Unlocking the Microstructure of Liquidity Risk: Understanding Interactions with Other Financial Risks and Best Practices in Oversight and Governance

Effective liquidity management and risk controls are crucial for maintaining the stability of both the global financial system and individual financial institutions. Despite consensus on this necessity, regulatory approaches have varied. Over recent decades, technological advancements have expanded the tools available for liquidity risk management. However, these innovations have also led to underestimations of actual risk exposure. This chapter aims to propose proactive policies and procedures for managing trading risk exposure and liquidity, particularly focusing on their interplay with counterparty, credit, and market risks. It offers practical solutions and internal regulations for financial operational divisions, emphasizing the unique challenges faced by trading units in both emerging and developed economies. Leveraging the author's background as a global market risk director and head of derivatives trading, this chapter offers valuable insights and guidelines for market participants, regulators, and policymakers to develop robust trading units within a sound regulatory framework. Specific techniques for managing trading risk are reviewed and adapted to the needs of developing markets, with a focus on multiple-asset proprietary portfolios. The chapter also explores the utility of trading risk models, such as Value-at-Risk (VaR), offering practical algorithms for parametric variance–covariance VaR. Guidelines for incorporating asset illiquidity into trading portfolios are provided, along with a thorough explanation of the Risk-Adjusted-Return-On-Capital (RAROC) technique. Additionally, the chapter addresses gaps in statistical data, offering solutions for incomplete and omitted statistics. In this context, this chapter presents comprehensive strategies for managing trading and liquidity risks, aiming to enhance the reliability and efficiency of financial markets in both emerging and developed economies.