UK: FCA Advises Hedge Funds On Managing And Disclosing Liquidity

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.

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