Liquidity Preparedness. A new focal point for regulators, the regulated and even the unregulated.

“Preparedness”. That’s a new term for me in the world of liquidity. If you would count your firm as an NBFI, a non-bank financial institution, it’s a word you need to commit to your vocabulary. Somebody you might not have been counting on has just raised the expectations bar. Here is what you need to know.

Margin calls are something which have regularly caused significant disruption in financial services. Archegos (March 2021) and the UK pooled liability-driven (LDI) sector (September 2022) are quite fresh in the memory.

What’s the fuss and who is making it?

The FSB. No, not the Russian secret service. This FSB is the Financial Stability Board, which is an international body that monitors and makes recommendations about the global financial system. In short, they worry about systemic issues; things which if they go bump in the night might cause disruption across the whole financial services industry and across borders.

If you are at an NBFI, be that a hedge fund, a pension fund, a commodities trader, or an insurance company, you might be thinking: “So, what, I am not regulated by the BIS or the FSB. That is not in my circle of concern.”

Here is the first point of interest.

You could think of the FSB as a complement to the BIS, the Bank for International Settlements. Neither the FSB nor the BIS are regulators per se. Regulation is a national-level thing. National regulations are based on guidelines which come from bodies such as the BIS. If you are in a bank, especially in the UK, you will be familiar with local regulations on intraday liquidity management. These are based on something called BCBS 248: Monitoring Tools for Intraday Liquidity Management.

The FSB has just published a consultation report: “Liquidity Preparedness for Margin and Collateral Calls.” Essentially this is guidance for financial authorities and standards-setting bodies (SSBs). ?

The focus is on liquidity management when there are big market movements, and firms’ ability to respond. It is focused on how margin and collateral demands can amplify problems at exactly the wrong time. Think back to the UK Pension near-death experience of September 2022; government policy decisions led to a lack of confidence in the UK, with a sell-off of government bonds, forcing prices down and triggering margin calls on derivatives that were an order of magnitude more than normal. Many LDI firms did not have the liquidity on hand to meet the demands and had to sell assets, which caused prices to drop more and triggered further margin calls. A death spiral. The Bank of England had to step in.

The report sets out a series of recommendations around governance, risk management, stress testing and operational capabilities which NBFIs should have in relation to margin and collateral calls. They are taking a wide view; they include securities finance transactions in their scope.

A summary view of what the report is saying might be: “We have seen that the quality of liquidity management in NBFIs is highly variable, and outright poor in many cases. We may not regulate those firms, but we do need to ensure stability in the world’s financial systems. So, here is what we believe is good practice which the relevant bodies should hold their local firms to.”

The report is worth reading so you understand where the focus is. One area it focuses on is what I would term operational capabilities, another is stress testing and governance, including a documented risk management appetite, is a third.

And, from that position high on the perch of global oversight, the report makes it clear that the FSB is going to expect countries to report on progress and that progress will be shared publicly. This is the “name & shame game”. I would also expect that the new bar will become a measurement for assessment in things like Hedge Fund due diligence: “How do you deal with the recommendations in the FSB report?”

So, if you are an NBFI, your referee will be moving the goal posts, sooner or later. Eventually, those guidelines will become requirements imposed on you. There are different ways you might think about this:

1.??? Manana. I’ll worry about that when it happens. No time for it now.

2.??? Opportunity. If I can understand where regulation is heading, I can tune my operations to those expectations without being under pressure.

Both approaches are plausible. With #1, when you do have to do something, you will likely rush to do enough to get a tick in the box. Probably, you’ll miss the chance to add value. With #2, your focus is on optimally setting up people, processes, and tools so you can deal easily with these new requirements.

I am indebted to my good friend and old colleague, in both senses of that word, Gregory Burnes , who is the Head of Operations at Marek Capital, a US-based hedge fund, for pointing out the new GSB report to me. Like me, Greg is a process hawk and like me, he believes in the need to be running operations in real-time; not end-of-day reconciliations (recs) and spending tomorrow fixing the breaks from the day before, but intraday recs, ensuring that all breaks are fixed before the end of the day. I have expanded on this view elsewhere – see here.

Here’s how Greg’s high bar interacts with the new requirements which will filter down from this FSB report. If you don’t do intraday real-time reconciliation, you will not be sure of your positions, be those securities, cash, or collateral, and you won’t know what has settled or not. Without that data, you do not have the information to manage your liquidity. All FSB recommendations aside, that leaves you as vulnerable as a wooden house on the Jersey shore next time there is a hurricane. And it will leave you scrambling to answer all those regulatory questions when the FSB guidelines finally trickle down through your regulator. The cost of compliance will be just that, a cost to get a tick in the box.

Even just reading the report is a great initial investment. You will immediately have a view on where your shop is relative to the new normal. Understand when you can and not just when you have to.

Thanks for reading. Perhaps you have a view? Please do let me know what you think of these notes. Feedback via the comments would be great.

If you would like to talk more about things liquidity, please just type: “Can we talk?” into the comments box.

Please feel free to get in contact: https://www.dhirubhai.net/in/bankersplumber/ and [email protected].

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