The CSSF tells Luxembourg regulated funds how they should do the swing – swing pricing, that is
On 30 July 2019, the CSSF1 published its answers to frequently asked questions (together, the "FAQ") regarding the swing pricing mechanism (the "SPM").
The principles articulated in the FAQ apply to Luxembourg regulated funds employing the SPM, i.e. (1) undertakings for collective investment in transferable securities ("UCITS") subject to part I of the Law of 17 December 2010 on undertakings for collective investment (the "UCI Law"), (2) undertakings for collective undertakings subject to part II of the UCI Law ("Part II UCIs") and (3) specialized investment funds ("SIFs"; together with the UCITS and the Part II UCIs, the "Regulated Funds") subject to the Law of 13 February 2007 (the "SIF Law").
The FAQ address (1) investor disclosure, (2) the net asset value ("NAV") calculation error under the CSSF Circular 02/772 , as well as (3) relevant internal governance matters concerning the SPM.
This note first sheds light on the basic principles of the SPM. We then take a look at the SPM's application in the Grand Duchy. The third part outlines the essential content of the FAQ, followed by our estimate of their market impact in the fourth part. In the final part, we try to situate the FAQ within the current developments in fund management.
1. Swing pricing fundamentals3
a. NAV and dilution
Swing pricing forms part of the NAV calculation process. The NAV is in essence calculated as the difference between the fund's assets (e.g. investments) and its liabilities (e.g. fees of the investment fund manager (the "IFM") and the fund's service providers). The NAV fluctuates to reflect the positive or negative performance of the assets on the one hand and the negative impact of the fund's liabilities on the other.
When the NAV is divided by the number of shares/ units/partnership or other ownership interests held by the investors (the "Shares"), the NAV per Share value is obtained. The NAV per Share facilitates the valuation of the investors' respective holdings and, as a consequence, transactions in the Shares.
If the NAV per Share is calculated correctly4, the trading investors know that they are being treated fairly when they purchase and redeem the Shares from a fund5 and the buy-and-hold investors know their Shares are being valued fairly. However, a problem may arise when the Shares are singlepriced, i.e. when investors can subscribe for and redeem the Shares at the same NAV per Share without paying any transaction charges.
Whereas the IFM can handle limited investor trading6 in the Shares ("Trading") by using available cash buffers, the IFM needs to compensate for Trading which exceeds available cash by buying the underlying assets with cash inflows from subscriptions or by selling the fund's assets to meet the redemptions. This activity may generate costs for a fund in several ways. subscriptions or by selling the fund's assets to meet the redemptions. This activity may generate costs for a fund in several ways.
First, the NAV for Trading is determined using the mid- or last-traded prices of the underlying securities7 . Conversely, the IFM buys the underlying securities at higher offer prices and sells them at lower bid prices. This price difference is called the "spread effect", which frequently increases with the size of the trade (the so-called market impact).
Moreover, the fund incurs additional costs associated with the transactions in underlying assets, such as commissions and taxes. In sum, the actual costs of subscribing or redeeming a Share may be higher or lower than the current NAV per Share. Because the incoming and outgoing investors pay no transaction charges, the bill has to be picked up by the remaining investors. Hence, Trading can have a material detrimental effect on the holdings of the remaining investors, especially when occurring at significant volumes.
One needs to bear in mind that a fund also incurs transaction costs when the IFM is pursuing the fund's investment policy. Nonetheless, while current investors accept those costs, they are not supposed to suffer dilution caused by actively trading investors.
1 Commission de Surveillance du Secteur Financier, the Luxembourg banking and financial markets supervisor.
2 Concerning the protection of investors in case of NAV calculation error and compensation of the consequences resulting from non-compliance with the investment rules applicable to undertakings for collective investment.
3 This part is largely based on (1) the Luxembourg investment fund association's ("ALFI") third edition of its swing pricing guidelines issued in May 2016 (document available to ALFI members only), (2) LEWRICK, Ulf and SCHANZ, Jochen. "Is the price right? Swing pricing and investor redemptions". Bank for International Settlements Working Papers N° 664, 2017 and (3) MALIK, Sheheryar and LINDNER, Peter. "On Swing Pricing and Systemic Risk Mitigation". IMF Working Paper 17/159, 2017.
4 Considerations around the exact methodology of the NAV's calculation go beyond the scope of this note.
5 For the purposes of this note, we disregard transfers between the investors themselves as the Regulated Funds are in principle obliged to sell and buy back the Shares at the investor's request.
6 The net value of subscription, redemption and switch orders transferred by the investors for a single fund on any trading day.
7 Open-ended Regulated Funds as a rule invest in liquid securities so that they are able to meet the requests of the trading investors at short notice.
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