The U.K.'s Financial Conduct Authority ("FCA")
recently advised investment managers that liquidity risks in their
funds must be managed appropriately and properly disclosed to
investors.
The U.K.'s financial regulator, along with the Bank of England,
completed a comprehensive review of large investment management
firms, with the intent of achieving a better understanding of their
liquidity management practices. The results of that review were released on Feb. 29 with an accompanying
update recommending best practices for investment managers to
manage liquidity in their funds. Even though the effort originated
as an examination of open-ended funds investing in the fixed-income
sector, the FCA's conclusions expressly apply across the entire
investment fund industry.
Due to the challenging conditions of recent years – including
market instability and persistently low interest rates – the
FCA stated that liquidity management is a "particularly
timely" consideration. With that in mind, the authors of the
report highlighted three areas to assist firms' assessments of
their own liquidity management:
- Tools, processes and underlying
assumptions – require continuous reassessment and updating to
ensure they remain suitable for market conditions;
- Operational preparedness – a
high degree of reassurance that tools, particularly extraordinary
measures, can be implemented smoothly when required; and
- Disclosure – clear and full disclosure to fund investors on liquidity risks and the tools available to the fund to manage those risks, such as swing pricing, deferred redemption and suspension.
While the FCA acknowledged that some difference will exist
between the level of liquidity indicated by most funds'
prospectuses and that of the specific underlying securities the
funds hold, sound liquidity management by fund managers will limit
the effect of this difference in order to reduce the risks to their
investors' ability to redeem. However, the FCA nonetheless
expects managers to ensure investors are "informed about the
nature and size of these risks through the fund
documentation," in accordance with existing requirements.
Since informed investors are able to make better decisions during
periods of market instability, the FCA states they are also less
likely to seek redemption during such times, which would in turn
reduce liquidity risks.
The FCA advised that proper disclosure of liquidity risk should
make clear the potential impact of low liquidity in portfolio
holdings on the volatility of fund investment returns; the ability
of the fund manager to use specific tools or exceptional measures
that could affect investors' redemption rights, and an
explanation of the situations in which they would be used; and a
description of these tools and measures as well as their potential
impact on investors. The regulator visited a large number of financial firms while
conducting its research, during which time it uncovered several
"good practices" on liquidity risk management and
oversight.
These included the following:
- Processes to ensure that the fund
dealing (i.e., subscriptions and redemptions) arrangements are
appropriate for the investment strategy of the fund. One example
cited was a product design stage that included a review of the
dealing frequency offered by prospective funds. This review
withheld product approval where the fund's investment strategy
and portfolio composition were inappropriate for the proposed
dealing timetable. Another example was the periodic review of
existing productsto ensure the fund dealing timetable remained
appropriate;
- A regular assessment of liquidity
demands, including redemptions, collateral calls and other fund
obligations;
- An ongoing assessment of the
liquidity of portfolio positions. Since liquidity characteristics
can change significantly over time and various market conditions,
portfolio liquidity assessments need to be updated accordingly. For
those portfolio holdings for which it can be difficult to obtain
reliable estimates of their liquidity, it is advisable for firms to
use a range of sources to assess their liquidity, including
external data feeds and input from internal trading
functions;
- Classification by investment managers
of fund holdings into liquidity buckets, defined by the estimated
time needed to dispose of the particular portfolio position. These
buckets may be used to indicate whether the liquidity of the
position is high, medium or low. Limits are then applied to
determine the total portfolio exposure to each bucket. These limits
should be adjusted over time to reflect changing market
conditions;
- Regular monitoring of bucket
exposures with an independent risk function that reports breaches
to the set limits, allowing the manager to respond according to
circumstances. In some instances, good practice included the
application of hard limits, requiring immediate action, and soft
limits, where the position is reviewed and the limit overruled
where appropriate and subject to the required approval
process;
- The use of stress testing by fund managers to assess the impact of extreme, but plausible, scenarios on their funds. Stress tests assess the impact of a range of factors, both in isolation and in combination, on their funds' ability to meet redemption requests. The results are used to inform investment decisions and, where appropriate, the level of limits on portfolio liquidity. Factors that are commonly stressed include (i) the volume of redemptions – funds are tested to determine the impact of the trades that would be required to meet redemptions, in terms of both time frames and investment performance – and (ii) market conditions – funds are tested against market stress situations that could severely reduce the ability of the fund to transact with other market participants.
The FCA's update also included good practices specifically
related to funds' handling of redemptions and related
transaction costs. It stated that good management reduces the costs
to remaining investors and removes incentives for redeeming early,
which can cause other investors to follow suit and create liquidity
pressures on the manager. Furthermore, effectively communicating
these policies to investors is essential. Other good practices the
FCA observed included the readjustment of managers' portfolios
following redemptions in order to ensure ongoing liquidity and the
establishment of a governing process — including the creation
of internal guidelines, measures and tools used in decision-making
—whereby the interests of all investors are protected.
Finally, while most funds are never required to use them, the FCA
advised they nonetheless develop and maintain tools and procedures
related to exceptional liquidity measures.
The FCA isn't the only regulator emphasizing the importance of
liquidity risk management. In the U.S., the Securities and Exchange
Commission ("SEC") released a proposed rule on open-end fund liquidity risk
management programs in September 2015. The rule would require
mutual funds and exchange-traded funds to create new programs to
improve their liquidity management and ensure they are able to meet
redemption requests during periods of market stress. The proposed
rule marked the first SEC guidance on the subject of liquidity in
more than two decades, demonstrating the level of prominence
currently being given to the topic. As a result, fund managers can
expect regulators on both sides of the Atlantic to continue their
efforts to establish and monitor fund liquidity regimes in order to
boost transparency and better protect investors.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.