3 Ways to Protect your Clients from Liquidity Risk - Pocket Risk


Helping Financial Advisors Know Their Clients – Risk Profiling, Client Psychology, Behavioral Finance, Compliance

3 Ways to Protect your Clients from Liquidity Risk

Before the 2008/2009 financial crisis you probably didn’t worry too much about your client’s liquidity risk. Getting their money out would be as simple as putting it in. That was until Northern Rock happened. Given what unfolded and the recent troubles in Cyprus, liquidity is something everyone should be concerned about when choosing investments.  Below we offer three ways to keep your client’s money safe.

1. Ask Them How Much Risk They Are Willing To Take

The first step is to ask your client’s how they would react during a liquidity crisis. At Pocket Risk we include such a question in our risk profiling assessment.

In the event of an emergency (e.g. personal or financial crisis) I want to get out of some of my investments within a few days.”

Followed by which client’s can decide on their level of agreement. You don’t need to ask this exact question but you should know how they would react if they couldn’t get their money out quickly.  During the financial crisis investors in “safe” money market funds had to wait almost three years to get their money back. Can your client wait three years to access their cash? Even if they could, would they be happy? Unlikely. Therefore, you should find out your client’s liquidity risk profile (what we would consider a subset of tolerance/attitude to risk).

Once you understand your client’s tolerance you can move forward and recommend tailored investment decisions.

2. Limit Counterparty Risk

From ETFs, to platforms to online exchanges. All of this wondrous technology has made investing quicker and cheaper. However, it takes us further away from our investments. For example, that GILT fund you bought for your client, is it in their name or the “street name” of your broker. What happens when a computer crashes and they loose the records? Will anyone be able to discover who owned what? These events are unlikely but not impossible and we should prepare for such outcomes.

Invest your client’s money in reputable firms with a solid track record like Vanguard. Avoid anything too synthetic. Here is a classic example of an Exchange Traded Commodity. Let’s see how many counterparties we can find if we invested in this asset (highlighted in red).

“ETFS EUR Daily Hedged Agriculture DJ-UBS EDSM (00XJ) is designed to track the Dow Jones-UBS Agriculture Subindex Euro Hedged Daily plus a collateral return. The product enables EUR investors to gain exposure to a total return investment in commodity futures with a daily hedge against movements in the EUR/USD exchange rate. The ETC is backed by contracts (fully funded swaps) with counterparties whose payment obligations are backed by collateral which is marked to market daily. The collateral is held in pledge accounts at The Bank of New York Mellon. Details of the collateral held are available at: www.etfsecurities.com.”

  1. Financial Planning Firm – 1st Counterparty
  2. Broker/Platform – 2nd Counterparty
  3. ETFS Limited – 3rd Counterparty who manages this asset
  4. Dow Jones-UBS Index – 4th Counterparty – If something goes wrong with the index how will it affect my client?
  5. Fully funded swaps? Various other counterparties – 5th Counterparty
  6. Bank of New York Mellon – 6th Counterparty

Ok, I will stop and I didn’t even mention exchanges or the banks of some of the counterparties. It’s endless but you get the point, limit the steps from your client to their money.

3. Diversification

Diversification has its obvious return benefits but it also has its liquidity benefits. Eliminating counterparty risk is impossible unless your client keeps their money under the bed. So your best bet is to eliminate any dependency on a single business, product, platform, process or decision maker. As an adviser, having to deal with multiple products, platforms and technologies is not efficient for your business but it protects your clients from the worst.

With the Cyprus crisis the European Union has all but stated that any deposits over $100,000 are not safe. If your client has over that amount in cash deposits they should spread it across the different banking groups (click here for the full list). They should be safe for up to £850,000 by our calculation.

Lastly, just to step up the doomsday scenario, we must ask whether we can even trust our own government. Paul Mason from the BBC doesn’t seem to think so. So it’s probably wise to have some money/investments offshore too. Don’t forget financial repression has happened before.