Governments around the world have launched a wide range of tax, financial, business and social measures to help organizations respond to and recover from the economic impacts of the global COVID-19 pandemic. No one could argue about the lack of visibility of this unprecedented situation and its impact on the short-, medium- and long-term outlooks on the economic and social situations. Indeed, the financial sector in Europe and globally has been struck hard and faced a dislocation during the beginning of the pandemic. As an example, compared with 2008, all the markets have been negative and no ‘fly-to-quality’ investments have been possible to manage risks and reduce volatilities.
Review of 2020
During 2020, the pandemic highlighted and increased the structural vulnerabilities associated with the financial markets and asset management activities, especially in the area of liquidity risk, which were identified by regulators as those that could potentially pose financial stability risks.
One key lesson was the importance of effective liquidity risk management to safeguard the interests and protection of investors, to maintain the orderliness and robustness of financial markets and to help reduce systemic risk, all of which support financial stability.
The main weaknesses regarding the liquidity risk management process are (1) the design process of the investment strategies, (2) the day-to-day liquidity management of different portfolios, and (3) the existence of contingency planning.
Regarding the design process, an effective liquidity risk management process should be established. While being proportionate, the liquidity risk management process has to be supported by strong and effective governance, and take into account any obligations (eg investor redemptions, margin calls from derivative counterparties, etc). Finally, and more importantly, the liquidity risk management process needs to be effective in both normal and stressed market conditions.
At the portfolio and investment levels, the financial stress emphasized that due consideration needs to be given to the current and historical liquidity of the assets and instruments to be invested in under normal and stressed market conditions. On the investor side, asset managers should take reasonable steps to enhance the understanding of the target investor base, the concentration thereof and the expected redemption and divestment patterns.
In addition, it should be ensured that the liquidity risk of the portfolios and investments and the liquidity risk management process are effectively disclosed to investors and prospective investors. Disclosures should be properly designed, taking into account the nature of the assets the asset managers intend to invest in and the degree of sophistication of the investor profile. Disclosures should be proportionate to the risks.
The pandemic also highlighted a lack of day-to-day liquidity management of investment strategies; the liquidity risk management process, established at the design phase, should be effectively performed and maintained, taking into account the investment strategy, liquidity profile and redemption policy of the investors.
The liquidity should be regularly measured, monitored and managed. Due consideration should be given to the interaction of liquidity risk with other risk factors such as market risk or reputational risk. Investment decisions should integrate liquidity management and stress testing. Stress testing arrangements should be appropriate with regard to the size, investment strategy, underlying assets and investor profile of the portfolio, while taking into account other factors where relevant.
Stress testing should be based on reliable and up-to-date information and carried out at a frequency relevant to the specific strategy, especially in anticipation of reasonably foreseeable stressed market conditions to which the strategy could be sensitive.
Finally, contingency plans should be implemented and periodically tested to ensure that any applicable liquidity management tool can be used where necessary and if activated, can be used in a prompt and orderly manner.
For example, the testing of the operational capacity should be such that, to the extent possible and on a reasonable basis, asset managers can use all available solutions, including in stressed market conditions, that will allow for the continued orderly functioning of the strategy and for maintaining investor confidence in the management of the portfolio.
Preview of 2021
For 2021, we can see that the world is at a turning point regarding its positioning and capacity to face and manage the pandemic in terms of Islamic finance. In addition, with other stress events, such as Brexit entering into force in December 2020, especially with a ‘No Deal’ situation, there will be fierce competition between the UK and other EU jurisdictions to attract investors from the GCC and Asia (both for Islamic and conventional finance).
In such a situation, several jurisdictions will need a differentiation factor, for example, develop a specific framework for the rising appetite for green Sukuk. Another way could be to support the financing of SMEs in Europe and assets/infrastructure using Sukuk or using the newly established and easy to deploy Reserved Alternative Investment Funds structure.
Conclusion
2021 will be a major test of the human capacity to find an efficient way to handle the pandemic, its impacts and to simply find a way to return to a normal life.
Ali Khokha was the former senior manager at PwC Luxembourg. He can be contacted at [email protected].