Liquidity Risk: Will vertical slicing become the new norm?
This month the Financial Conduct Authority (FCA) released publications on what it expects from firms regarding liquidity risk management and compliance. In a recent press release, FCA warned that their most recent review of asset managers’ liquidity risk management and compliance “should serve as a warning to all asset managers that they need to get this right”. The FCA clearly stated that it expects boards to discuss the FCA findings and assure themselves that their firms are not amongst the minority with severe gaps in managing liquidity risk.
The FCA’s views on vertical slicing of liquidity risk
The FCA highlights looking at "vertical slices" of the portfolio as a requirement going forward. This may be new to some risk and compliance people. The FCA noted:
“A wide range of approaches to liquidity stress testing with some methodologies insufficient to assess the actual liquidity of the portfolio, using assumptions that were not appropriately conservative. For example, some firms’ models assumed that they would always sell the most liquid assets, without ever giving regard to the liquidity of selling a ‘vertical slice’ of the portfolio.”
As a result the requirement to consider a ‘vertical slice’ may have significant implications for firms' management of fund transactions before and after significant redemptions, the monitoring/testing/sampling that Compliance and Risk Officers should be doing around this, and there should be liquidity stress testing in place to model this process.
What is the AQMetrics approach to Vertical Slicing
"Vertical Slicing" was introduced into AQMetrics technology some years ago as a core part of Pure Redemption Stress tests. It is a Liquidation Strategy used by many users of AQMetrics technology.
The idea behind Vertical Slicing is to keep the fund composition intact after a severe Redemption. Selling assets in a "pro-rata" fashion, or more specifically, selling off the same portion of each asset class in the fund to meet the redemption requirement in a controlled and vertically sliced manner achieves this goal. This strategy is in contrast to the Waterfall approach used by REITs for example. Using the waterfall approach the fund manager sells off the most liquid assets in the fund first to meet the redemption requirement. Intuitively, the latter leaves the fund in a far "less liquid" state for the remaining Investors in the fund. The Vertical Slicing approach is used to ensure fairness to Investors who remain investing in the fund after a large redemption occurs.
How it works
The liquidation strategy is configured in AQMetrics technology before automated stress testing against any given fund. AQMetrics technology defaults the liquidation strategy to use Vertical Slicing. Vertical Slicing is viewed in the AQMetrics technology as part of the decision tree layer for any given stress test.
End users view the fund composition in the AQMetrics user interface to ensure the asset weighting is intact over rounds of the redemption stress test. Further drill-through functionality is provided for the HQLA (high-quality liquid assets) of the fund and includes the asset weighting in the drill-through. When Vertical Slicing is used, this asset weighting remains the same over each round of redemption stress test. Further when two rounds of redemption stress tests are run the exogenous redemption shock of the first round, will differ from the endogenous shock of the second round which in turn gives rise to different RCR (Redemption Coverage Ratio) values for both rounds. Typically when Vertical Slicing is used, the second-round RCR will greatly exceed the first-round value. This is ultimately the reason why at AQMetrics the automated test is typically configured to run over two rounds only.
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