Curated Content Luxembourg: AIFMD II: Liquidity Management Tools – Latest Developments

Discover our analysis of the latest developments in the AIFMD II legislative process regarding liquidity management tools.

We provide a practical explanation of changes, amendments and additions proposed for the revised AIFMD. The analysis is made from three angles: the European Commission Proposal of 21 November 2021, the European Parliament Draft report of 16 May 2022 and the European Council Position of 17 June 2022.

European Commission proposed directive - Liquidity management tools

LMTs allow AIFMs of open-ended alternative investment funds to manage redemption pressure in exceptional circumstances such as stressed markets, black swan events and other low-probability events that may have a major financial impact on either an AIFM or an AIF or other areas of the financial markets. LMTs may therefore protect either financial market participants or global financial stability, but they may not be used in the best interests of investors.

The AIFMD II aims to regulate and harmonise LMTs at the EU level.

AIFMs of open-ended AIFs based in any member state must choose at least one LMT from the harmonised list in Appendix V points 2 to 4 of the Commission proposal (i.e. redemption gates, notice periods or redemption fees).

Member states shall ensure that at least the LMTs set out in Appendix V are available to AIFMs managing open-ended AIFs:

• Suspension of redemptions and subscriptions.
• Redemption gates.
• Notice periods.
• Redemption fees.
• Swing pricing.
• Anti-dilution levy.
• Redemptions in kind.
• Side pockets.

The LMT(s) selected by the AIFM should be appropriate and used in the interest of the AIF's investors based on the suitability of the LMT(s) for the fund's investment strategy, liquidity profile and redemption policy.

In the interest of AIF investors, an AIFM that manages an open-ended AIF may temporarily suspend the repurchase or redemption of units or activate redemption gates, notice periods and redemption fees if these LMTs are included in the fund rules or the articles of incorporation of the AIFM. The temporary suspension is an option strictly limited to exceptional cases and circumstances and should always be justified according to the interests of the AIF's investors.

An AIFM should promptly notify the regulatory authorities of its home member state when activating or deactivating redemption gates, notice periods or redemption fees. The regulatory authorities of the AIFM's home member state should notify without delay the regulatory authorities of a host member state of the AIFM, ESMA and ESRB of any notifications received regarding the activation and deactivation of LMTs.

LMTs should be activated and deactivated based on detailed policies and procedures explaining the operational and administrative arrangements for their use.

Redemption fees are defined as fees charged to investors when redeeming their fund's shares or units.

Redemption gates are defined as a temporary restriction of the right of shareholders to redeem their shares. This restriction may be full, in which case investors cannot redeem their shares or units at all, or partial, where the investors can only redeem a certain portion of their shares or units.

In the interest of investors or of the public, national regulators may require an AIFM to activate or deactivate an LMT, such as suspension of redemptions and subscriptions and redemption gates or another LMT selected by the AIFM as considered the most suitable given the type of open-ended AIF or group of open-ended AIFs concerned, and investor protection or financial stability risks that necessitate this requirement.

ESMA may require non-EU AIFMs that are marketing AIFs that they manage in the union, or EU AIFMs managing non-EU AIFs, to activate or deactivate certain LMTs, the suspension of redemptions and subscriptions and redemption gates or another LMT selected by the AIFM as considered the most suitable given the type of open-ended AIF or group of open-ended AIFs concerned, and investor protection or financial stability risks.

ESMA should develop draft regulatory technical standards on criteria for the selection and use of suitable LMTs by AIFMs for liquidity risk management, including appropriate disclosures to investors, for adoption by the European Commission.

ESMA should develop draft RTS to specify the characteristics of the eight LMTs detailed above.

EU Parliament draft report - Liquidity management tools

AIFMs of open-ended AIFs based in any member state are required to choose at least one LMT from the harmonised list set out in Appendix V under points 2, 3, 4, 5, 6 and 8) (i.e. redemption gates, notice periods, redemption fees, swing pricing, anti-dilution levy and side-pockets). The European Parliament draft report added the last three LMTs.

An AIFM that manages an open-ended AIF may, in the interest of the AIF's investors, temporarily suspend the repurchase or redemption of the AIF's shares or units or activate redemption gates, notice periods and redemption fees, swing pricing, anti-dilution levy or side-pockets if these LMTs are cited in the fund rules or the articles of incorporation of the AIFM. Similarly, the final three LMTs have been added by the European Parliament draft report .

An AIFM should promptly notify the regulatory authorities of its home member state when activating or deactivating one of the following LMTs in situations of liquidity stress: the suspension of redemptions and subscriptions, redemption gates, notice periods or redemption fees. The references to situations of liquidity stress and suspension of redemptions and subscriptions have been added by the European Parliament draft report . The regulatory authorities of the AIFM's home member state should notify, without delay, the regulatory authorities of a host member state of the AIFM and ESMA. The European Systemic Risk Board should be notified only if there is a potential risk to the stability and integrity of the financial system. The restriction of the ESRB notification to such cases differs from the Commission proposal, a difference commensurate with ESRB's mission.

The European Parliament draft report has deleted the draft RTS specifying the characteristics of the LMTs, replacing them with draft RTS from ESMA on the criteria to be used by regulatory authorities for determining whether an AIF demonstrates liquidity robustness .

The draft RTS from ESMA on criteria for the selection and use of suitable LMTs by AIFMs for liquidity risk management is maintained in the European Parliament draft report. However, the latter provides that the RTS should recognise that the primary responsibility for liquidity risk management remains with the AIFM. They would also allow adequate time for adaptation before they apply, in particular, for existing AIFs.

In exceptional circumstances and after consulting the AIFM, national regulators may require an AIFM to activate or deactivate an LMT, such as suspension of redemptions and subscriptions and redemption gates or another LMT selected by the AIFM as considered the most suitable given the type of open-ended AIF or group of open-ended AIFs concerned, if financial stability risks that necessitate this requirement, in the interest of investors. The European Parliament draft report refers only to the interest of investors, not the public. Moreover, this power given to regulators is restricted to exceptional circumstances and consultation of the AIFM, whereas they are not mentioned in the Commission proposal. The LMT to be activated or deactivated should be the most suitable considering the type of open-ended AIFs and if financial stability risks necessitate this requirement. These two criteria are cumulative in the European Parliament draft report. In contrast, in the Commission proposal, suitability to the type of open-ended AIFs and investor protection are alternative to financial stability risks. The similar power for ESMA included in the Commission proposal has been deleted in the European Parliament draft report.

The definition of redemption gates by the European Parliament draft report is similar to that in the Commission proposal. However, the temporary restriction of the right of shareholders to redeem their shares or units cannot be full, only partial, stipulating that investors can redeem a certain portion of their shares or units.

The redemption fee is defined as a pre-determined fee charged to investors when redeeming the fund's units or shares. The European Parliament draft report requires a redemption fee to be pre-determined, whereas the Commission proposal does not.

The Commission proposal and the European Parliament draft report define the anti-dilution levy similarly. However, the European Parliament draft report adds the following requirement: calculation of the anti-dilution levy should consider ongoing liquidity costs and market conditions.

The Council position - Liquidity management tools

After assessing suitability with regard to the investment strategy pursued, the liquidity profile and redemption policy, an AIFM that manages an open-ended AIF should select at least two appropriate LMTs from the list set out in Appendix V, points 2 to 7 (i.e. redemption gates, notice periods, liquidity fees on redemption, swing and/or dual pricing, anti-dilution levy, and redemptions in kind) for possible use in the interests of the AIF's investors. By way of derogation, the AIFM may select only one LMT from Appendix V points 2 to 7 for an AIF it manages, if that AIF is authorised as a money market fund according to Regulation (EU) 2017/1131. The Commission proposal and European Parliament draft report refer to only one LMT, among different lists of LMTs, without mentioning money market funds. By contrast, the Council position includes special provisions applying to the money market funds, and it is the only one to include dual pricing in appendix V.

Under the Commission proposal, the AIFM should implement detailed policies and procedures for the activation and deactivation of any selected LMT and the operational and administrative arrangements for using such a tool. However, the Council position requires the AIFM to communicate such a decision and relevant explanations to the regulatory authorities of the AIF's home member state.

Redemption in kind, as referred to in Appendix V point 7, can be activated only to meet redemptions requested by professional investors and if the redemption in kind corresponds to a pro rata share of the assets held by the AIF. By way of derogation, the redemption in kind may not correspond to a pro rata share of the assets held by the AIF if that AIF is solely marketed to professional investors or whose investment policy is to replicate the composition of a particular stock or debt securities index, and additionally if that AIF is an exchange-traded fund as defined by MiFIR article 2(26). This provision is mentioned only in the Council position.

An AIFM that manages an open-ended AIF may, in the interest of its investors, temporarily suspend the repurchase or redemption of the AIF's units or shares, or activate or deactivate other LMTs from the list set out in Appendix V points 2 to 7, and included in the fund rules or the articles of incorporation of the AIF. In the interest of AIF investors, to ensure subscriptions and redemptions are processed at a fair price, the AIFM may also activate side-pockets, as referred to in point 8 of Appendix V, in situations where the AIFM cannot ensure fair and accurate valuation of some assets or where some assets have become non-tradable. The temporary suspension and activation of side-pockets may be carried out only in exceptional cases where circumstances so require, and they are justified with regard to the interests of investors.

An AIFM should, without delay, notify the regulatory authorities of its home member state when activating or deactivating the suspension of redemptions and redemption gates referred to in points 1 and 2 of Appendix V. The Commission proposal provides for such notification in relation to three LMTs, and the European Parliament draft report requires notification for four LMTs.

An AIFM should notify the same regulatory authorities when activating or deactivating side-pockets, as referred to in point 8, in a reasonable timeframe before the activation or deactivation of this LMT . A member state may require notification from the AIFM to the regulatory authorities of the AIFM's home member state when the AIFM decides to activate redemption in kind, extend the notice period or increase the liquidity fee, the cap of the swing factor of the swing pricing or the anti-dilution levy fee set out in the fund prospectus, or increase the bid-ask spread in dual pricing for liquidity management purposes. This wording is only included in the Council position.

The regulatory authorities of the AIFM's home member state member should notify, without delay, the regulatory authorities of a host member state of the AIFM and ESMA of any notifications received under this paragraph and, if there are potential risks to the stability and integrity of the financial system, the European Systemic Risk Board . The approach of the Council position regarding notification of the ESRB is similar to that in the European Parliament draft report.

Member states should ensure that at least the LMTs set out in Appendix V are available to AIFMs managing open-ended AIFs, namely:

• Suspension of redemptions and subscriptions.
• Redemption gates are defined as partial, not full, as in the European Parliament draft report .
• Notice periods.
• Liquidity fees.
• Swing and/or dual pricing. Dual pricing only appears in the Council position.
• Anti-dilution levy.
• Redemption in kind.
• Side-pockets.

The Council position does not amend the power of regulatory authorities to require AIFMs to activate or deactivate certain LMTs. In contrast, it is amended in the Commission proposal and the European Parliament draft report. Therefore, article 46(2) point j is not modified in the Council position, meaning that the regulatory authorities may require suspension of the issue, repurchase or redemption of shares or units in the interest of shareholders/unitholders or the public, as it is already the case in the current version of the AIFMD.

ESMA should develop draft RTS to specify the characteristics of the LMTs set out in Appendix V, as included in the Commission proposal but deleted from the European Parliament draft report.

ESMA should draw up guidelines determining criteria for selecting and using appropriate LMTs by AIFMs for liquidity risk management, including proper disclosures to investors, considering the capability of such tools to reduce undue advantages for investors that redeem their investments first and to mitigate financial stability risks. The Commission proposal and the European Parliament draft report refer to draft RTS to be drawn up by ESMA, not guidelines. These guidelines should also indicate the circumstances in which side-pockets can be activated.

The power of ESMA to require the activation or deactivation of certain LMTs by non-EU AIFMs that are marketing AIFs that they manage within the union or EU AIFMs managing non-EU AIFs is not added by the Council position nor the European Parliament draft report, but it is by the Commission proposal.

Regarding the cooperation obligation , the Council position requires notification of the ESRB in various cases, but only if there are potential risks to the stability and integrity of the financial system . By contrast, the Commission proposal does not refer to the stability and integrity of the financial system. Although the Commission proposal requires ESMA to draw up draft RTS indicating in which situations the regulatory authorities may exercise the powers set out in Article 46(2) point (j), the Council position requires ESMA to draw up guidelines.

Next steps in the legislative process

The legislation is currently at the committee stage in the European Parliament, and the Committee on Economic and Monetary Affairs will vote on its position for negotiations. The Council must also publish its negotiation mandate. The trialogue negotiations will begin once these positions have been adopted. The provisional agreement resulting from the trialogue must then be voted on by both Parliament and Council.

The amendments and additions provided by the Commission proposal, the European Parliament draft report, and the Council position should lead to the strengthening and growth of the European alternative investment fund sector. They should help to make capital more accessible in Europe. The level 2 legislation should also provide additional clarity. We expect AIFMD II to come into force in 2025.

Discover our AIFMD II timeline and analysis for the latest developments in the AIFMD II legislative process: https://www.cs-avocats.lu/publications/aifmd-ii-latest-developments/

This timeline also covers the following areas: loan origination, delegation, distribution and national private placement regimes, depositaries, activities and services performed by AIFMs and investor protection.

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.