FSA Policy Statement (PS) 09/16: Pricing Liquidity Risk - Mechanism to Allocate Cost or Incentivise Business Behaviour?

On 5 October 2009, the UK’s Financial Services Authority (FSA) published ‘PS 09/16, Strengthening liquidity standards’. The PS introduces systems and controls requirements (SYSC), including the accurate quantification of liquidity costs and benefits to be fully incorporated into product pricing through a mechanism that aligns the commercial incentives in relation to individual products, business lines or strategies with the associated liquidity risks that each pose.

The purpose of charging the costs of liquidity consumed is to enable businesses/traders to make informed decisions based upon knowledge of the full costs of doing business including the costs of maintaining adequate liquidity. However, can the twin objectives of cost allocation and incentivising appropriate business behaviours be achieved through a liquidity pricing mechanism?

The means by which liquidity transfer pricing objectives are approached can vary significantly. An organisation may simply wish to ensure that liquidity costs are allocated as accurately as possibly. Such an approach is invariably time consuming in terms of determining the amount to be charged, simplistic and usually after the event and therefore of reduced value to the business decision makers operating at the margin. Alternatively a transfer pricing mechanism based upon current marginal pricing has the advantage of being timely but often does not reflect the true costs of liquidity incurred by the organisation. No matter which approach is adopted, the establishment of a charging mechanism requires:

• The determination of the amount against which a charge is to be made.
• The determination of the rate to be applied to reflect the cost.

The issues associated with both are many and varied, requiring the acceptance of a series of compromises.

Determination of the Amount Against Which a Charge is to be Made

Value date data

Many regulated institutions are subject to trade date accounting. However, liquidity is driven by activities based upon value date conventions. Therefore a significant initial exercise is often required to create a trial balance and position keeping based upon value date data. Although conceptually simple, the following questions/issues need to be addressed:

• Capturing and storing value date data – Is data captured and stored for analytical purposes or used simply to satisfy temporary back office operational requirements?
• Indefinite value dates – Has the variability of settlement dates (dependent on settlement process) been appropriately considered?
• Estimated value dates – How should contracts incorporating an element of optionality be evaluated in terms of the probability of whether or not the option is likely to be exercised?
• Maturity date relevance for liquidity risk purposes – Where the asset is not intended to be held until maturity, has the average or probable/predicted trading period of the asset been calculated?
• Absence of maturity date – In the valid absence of a maturity date (e.g. on demand and ‘at call’ deposits), have estimates for liquidity risk management purposes been made (e.g. based upon historical performance)?

Value determination

In addition to understanding the value date, consideration must be given to the value of the position either consuming or generating liquidity against which a charge or credit respectively can be made:

• Estimated values – How are the cash flows of an instrument subject to interest rate resets (e.g. interest rate swaps and floating rate notes) estimated?
• Cost versus market value – How to reconcile the principle that the value used for consumption of liquidity is based on the cost of an asset whilst the valuation of potential liquidity sources is based upon market (liquid) values?
• Institution-wide factors – Consideration also needs to be given to the treatment of balance sheet items not easily assigned to individual businesses within a firm. These include receivables and payables, margin calls for exchange traded and over the counter (OTC) derivatives, etc.

Determination of the Rate to be Applied to Reflect the Cost

Assuming all of the above obstacles can be resolved and an organisation is comfortable with the estimation procedures it deploys to determine a value and maturity date, the cost or price at which the underlying value of liquidity consumed or created is to be priced/charged is still subject to debate.

Historic cost versus current costs

The first question to resolve is whether the rate charged will be based upon the unit cost being the daily weighted cost of liquidity (i.e. daily interest expense over the total sources of liquidity) or whether the total sources of liquidity are broken down into time buckets for which unit costs for each time period are determined.

Unit cost versus a synthetic yield curve

The second question to resolve is whether the liquidity charged to the businesses should reflect the credit worthiness of the organisation at the time the liquidity was raised or the current or future (particularly in a stressed environment) credit spreads assigned to the organisation by the markets?

Cost versus market-linked pricing

The argument over the merits of cost allocation versus transfer pricing to incentivise appropriate business behaviours reaches its fulfilment with the evaluation of charges based on cost as opposed to market linked pricing:

• Interpolation – Should an interpolated yield curve be created where an organisation does not have funding outstanding either in part or in whole sufficient to match assets held with equivalent maturities (or estimated holding periods)?
• Spread pricing – To facilitate appropriate business decision-making and in the interest of transparency, has consideration been given to basing liquidity charges on a spread to market interest rates?

Two-way pricing

The fourth question to resolve is whether the effects and consequences of two-way pricing (i.e., where liquidity generation is regulated by varying the internal liquidity bid-offer spread) have been fully considered and understood?

Internal and external counterparties

Inter-bank trading provides the external window to a credit institution’s appetite for liquidity. However, the inter-bank market operates with very short-term horizons and does not present the full picture of a credit institution’s liquidity status or appetite encompassing the degree to which it requires a liquidity buffer of high quality low (and therefore costly) yielding tradable assets and the proportion of its funding sources it requires with maturities beyond one month/year.

The fifth question to resolve is whether a two-tier mechanism for charging liquidity to the businesses should be created reflecting short-term liquidity requirements based on highly transparent inter-bank market prices and an incremental franchise cost for longer-term borrowings?

Transparency and Confidentiality of Pricing

Pricing is a competitive tool but equally has implications for an organisation if it is too readily available to the competition. In credit institutions in particular, the requirement to retain confidentiality over the full costs of liquidity (as opposed to inter-bank pricing) should not be undervalued.

Other Significant Issues

Contingent liquidity

Demand for contingent liquidity may be calculated in a number of ways. However, should costs pertaining to the expected and (to the degree provided for) the unexpected contingent liability be priced, and if so how?

Management versus legal entity reporting

A final question to resolve is whether the reporting of business performance should reflect the business unit structure or the legal entity structure through which liquidity is derived and supplied, i.e. whether appropriate business behaviour and decision making is being incentivised across all legal entities.

Conclusion

Liquidity risk management is not an accounting exercise but seeks to manage and mitigate liquidity risk exposures. Hence, the primary purpose of a liquidity pricing mechanism is to incentivise business behaviours consistent with the risk appetite of the firm and ensure that the desired liquidity risk profile is not significantly compromised.

By comprehensively addressing the points raised above, an institution will be well placed to comply with both the spirit and letter of regulatory requirements. The firm will have ensured that it has not only quantified liquidity costs, benefits and risks but also fully incorporated them into its practices. Such incorporation has the significantly positive effect of aligning the risk-taking incentives of the various businesses to the liquidity risk to which the institution as a whole is exposed.