask spread
• Kyle’s Lambda

Then, in order to adequately weight them, and create a valid benchmark, we have selected a broad range of fund portfolios (more than 80) and computed the value of all these indicators for each portfolio line (more than 7,000 securities and 70,000 lines of fi nancial data).

Finally, weights of the different indicators as well as the global liquidity scale have been scientifically defined by using the Principal Component Analysis econometric method.

Liability side

Forecasting the investors’ behaviour is key in liquidity risk management for investment funds but remains a challenging task considering the low level of transparency of investors.

Bearing that in mind, there are still ways of defining potential trends in subscriptions and redemptions.

The past evolution of the number of shares can be used as an indicator of what could happen in the future. But, in order to remain reliable, these analyses need to be based on strong and relevant statistical techniques.

The method selected is therefore based on a structured technical approach relying on Time Series Analysis. Based on the historical trends of subscriptions and redemptions, we define the function that best fits the past distributions to generate reliable forecasts.

The issue that has to be addressed is not limited to the future trend forecast but should be extended to potential stress levels of redemptions. Therefore, based on the level of noise measured in the previous step and using the Pindyck - Rubinfeld approach, we determine different stress scenarios aligned with past investors behaviour using different intervals of confidence.

Finally, we link these stressed trends to the amount of cash and other liquidity facilities, with certainty available to the fund, to determine how redemptions would affect the fund’s liquidity in stressed circumstances.

The new regulations regarding liquidity risk pose considerable challenges to the fund industry in various aspects. And as far as the regulations are concerned, it must be pointed out that the regulator is not providing any recommendations on how to meet these new requirements.

Therefore, in order to support client in this new challenge, at PwC, we have developed a new approach summarised in a comprehensive report called: The PwC Allert report.

ALLERT stands for Asset and Liability Liquidity Expected Ratio and Trend as this report provides you with information on the liquidity of the portfolio as well as expectations in terms of subscriptions and redemption both in terms of rating and future trends.

In order to ensure the efficiency of the process, we will provide you with this report duly filled, meaning that your risk team will not spend time on the production of the report but capitalise on their expert judgment to complete, challenge and interpret the results.

Also, as we want this report to be tailored to your needs, we follow a modular approach: you only pay for the module(s) you need.

Deliverables

You will be provided at a defi ned frequency with the ALLERT reports and will receive one Excel workbook per fund (and a complementary PDF on simple request) that discloses:

1. A synoptic dashboard;
2. The ALLERT report for each sub-fund;
3. The liquidity ratings for each security included in each sub-fund.

As illustrated in the charts below, the primary deliverable will be an Excel workbook containing all the results for a particular fund. The final layout could slightly vary as it may subsequently be readjusted.

How we can help

Our specialist team members have gained a strong expertise as consultants and through their experience within the financial industry. As a result, they are able to quickly understand your concerns. Our solution is proportionate to the scale, diversity and complexity of your activities, hence it is really tailored and sound.

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