Regulation > Do liquid assets give you risk?

Published: 14th October 2009 by William Webster

Do liquid assets give you risk?

This is written for anyone interested in liquidity. Here’s a brief summary. 

• Firms will be required to hold substantially more liquidity (20%);
• T-bills, cash and treasuries (Gilts) will be the main recipients;
• Gilts are not risk free;
• Interest rate risk can be hedged;
• Swap spread risk, (basis risk), can’t and the risk can be large;
• Try the liquid asset KISS test;
• It’s the balance sheet structure that will give you the edge (is that what individual assessments are about?)

In the UK the FSA requires firms to assess how much liquidity is needed to withstand stressed conditions. Similar much tighter liquidity standards are now being considered internationally. The consensus is that firms will need to substantially increase their holdings of quality liquid assets, with 20% being an oft referred to balance sheet ratio. So what counts as being liquid? 

Assets that can be sold immediately without incurring wide bid-offer spreads. This limits you to cash, treasury bills and treasury bonds (Gilts in the UK). Therein is the cost, these assets all have very low returns.

To reduce the effect some clients are looking to buy longer dated government bonds with better yields. Does this make sense? In the Sterling market 2.50% for 5 years or 3.85% for 20 years does look better that 0.30% for 3 months. (Other currencies have similar positive yield curves). But that’s not the end of the story. Gilts are not risk free. 

A £10m 5 year investment has a basis point value of £4,450 and for a similar 20 year holding the BPV is £13,600. Yes, you will gain if rates fall and yes, you will meet the liquidity standards but if rates back up your asset valuation will look very unhealthy. What’s the solution? 

Most firms hedge this type of exposure with swaps. You pay the fixed coupon away and receive Libor (or with government bonds a bit less depending on the swap spread). Still Libor is better than the bill rate isn’t it? Well yes and no. 

Your swapped return may well be better than buying T-bills but what risks have you got yourself into? 

First, swaps are normally subject to collateral. If you pay fixed interest and rates fall you will end up being called for margin, a drain on liquidity - be prepared. 

Second, collateral management is a process it has operational risks and requires an assessment independent of your counterparty. Can you do this? 

Third, there is “swap spread risk” a type of basis risk. I’ll explain it in more detail because it is frequently overlooked and it certainly can hurt you. 

When you asset swap the Gilt you pay fixed interest and receive Libor in the swap market. Your investment now comprises the bond and the swap, your interest rate exposure is hedged. But Gilt yields and swap rates don’t always move in step. Supply and demand conditions can alter the relationship. Here is a scenario for you to consider. 

What happens when quantitative easing eventually unwinds particularly if governments are heavily reliant on issuance to finance spending? Could government bond yields rise faster than swap rates? If you are sitting on swapped Gilts the combined position (bond and swap) wouldn’t look too healthy. If you are in a mark-to-market (MTM/IAS 39) environment you would see a P&L impact. Even if you escape MTM you would have been better off had you waited to invest because Gilts now offer you a much more attractive swapped return. 

Incidentally for every basis point the swap spread narrows the cost will not be that dissimilar to the BPVs quoted earlier. 

Spreads may of course move in your favour and that’s the beauty of trading but is that what liquidity management is about? It’s your call. After applying KISS (Keep It Simple Stupid) my order of preference is: 

1. T-bills (minimal return)
2. Cash deposits (credit assessment required)
3. Gilts (exposure to the basis risk outlined above) 

Although it’s not everyone’s opinion I’ve excluded money market funds. You really do have to ask yourself whether they pass the KISS test. 

If spending time on asset selection is so poorly rewarded and with the choices being so limited where can you get the edge? 

You need to look at the structure of your balance sheet. What causes you to hold elevated levels of liquidity? What can you genuinely do to mitigate this and how can you pass the cost on? 

Isn’t that what individual liquidity assessments are about?

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