As we steadily work through the implementation of the ESMA Liquidity Stress Testing requirements with our clients ahead of the deadline at end of September, we are having a lot of interesting conversations. One key question being discussed is around which historical market scenarios are the most appropriate to stress test the likely behaviour of their portfolios from a liquidity perspective.
Two notable points have emerged from those discussions. Firstly, many of our clients have spoken about how their portfolios have just come through a very real-life liquidity stress test in terms of the COVID crisis. This has provided far more valuable insights into the liquidity strengths and weaknesses of their portfolios versus what one usually gains from the more theoretical exercise of back testing portfolios through historical scenarios that could be deemed to be out of date.
Secondly, there is a good body of opinion amongst our clients that trying to predict the future via historical stress testing is somewhat of a pointless exercise. Arguments include: “no two crises are the same,” “the next time is always different” or the analogy that “you can’t drive a car while looking through the rear-view mirror.” The COVID crisis has given some pause for thought. “Clearly, the risk of a resurgence of the virus is still very much with us and if, unfortunately, that did happen then we suppose it would be a case of history repeating itself and thus wouldn’t markets perform similarly?”.
As is often the case, there are many divergent opinions among our clients on this point, but the response that resonated with us most was “events may well repeat themselves but it’s the outcomes that will always be different!”.
