Liquidity risk management at wholesale trading firms

Firms often did not consider the cashflow mismatch from having to meet several central clearing counterparties' margin calls before receiving margin payments from their clients. This resulted in a significant drain on their liquidity as there would generally be a two-day waiting period for firms to receive margin payments from clients.

Firms often utilise counterbalancing short and long settlement positions to mitigate their market risk but fail to consider operational risk.

Some firms had inadequate knowledge of their clients' business profiles, including the concentration of the client exposure within the firms’ business. The review highlighted that liquidity stress events often revealed to firms that they had previously unknown concentrations of clients within their exposures. For example, some firms did not appreciate that two or more counterparties in their portfolios were connected. As a result, these firms were underestimating their total concentration risk and were therefore not appropriately incorporating this into their liquidity risk management.

In a few instances, firms did not accurately assess the speed at which clients will withdraw their money in stressed periods, especially in the case of reputational damage. Some firms underestimated the size and speed of outflows and were unprepared to handle this in response to stress events arising. For example, in the case of one small firm, a client withdrew all Title Transfer Collateral Agreements (TTCAs) within 24 hours, showing the importance of appropriately considering the severity of stress scenarios.

Firms with strong liquidity risk management frameworks focus on the practical management and specific nature of their risks first, alongside and beyond compliance with regulatory requirements. The FCA found that less robust frameworks often had a limited focus on ensuring compliance with the Liquid Asset Threshold Requirement (LATR) as opposed to considering that a more dynamic approach to calculating the LATR and managing liquidity may be required where firms' liquidity profiles are subject to material and rapid change. This often resulted in insufficient liquid assets, from a practical perspective, to effectively mitigate their liquidity risk. In particular, some wholesale trading firms had a more dynamic or daily computation of their LATR which would capture the volatility of their funds more accurately than the static computation within their ICARA that is aligned with regulations. This approach, which is not detailed in the regulations, provides a more prudent approach to the LATR computation for these firms and highlights the need for all firms to consider thresholds from both a regulatory and practical perspective.

The FCA cited in good practice that firms conducted forward-looking stress assessments each day on their margin call inflows and outflows, in both business-as-usual (BAU) and stressed conditions at the beginning of the day, as well as the end of the day. The frequency of their stress testing reflected the instantaneous nature of liquidity stresses, ensuring they are always adequately prepared to support substantial cash outflows given a stress event. The most prepared firms demonstrated an in-depth understanding of their business model to ensure that a comprehensive assessment of potential risks, including idiosyncratic risks, had been considered in the liquidity management framework. This would allow the firm to consider a broader range of severe and plausible stress scenarios and ensure the firm is readily prepared to address these risks were they to occur.

In the FCA’s review, Contingency Funding Plans (CFPs) were considered more robust and effective where there were multiple actions to increase or conserve liquidity levels that were appropriate for the firm’s unique circumstances, and where multiple persons within the firm knew key details on how to enact the CFP to reduce key person risk. The FCA emphasised the need for CFPs to be operational and able to be enacted in a timely manner to minimisethe impact of liquidity stresses. Some firms did not regularly test the operability of their CFP or did not know the governance processes to enact the plan, which reduced their ability to address liquidity stress in a timely manner.

Strong liquidity risk management frameworks were developed from firms that had strong expertise in both the operational aspects of their business and the key liquidity risks that they face. Firms can develop this through a strong interconnectedness of their operations and liquidity risk management teams, ensuring they have a clear understanding of their underlying products and of the timing and magnitude of BAU and stressed cashflows arising from operational processes. In addition, several firms did not consider the impact on outsourcing as part of their liquidity stress testing, instead considering the risks as owned by the outsourcing party. Considering all potential risks that may have an impact on liquidity is essential to ensuring firms are prepared to address liquidity shocks as they arise.