The credit crisis of 2008 highlighted the criticality of effective liquidity management and demonstrated the difficulties broker-dealers face without adequate funding sources. In response, the Financial Industry Regulatory Authority (“FINRA”) has been taking steps to impose new requirements that will impact many broker-dealers, especially those that hold inventory positions or that clear and carry customer transactions.
Following up on guidance issued in November of 2010, FINRA last month issued new liquidity risk management guidance after a year-long liquidity review of 43 member firms under a stressed environment.
While the guidance was issued as a FINRA notice and therefore lacks the standing of a rule, we expect FINRA to enforce it in the course of future examinations. Further, we expect the Securities and Exchange Commission (“SEC”) to issue more specific rules next year that will apply to all firms that carry and clear customer accounts.
This post highlights key elements and considerations that broker-dealers should include in an effective liquidity risk management plan.
Key Elements of Liquidity Risk Management
In our view, FINRA’s guidance – and potential SEC rulemaking in this arena – is most impactful and challenging for broker-dealers in the five areas outlined below.
- Maintenance of contingency funding plans and facilities should take place at the broker-dealer level. FINRA’s guidance makes clear that broker-dealer funding plans that are solely reliant on the parent are unacceptable. FINRA found that such arrangements are inadequate because a parent is often committed to multiple affiliates. In the absence of exclusive contingent facilities, funding is less likely to be available to the broker-dealer during times when it is needed most. However, directly sourcing committed liquidity at the broker-dealer level may reduce the parent’s flexibility in managing enterprise-wide liquidity.
- Broker-dealers need to secure dedicated third party committed lending facilities with unrestrictive covenants. FINRA recommends discounting or entirely excluding facilities that limit funding during adverse conditions. As a result, firms will likely have to incur higher commitment fees and interest rates in exchange for improved covenants. We expect that broker-dealers will find it challenging and expensive to obtain these facilities, which may cause them to terminate their clearing operations and become introducing brokers. Additionally, introducing brokers should consider implementing their own committed third party lending facilities with limited covenants in anticipation of curtailed funding capacity offered by their clearing brokers during periods of stress.
- Broker-dealers must be realistic about the value of collateral when contemplating secured financing options. Secured financing is a useful component of liquidity risk management plans, but broker-dealers must recognize that counterparties will discontinue funding or require severe collateral haircuts during times of stress. FINRA found that most firms’ haircut assumptions were overly optimistic, particularly for illiquid assets. To the extent that firms rely on secured financing, they should be extremely conservative when valuing their collateral.
- Overreliance on the Fixed Income Clearing Corporation’s (“FICC”) General Collateral Facility (“GCF”) to replace existing repo financing is unrealistic due to the FICC’s capacity limitations. The FICC’s rules limit GCF capacity to 140 percent of a firm’s activity for the previous 30 days. FINRA found that many firms’ liquidity funding plans relied on this avenue without accounting for this rule. As a result, a seemingly attractive source of liquidity may not in fact be available, which underscores the importance of diversified sources of funding.
- On-going funding and liquidity risk assessments will be expected. This will include assessing liquidity needs and having a contingency plan readily available when needed. This assessment should include anticipating liquidity needs resulting from new products. Firms should also be ready to devote resources to ancillary activities, e.g., training for both senior management and staff to ensure they have an adequate understanding of potential funding and liquidity risks.
 Recent comments and rulemaking by the SEC indicate the agency’s increased focus on liquidity risk in securities markets. See PwC’s first take: Ten key points from the SEC’s proposed liquidity risk management rule for mutual funds (September 2015).
The preceding post comes to us from PwC and is based on their Regulatory Brief, which is available here and was published on October 12, 2015.