A new report from State Street Corporation and the Alternative Investment Management Association says that nearly half of the market participants surveyed believe that decreased market liquidity is a secular change, not a cyclical one: that is, that it is a climate that is here to stay, not a rain that will go away.
The underlying survey canvassed institutional asset owners, managers, and hedge funds. More than three fifths the respondents say that liquidity conditions have had an impact on their own strategies. Nearly one third rank this impact as "significant." The changes in strategy can go in more than one direction.
The report quotes Lou Maiuri, executive vice president at State Street, saying that increased regulation and the cost-management pressures that go with it are "causing many players in the investment industry to think again about the fundamentals: what roles they play, where they invest, and how they transact their business."
ETFs and Liquid Alternatives
Exchange-traded funds, especially bond ETFs, have benefited from the change in climate, because investors are attracted by their marriage of liquidity and yield. Some observers, though, are wary of ETFs, fearing as the report puts it "a disorderly market environment if investors decide to reduce their exposure en masse."
Is the issue that makes some wary the asset class (bonds) or the product through which an institution may gain access to that class? The report quotes David LaValle, US head of SPDR RTF Capital Markets, on the importance of clarity on that point.
"Investors should be thoughtful about the liquidity profile of the asset class they're looking to gain exposure to. Once they assess that, there's a separate, product-focused conversation to have. Often, these two types of risk are conflated and so it's critical to decouple them."
Liquid alternatives, too, are a manner in which some institutions are trying to have their liquidity and eat it as yield, too. These include both '40 Act funds in the United States and UCITS funds in Europe. Assets within UCITS funds have increased by 40% over the past five years, getting to $286.4 billion in April 2016.
Instead of fleeing from the new illiquid status quo, though, some market participants have decided to embrace it, increasing their allocation of funds to the more illiquid classes such as real estate or PR funds. Pension funds, in particular, with their long time horizons, are well positioned to take advantage of an illiquidity premium.
If an institution has cash at hand: what then?
Another matter covered in the report is the degree to which treasurers and cash managers are reviewing how they manage cash, and collateral. Thirty eight percent of respondents said that they are reviewing their collateral management policies: 35% say that they will likely change those policies over the next year. That does not include other respondents who said, "Yes, we have taken action within the past year." Likewise, and with the same caveat, 40% say they are reviewing their cash investment policy, 36% say that they will change it.
One of the obvious reasons for this is that central banks and their "quantitative easing" have made the risk-free instruments virtually yield free. So institutions wanting yield are driven to use it elsewhere. If they want to keep it on the balance sheet as "cash," that elsewhere has to involve riskier fixed income securities. Also, institutions "face geopolitical volatility that creates currency swings - affecting ash flow, their global operations, and liquidity."
In an appendix, State Street and AIMA look at the key regulatory initiatives since the 2007-09 financial crises that have had an impact on liquidity. They include: Basel III; the Dodd-Frank Act in the U.S.; the Markets in Financial Instruments Directive in the EU, and its regulatory follow-up (MiFID and MiFIR); and the U.S. SEC's liquidity risk rules.
The new SEC rules are to be phased into effect starting in December 2018. They include, in the report's summary, "a three-day minimum liquid asset requirement, the bucketing of portfolio assets according to their liquidity value, and limits on the ability of open-ended funds to hold large amounts of illiquid assets."