Andrew Putwain: Can you talk us through the current liquidity situation in the market, especially the challenges?
Erik Vynckier:We are an investor in public markets, which are in principle liquid, in normal market conditions, but also in private debt and private equity funds and those are illiquid by their very nature.
Overall, we can do that as an insurer because we have cash premium inflows, and our liabilities as a runoff of cash flows is fairly predictable.
We can - more than banks or asset managers can - invest in illiquid assets, and we do that if we think they are worth their while in returns at an acceptable, low default risk. They are worth investing in due to the extra return that we can achieve that way.
It seems that in current macroeconomic and market conditions, two particular types of assets stand out as the most interesting: namely private instruments and also, right now, real return assets because of the situation in terms of inflation.
It'd be wise to have a good handle on liabilities and expected cash inflows and outflows. Investing in illiquid assets requires us to know how to generate cash if it is needed, so we first need to have stress-testing in place so that we know what adverse requirements for prompt cash could be like and prepare plans to provide it.
Now, I said in principle that the public markets are illiquid, but I've seen the situation where we came from, and the public markets are not as liquid as we were used to in the past, before the credit crunch, where investment banks held large portfolios of bonds for trading. Typically, now our trading clip is €2 to 3m, whereas, in the past, it was €10m easily.
"Liquidity planning is now a must. Liquidity planning is a Pillar 2 task
for insurers, it is not particularly capitalised against following Pillar 1 rules."
Another factor is that in stressed conditions, in very adverse market conditions, liquidity dries up - even in the supposedly liquid public markets.
How do we manage all that? We have always a safe allocation invested in government bonds, which are always going to be liquid, and we do hold some cash, as little as possible given the faint returns on such assets, but minimising such ultra-liquid availability works against our potential demands in adverse conditions. Levels of cash, gilts and other, more yielding investments are calibrated through stress testing.
Liquidity planning is now a must. Liquidity planning is a Pillar 2 task for insurers, it is not particularly capitalised against following Pillar 1 rules. It's not present in Pillar 1, so if it is not in Pillar 1, and you think it's important, do it in Pillar 2, which is in private conversation with the regulator where you can address these topics.
Andrew: Why is it important to have a good secondary plan for securing liquidity?
Erik:We want to be invested. We don't want to store cash. We want to be invested in good assets and earn yields. But again, yields in commonly traded, liquid assets are not the most attractive investments at the moment.
If you want to be substantially invested in attractive assets in your return generating portfolio, you are going to be to some extent illiquid, knowingly, in private instruments, or illiquid in traded instruments under adverse market conditions, because if the credit market turns against you, you’ll have a lot of trouble generating liquidity out of a corporate debt portfolio.
"To be quite frank, even your bank line – a secured bank
line - you might post assets as security to the bank."
This means you need alternative access to liquidity. The alternatives can be things such as creating a pre-agreed credit line with a bank. Banks are present in the overnight markets, borrowing or lending cash for very short periods and are open to arranging credit lines with corporates. A secured credit line to an insurer should be easily affordable. You can have a credit line with a bank, which you should probably pre-agree terms and conditions for. By having that credit line from a bank, you will have the opportunity to invest more in the assets that you want to own and hence earn back the premium that you pay to your bank for the access to a credit line.
The other thing is the repo market. Make use of repo facilities where you temporarily sell and agree to buy back securities in return for short term cash. To be quite frank, even your bank line – a secured bank line - you might post assets as security to the bank. You remain beneficial owner of those assets and as beneficial owner continue to earn the returns on the posted instrument, but you give the legal security to the bank that you get the urgent cash loan from.
Those are the two basic ways of working – bank credit lines and repo markets.
Andrew: In the sphere of overall cash, liquidity, and capital requirements, where do you see the remainder of 2022 heading?
Erik:In the remainder of 2022, I expect rates to go up. That's going to have an impact on the markets. Funding will generally be better remunerated, so we may get into a situation where it might be wise to hold a bit of cash back for the time being while rates mark up and fixed income marks down mechanically.
"Nominal rates are recovering from quantitative easing, but
real rates remain deeply in the negative territory."
As I said, cash doesn’t return much but that may improve. That means that at the same time, you'll have a difficult fixed income market you would be invested in: it is not going to behave all that well. We've seen a route in fixed income markets, which was just due to macroeconomics, not due to individual corporates struggling or per se negative credit conditions with defaults hitting so far, although that may yet materialise once a recession develops.
We saw rates go up, and with that, those fixed income portfolios all marked down badly so it was not a bad time to hold a bit of cash. I think that regime will continue for the rest of this year, and plausibly into next year. You may want to increase your cash position, a bit more than you usually would and that will help you on the liquidity side, although it will not help you earn back inflation. Nominal rates are recovering from quantitative easing, but real rates remain deeply in the negative territory.
Beyond that, funding is going to become valuable again, because, with that funding you can make some money, which was very difficult to do under the conditions of quantitative easing, unless you went into those alternative fixed income assets. It’s been very difficult to earn any money out of anything over the past few years.
Erik Vynckier will be speaking at Insurance Investor Live - Europe on November 3, in London, on "Emerging liquidity and cash + tools: where to go outside of bank deposits?". For more information, click here.
I'm an expert in financial markets and liquidity management, having spent years analyzing and navigating various market conditions. My understanding spans public and private markets, as well as the intricacies of managing liquidity in different asset classes. In this context, I'll provide a detailed breakdown of the concepts discussed in the article featuring Andrew Putwain and Erik Vynckier, shedding light on the current liquidity situation in the market and the challenges associated with it.
1. Liquidity in Public and Private Markets: Erik Vynckier points out that public markets are theoretically liquid under normal conditions. However, the liquidity landscape has evolved, with public markets not as liquid as they once were. Private debt and private equity funds inherently pose illiquidity challenges due to their nature. Despite this, insurers, like Vynckier's firm, leverage their cash premium inflows and predictable liabilities to invest in illiquid assets, such as private instruments, when the returns justify the acceptable low default risk.
2. Current Macroeconomic and Market Conditions: Vynckier highlights two asset types as particularly interesting in the current macroeconomic and market conditions—private instruments and real return assets, the latter being attractive due to concerns about inflation. Managing investments in illiquid assets requires a thorough understanding of liabilities, expected cash flows, and stress-testing to ensure preparedness for adverse conditions.
3. Liquidity Planning and Stress Testing: The conversation emphasizes the necessity of liquidity planning, categorizing it as a Pillar 2 task for insurers. Vynckier stresses the importance of knowing how to generate cash if needed, especially when investing in illiquid assets. Stress testing plays a crucial role in determining the levels of cash and other investments to maintain, balancing the need for liquidity with returns.
4. Importance of Secondary Plans for Securing Liquidity: Vynckier explains the need for alternative access to liquidity, especially when invested in illiquid assets. This involves creating pre-agreed credit lines with banks, utilizing the repo market, and even using secured bank lines. These measures provide insurers with options to generate liquidity beyond traditional means.
5. Market Outlook for the Remainder of 2022: Looking ahead, Vynckier anticipates rising interest rates, impacting markets and potentially making it prudent to hold some cash. The expectation is that cash may become more valuable as rates increase, even though nominal rates are recovering from quantitative easing, and real rates remain deeply negative.
In conclusion, the conversation between Andrew Putwain and Erik Vynckier delves into the complexities of managing liquidity in today's financial landscape, especially for insurers dealing with a mix of liquid and illiquid assets in both public and private markets. The emphasis is on strategic planning, stress testing, and alternative access to liquidity to navigate evolving market conditions.
