Now more than ever, it’s in your firm’s best interest to refocus attention toward your liquidity strategies and how to enact them. Learn why.
Successfully running a futures commission merchant business or brokerage firm requires more than state-of-the-art trading technology and market access. You also need quick access to cash in case your clients suddenly require liquidity. That’s never been easy, but it’s especially challenging in today’s environment of rapid regulatory and technological change.
For instance, consider the imminent transition to T+2 in the U.S. securities markets. The shortened settlement—which will be somewhat offset by lower financing costs—could potentially impact on how you manage your cash flow. It will depend on how much exposure you have to clients who are active in the equity options markets and exchange traded funds (ETF) markets.
Balancing the risks your firm faces and determining optimal allocation requires a more active approach to managing reserves. Fortunately, there are a number of strategic liquidity options firms can be ready to employ to meet these challenges. To begin, it helps to take a look at what has changed.
Event Shocks Receive a Higher Magnification
Things happen. From unexpected political developments like Brexit, to extended drought conditions in agricultural areas, events like these have always moved markets. What has changed is that thanks to technology and instant and continual media coverage, there is now virtually no lag between the occurrence of an event and the trading response it triggers. This increased velocity fueled by leveraged trading means even mild events can significantly change your clients' need for liquidity.
Consider how a slight rally in corn due to bad weather in South America was sufficient to ignite a liquidity swing on the local exchange in January 2017. That swing rippled through global trading accounts increasingly magnified by leveraged positions. The result was forced drawdowns of many U.S. clients’ invested funds to meet margin calls. A liquidity crunch was subsequently triggered at firms with reserve strategies that were misaligned with the speed and degree at which the market reacted. Considering the rise in global political risk, and the propensity for larger climate-driven events to occur, more responsive liquidity strategies are recommended.
Regulatory Changes Add New Liquidity Crosscurrents
The liquidity stress testing rules from the Federal Reserve Board have already had an impact. They have transferred some of the liquidity risk from bank holding companies to larger broker-dealers. This has led firms—perhaps even yours—to extend the duration of certain types of securities transactions. The result has been an increase in structured transactions, including securities lending with maturity terms, collateral upgrades and swaps transactions. In turn, there has been an extension of short-term cash flow projections beyond the prescribed regulatory metrics. Now, liquidity calculations will be further impacted with the adoption of T+2.
The early September switch to a shorter settlement cycle for broker-dealer transactions removes a key friction point in transaction processing. By leveraging technology to gain efficiencies in cash deployment, T+2 will reduce counterparty and credit risk while increasing market liquidity and lowering collateral requirements. This also means if your firm generates revenue through securities lending, you now have a narrower window for recalling securities.
With the arrival of T+2, liquidity, forecasting and collateral management need to adjust. Lower liquid reserve requirements may enable you to explore higher-yielding and potentially longer-duration alternatives for investing your firm’s capital.
Adding to the Tool Kit
As the nature and causes for liquidity shift, it is time to expand beyond the securities tool kit you currently rely on for risk management and reconsider the inclusion of backup liquidity options that may not have figured as prominently in the recent past. These options include short-term lines of credit, repo facilities and residual interest lines. When considering credit to meet liquidity needs, consider the following:
- Does the committed amount provide the firm with enough dry powder to meet its needs during a liquidity crisis?
- Are draws on the credit facility restricted based on purpose?
- Is the commitment period long enough for the firm’s needs?
- Is the repayment structure sufficient?
- Can the credit facility be used to meet regulatory capital needs?
Plan ahead so that your firm has the liquidity it will need since it can take anywhere from a few weeks to a few months to obtain credit approval.
Regularly Revisiting Liquidity Strategy
Now more than ever, it’s in your firm’s best interest to refocus attention toward your liquidity strategies and how to enact them. Not only can it help stabilize capital, it puts you in a better position for weathering future liquidity events with barely a ripple in your bottom line.