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Oct 30, 2014

Liquidity Risk Deadly, But Often Ignored

by David Ensor

David EnsorIndividuals, corporations, banks, municipalities, provinces and sovereign states can and do default on their debts and other obligations—so do investment funds. One of the definitions of bankruptcy or insolvency is being unable to pay one’s obligations as they fall due.

So, let me pose a question: are you comfortable believing that you are and would be able to meet all your financial obligations in all foreseeable circumstances?

 

Many people budget, but they tend to do so in a mechanistic way, forecasting outgoings and income over relatively short time frames, without “stressing” both sides of the calculation. This leaves them vulnerable to unanticipated changes in circumstances. Of course, your financial advisers quite properly urge you, their client, to maintain a liquidity buffer of at least several months’ worth of expenses, yet I wonder whether they also suggest that you step back from the mundane and expected to consider scenarios in which your circumstances could change beyond the usual concerns about unemployment or illness.

Consider this: apart from the cash in your wallet, or the bundles of notes you (naturally!) have stashed in your mattress or safe, almost all of what you consider your available liquidity in fact represents an obligation to you from a third party, be it a bank, mutual fund manager or other investment manager, which is represented by a series of entries in some form of electronic ledger. Of course, even those Canadian dollar notes represent a “promise” that they have a value which others will accept!

I am not trying to make you paranoid or drive you to becoming a “survivalist” with your own bunker; rather I am asking that you start thinking about what liquidity is and how, like everything else in this complex world of ours, it carries its own risks which need to be considered.

More questions: how many bank accounts do you have, and with how many different institutions? If domestic, are the balances covered by CDIC protection? How do you get access to funds? It is supposed to be your money, but unless the holder is willing and able to give you its full value on demand, you may be fooling yourself that you have enough liquidity to meet reasonable scenarios. As events in Cyprus showed, if you cannot get your hands on the funds or cannot direct them freely, they are in fact worthless.

Again, I am not suggesting that the Canadian banking system is at serious risk of failure or insolvency (although its exposure to Canadians’ mortgage and private debts is becoming a concern), but that you should proactively consider diversifying your bank risk without going to ridiculous lengths.

And if you are unwise enough to succumb to the marketing blandishments of Canada’s mutual fund racket, I hope that you have studied the financial strength and ownership of the fund management company (s), as well as the level of liquidity risk in the individual mutual funds that you own; this is very much reliant on the ability of the manager to realize cash for the underlying assets in all circumstances—something which recent history has shown cannot, in fact, be relied upon.

Do you have investments in hedge funds, or “funds of funds”? “Lucky” you! I hope that you have studied the contractual terms and the “lock-up” periods that are prevalent in such investment vehicles. You might be surprised how easy it is for the manager to deny you access to the proceeds of any request to sell.

What about ETFS? A wonderful invention but again they depend upon the smooth functioning of the underlying markets and on the willingness and ability of the market-makers to continue to provide a price and a tight bid-offer spread. Otherwise, their liquidity is just an illusion.

The essential point to know about liquidity is that when it is not needed, it is often not considered nor properly priced; yet, when it is needed it is often unavailable or severely rationed. Remember, banks control their ATM networks and payment systems—and, in extremis, they are definitely not your friend! Market-makers and investment managers tend to exhibit herd-like behaviour, with everyone moving in the same direction at once—enough to give sheep and lemmings a bad name. They will all claim that they are well aware of liquidity risk and have robust plans to address, manage and mitigate it—but experience dictates that many of them really only pay lip-service to it, because they believe that such problems happen to other people. Nonsense, of course. 

I hope, dear Reader, you are not by now a quivering wreck, dosed with Valium or Xanax! We live in a world in which it is increasingly hard to separate and protect against risks such as liquidity, because the financial institutions and the systems which they are part of are so interconnected, and have a complex web of dependencies. Being aware of and considering the risks to one’s own ability to remain solvent and meet all one’s obligations as they fall due is simply prudent and should promote a better night’s sleep.

Finally, make sure that you are being compensated in terms of expected returns for all the risks you face in any investment—including liquidity. All too often, the so-called liquidity risk premium is non-existent. You have been warned!

David Ensor, Risk Management Consultant

david.ensor@btinternet.com