Liquidity Risk Management in Wholesale Brokers

Recent periods of heightened market volatility have highlighted a number of liquidity risk vulnerabilities for a range of investment firms captured under the Financial Conduct Authority’s (“FCA”) Investment Firms Prudential Regime (“IFPR”). These vulnerabilities have been particularly prominent within the subset of IFPR firms undertaking brokerage activity with wholesale counterparties, leading to enhanced regulatory scrutiny for these firms. This blog focuses on these heightened sources of risk for FCA-regulated wholesale brokers, as well as the FCA’s recent focus, and our observations within the sector.

Regulatory Focus

While liquidity risk cemented its position as a recurring theme in global supervisory priorities after the Global Financial Crisis, regulatory focus on the topic has increased notably in recent years, including for non-bank financial institutions (“NBFIs”).

In the UK, FCA scrutiny on liquidity risk management in wholesale brokers has sharply increased with this overall trend. In January 2023, the FCA published a Dear CEO letter (FCA’s January 2023 wholesale broker Dear CEO letter) containing, among other topics, observations of shortcomings in liquidity risk management within wholesale brokers captured under IFPR. In it, the FCA note that in “the subset of clearing brokers that face heightened liquidity risks…liquidity risk management and stress testing was not fit for the current market environment.” As a result, the FCA noted the intention to undertake “targeted work in this space.”

Liquidity risk management subsequently featured heavily in the FCA’s November 2023 IFPR Implementation Observations concluding report and recently published supervisory strategy for wholesale brokers. Our recent blog on this supervisory strategy highlighted continued focus points for the regulator relating of liquidity risk management, a number of which are explored below in detail based on our recent work in the sector.

In addition to FCA focus in the UK, the Bank for International Settlements (“BIS”) published a May 2023 report discussing a number of similar concerns, titled Margin Dynamics in Centrally Cleared Commodities Markets in 2022. The report outlines the ongoing trade-off between liquidity risk and counterparty credit risk that is inherent in Central Clearing Counterparties’ (“CCPs”) margining practices, with the former substantially increasing as the latter is increasingly mitigated through initial and variation margin requirements.

Similarly, in April 2024, the Financial Stability Board (“FSB”) published a consultation report titled Liquidity Preparedness for Margin and Collateral Calls, reiterating the increasing importance of, and consequent regulatory focus on, this source of liquidity risk faced by many investment firms. Both reports, while non-binding for FCA-regulated investment firms, demonstrate the globally consistent focus on this key source of liquidity risk.

Areas of Challenge

1. Liquidity Stress Testing

One of the primary concerns raised by the FCA in their November 2023 IFPR Implementation Observations concluding report, and a frequent area of challenge for firms in our observations, is the development and modelling of adequately stressed conditions and consideration of relevant liquidity risks which underpin the quantification of Liquid Assets Threshold Requirement (“LATR”) ‘Assessment A,’ as required by MIFIDPRU 7. The FCA noted that some firms “did not assess cashflows under stressed business conditions,” while others applied “only a subset of liquidity stresses applicable to their business model.” It is evident from FCA feedback that the identification and measurement of firms’ most material liquidity risk drivers through liquidity stress testing represents a continuing challenge for a range of firms captured under the IFPR. The examples provided below capture our observations of common areas of challenge in this context.

Liquidity risk arising from margin requirements

As highlighted above, liquidity risk stemming from margin calls from CCPs and other brokers represents one of the most material liquidity risk drivers associated with brokerage activity. The assumed size and timing of these potential margin calls consequently requires careful consideration within those firms’ liquidity stress testing processes and broader liquidity risk management frameworks. Firms adopt a wide range of methodologies to quantify the size of this risk (e.g. Value-at-Risk), however frequently face challenges relating to both quantifying stressed cash flows arising from assumed market shock(s), as well as the subsequent ‘profiling’ of the timing of these cash flows.

Liquidity risk arising from credit offered to clients

A common feature of wholesale brokers’ business models is the provision of credit, to facilitate clients’ trading activity and reduce their operational burden and liquidity requirements. MIFIDPRU rules¹ include specific guidance for firms to consider such off-balance sheet liquidity risks. We have observed, however, challenges relating to the comprehensive identification and quantification of potential liquidity risks associated with these credit facilities during stress events. Firms’ liquidity requirements arising from the provision of credit under these facilities may fluctuate materially depending on, among other factors, clients’ remaining capacity going into a stress, franchise client considerations and excess collateral balances held on account. As a result, firms face challenges in ensuring appropriately conservative assumptions within liquidity stress testing that are aligned with other related stress assumptions.

Funding liquidity risk

Many MIFIDPRU firms rely on a combination of credit/liquidity facilities and usable collateral received from clients under Title Transfer Collateral Agreements (“TTCAs”). An in-depth liquidity risk identification process, to understand any liquidity risk associated with these funding sources, is critical in ensuring sufficient resources can be held against all material risks of harm. Namely, the risks that providers of uncommitted facilities funding have the right to withdraw such funding in periods of stress, and that clients holding material excess collateral balances provided under TTCAs may withdraw these balances, due to either their own liquidity needs or credit concerns, resulting in a scenario similar to a “run-on-the-bank”.  

Granularity of cash flow forecasting

An issue raised by the FCA in their November 2023 IFPR Implementation Observations concluding report, and frequently observed during our work with firms in the sector, is the lack of a “time-granular analysis of cash flows,” without which liquidity stress testing cannot identify peak cumulative cash requirements. Recent market events have demonstrated the speed and magnitude with which certain market variables can move, resulting in significant additional liquidity requirements on both an inter-day and intraday basis for wholesale brokers. Intraday liquidity risk was also specifically highlighted as an area of focus by the FCA within their January 2023 broker Dear CEO letter preceding the recent targeted liquidity review, highlighting observations of industry-wide challenges in this area. 

2. Liquid Asset Threshold Requirement

Some firms have faced challenges in calibrating liquidity requirements while considering the required forward-looking, four-quarter view prescribed by MIFIDPRU 7. In particular, we have observed difficulties in determining how this longer-term forecasting process interacts with point-in-time liquidity stress testing, while remaining consistent with MIFIDPRU 7 requirements.

3. Contingency Funding Planning

The market stress events over recent years noted above, and the resulting significant inter-day and intraday liquidity requirements for a range of MIFIDPRU firms, have highlighted the need for firms to have in place robust, fast-acting Contingency Funding Plans (“CFPs”). Firms undertaking brokerage activity are subject to material intraday liquidity risk, arising from, for example, requirements to meet potentially significant intraday margin calls from CCPs on client and house positions. This business model-driven risk underscores the importance of CFPs in the sector that: are forward-looking; are fast-acting; contain clear governance arrangements; and provide a ‘menu’ of feasible actions that can be taken to generate or preserve liquidity in extremely short timeframes.

Be prepared

Focus on liquidity risk continues to grow, illustrated by references to the topic within the FCA’s supervisory strategy for wholesale brokers. Both firm-specific and market-wide stress events over the past three years have repeatedly illustrated the importance of sound management of this key risk type. Given the speed with which liquidity stress events can and do unfold, MIFIDPRU investment firms should proactively ensure that they continue to develop their liquidity risk management frameworks, built on a comprehensive process to identify and adequately assess all material sources of liquidity risk to which they are exposed. In doing so, firms should consider leveraging FCA and other feedback (for example the FSB’s recommendations), to ensure sufficient capabilities are in place to withstand liquidity shocks.

Get in Touch

Should you have any queries, or would like to discuss any of the above topics, please contact any author of this blog.

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References

1. MIFIDPRU 7 Annex 1