Further Liquidity Regulatory Scrutiny Needed

Last month it was great to see a number of key liquidity risk management developments finally enter into force, including:

ESMA’s new guidelines on liquidity stress testing in UCITS and AIFs
The FCA’s new rules for certain open-ended funds investing in inherently illiquid assets; and
Article 37 MMF Reporting for both Q1 and Q2

Additionally, continuing the liquidity theme, September also saw the Canadian Securities Administrators (CSA) publish guidance on effective liquidity risk management.

Liquidity risk management, where investment funds are not able to sell assets quickly enough to reimburse fleeing investors, was propelled into the spotlight this year by the COVID-19 pandemic. Although the above developments are all positive steps to address liquidity risk management in the fund industry, more is still needed to protect investors and preserve financial stability.

Information Requests

COVID-19 clearly intensified the requirements for a robust liquidity risk management framework. At the start of the pandemic, regulators across the EU began requesting liquidity information from asset managers in varying manners, for example:

Luxembourg: The CSSF launched a questionnaire to provide the CSSF with weekly updates on financial data (total net assets, subscriptions and redemptions) and an update on governance arrangements in relation to the activities performed by IFMs.
Ireland: Central Bank of Ireland issued a UCITS liquidity questionnaire which was required to be completed by March. They also requested the prompt notifications from any manager facing a liquidity crunch demanding significant action.
United Kingdom: In August, the FCA and BoE launched a survey to review the liquidity mismatch in open-ended funds, requesting completion by 30th September 2020.
France: The AMF requested daily updates of any breaches of investment restrictions and the use of liquidity risk management tools such as swing pricing.

This approach by EU regulators at the start of the pandemic, clearly as a collective anticipating a liquidity crunch, however, without any form of collective coordinated harmonised oversight, clearly displays crucial shortcomings at an EU level. Below we’ll discuss some of these shortcomings.

EU Shortcomings

UCITS

To begin with, given UCITS are the premier European Retail funds product, there are a number of obvious omissions from the regulation concerning liquidity risk management. These include:

No definition of illiquid assets / liquid assets
No specified maximum % in illiquid assets
No standardised comparative liquidity risk indicators
No formalised regulatory or investor reporting in respect of liquidity

Consistency

Another shortcoming we have previously discussed, is the lack of consistency between the UCITS and AIFMD regimes. It was great to see ESMA raise this issue in their recent letter reviewing AIFMD. In the letter, ESMA mentioned the need for greater harmonisation between the UCITS and AIFMD framework, and in particular, the different level of granularity with respect to liquidity risk management requirements.

The follows the ESRB recommendations, which suggest bringing the UCITS Directive closer to the requirements under AIFMD and the EU MMF Regulation. In their recommendations, they stated that reporting should cover at a minimum:

The value of assets under management for all UCITS managed by a management company;
Instruments traded and individual exposures;
Investment strategy;
Global exposure/leverage;
Stress testing;
Efficient portfolio management techniques;
Counterparty risk/collateral;
Liquidity risk;
Credit risk; and
Trading volumes.

The Commission is due to report on the implementation of these recommendations by the end of the year.

Methodology

An oversight in both recommendations is that neither UCITS nor AIFMD specify a specific methodology for calculating liquidity, including:

Trading volumes
Capture rates
Fixed income approaches

This in contrast the US SEC Liquidity Risk Management Framework requirements which set out a specific methodology to be followed, although that methodology is not without its shortcomings.

The European fund markets are far too intertwined, with repercussions felt throughout when there are failures in one jurisdiction. With this in mind, it is quite incredible that EU Regulators have still not implemented a coordinated, harmonised approach to oversight of investment funds’ liquidity. This doesn’t need to be too disruptive – regulators should agree a straight-forward, consistent calculation of funds liquidity.

For example:

To require calculation and reporting of the percentage of a portfolio that can be liquidated in (i) 1 day and (ii) in 7 days.
To require a simplistic methodology to be followed; e.g.
– Equities based on 60-day average weighted traded volumes and an assumed market capture rate of 25%.
– Fixed income – based on yield and the % of owned of the debt in issues.
– Funds invested into – based on their redemption frequency, with adjustments where there are known issues (e.g. for suspended property funds).

Whilst it may not be perfect, an agreed simplistic method would provide consistency of approach and meaningful oversight.

On a positive note, last week ESMA published its 2021 Work Programme (WP) setting out its priorities and areas of focus for the next 12 months. Part of their key objectives includes achieving greater convergence and consistency of NCAs’ supervisory approaches and practices in relation to the EU legislation on investment management, with a particular focus on improving investor protection and financial stability through ESMA’s work on funds’ liquidity.

With liquidity scrutiny set to continue, fund managers should be prepared to deal with increased levels of reporting requirements. They should have in place appropriate liquidity risk management policies and procedures to meet future heightened reporting. The huge amount of data needed to be put together to meet liquidity risk management reporting requirements, means that technology is a must. Our automated liquidity risk management solution is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into product governance, throughout the product lifecycle.