Liquidity Risk Management

Regulatory Obligations and Related Considerations

Regulatory Obligations:

Effective liquidity controls are critical elements in a broker-dealer’s risk management framework. Exchange Act Rule 17a-3(a)(23) requires firms that meet specified thresholds to make and keep current records documenting the credit, market and liquidity risk management controls established and maintained by the firm to assist it in analyzing and managing the risks associated with its business.

FINRA routinely reviews and has shared observations on firms’ liquidity risk management practices, as discussed in Regulatory Notice 15-33 (Guidance on Liquidity Risk Management Practices) and Regulatory Notice 21-12 (FINRA Reminds Member Firms of Their Obligations Regarding Customer Order Handling, Margin Requirements and Effective Liquidity Management Practices During Extreme Market Conditions). Additionally, FINRA has adopted a new filing requirement—the Supplemental Liquidity Schedule—for firms with large customer and counterparty exposures. As noted in Regulatory Notice 21-31 (FINRA Establishes New Supplemental Liquidity Schedule (SLS)), the new SLS is designed to improve FINRA’s ability to monitor for potential adverse changes in these firms’ liquidity risk.

Related Considerations:

  • What departments at your firm are responsible for liquidity management?
  • How often does your firm review and adjust its assumptions regarding clearing deposits in its liquidity management plan and stress test framework? 
  • Does your firm’s liquidity management practices include processes for:
    • accessing liquidity during common stress conditions—such as increases in firm and client activities—as well as “black swan” events;
    • determining how the funding would be used; and
    • using empirical data from recent stress events to increase the robustness of its stress testing?
  • Does your firm’s contingency funding plan take into consideration the amount of time needed to address margin calls from both customers and counterparties? Does your firm also take into consideration the type of transactions that are impacting the firm’s liquidity?
  • What kind of stress tests (e.g., market or idiosyncratic) does your firm conduct? Do these tests include concentration limits within securities or sectors, and incorporate holdings across accounts held at other financial institutions?

Exam Observations and Effective Practices

Exam Observations:

  • Not Modifying Business Models – Failing to incorporate the results of firms’ stress tests into their business model.
  • Establishing Inaccurate Clearing Deposit Requirements – Incorrectly basing clearing deposit requirements on information that doesn’t accurately represent their business operations (e.g., using the amounts listed on FOCUS reports rather than spikes in deposit requirements that may have occurred on an intra-month basis).
  • No Liquidity Contingency Plans – Failing to develop contingency plans for operating in a stressed environment with specific steps to address certain stress conditions, including identifying the firm staff responsible for enacting the plan and the process for accessing liquidity during a stress event, as well as setting standards to determine how liquidity funding would be used.

Effective Practices:

  • Liquidity Risk Management Updates – Updating liquidity risk management practices to take into account a firm’s current business activities, including:
    • establishing governance around liquidity management, determining who is responsible for monitoring the firm’s liquidity position, how often they monitor that position and how frequently they meet as a group; and
    • creating a liquidity management plan that considers:
      • quality of funding sources;
      • potential mismatches in duration between liquidity sources and uses;
      • potential losses of counterparties;
      • how the firm obtains funding in a business-as-usual condition and stressed conditions;
      • assumptions based on idiosyncratic and market-wide conditions;
      • early warning indicators and escalation procedures if risk limits are neared or breached; and
      • material changes in market value of firm inventory over a short period of time.
  • Stress Tests – Conducting stress tests in a manner and frequency that consider the complexity and risk of the firm’s business model, including:
    • assumptions specific to the firm’s business (e.g., increased haircuts on collateral pledged by firm, availability of funding from a parent firm) and based on historical data;
    • the firm’s sources and uses of liquidity, and if these sources can realistically fund its uses in a stressed environment;
    • the potential impact of off-balance sheet items (e.g., non-regular way settlement trades, forward contracts) on liquidity; and
    • periodic governance group review of stress tests.

Additional Resources

  • Regulatory Notice 21-31 (FINRA Establishes New Supplemental Liquidity Schedule (SLS))
  • Regulatory Notice 21-12 (FINRA Reminds Member Firms of Their Obligations Regarding Customer Order Handling, Margin Requirements and Effective Liquidity Management Practices During Extreme Market Conditions)
  • Regulatory Notice 15-33 (Guidance on Liquidity Risk Management Practices)
  • Regulatory Notice 10-57 (Funding and Liquidity Risk Management Practices)
  • FINRA’s Funding and Liquidity Topic Page
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