Although liquidity risk management practices vary in different jurisdictions, in most cases, asset managers are required to monitor the liquidity of the fund on a frequent basis. Whilst many aspects of the regulations are broadly similar, differences can be seen from what is considered “liquid”, and around methodology to liquidity buckets, stress testing and reporting requirements.
In Europe for example, neither UCITS nor AIFMD specify a specific methodology for calculating liquidity. This is in contrast to 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.
As well as the calculation differences, another notable key difference is in the liquidity buckets used for monitoring and reporting purposes. UCITS for example makes reference to liquid assets and highly liquid assets for different aspects of the regulation, but contains no specific bucketing of liquidity for monitoring or for reporting purposes. In contrast, AIFMD and the US liquidity rules set out monitoring buckets, albeit the buckets are entirely different.
Over the next few weeks, we will be taking a brief look at the different liquidity requirements for a number of regulatory regimes across the globe, including the requirements in Europe under AIFMD, UCITS and MMF Regulation, the SEC liquidity requirements and few others of note from further afield.
This week, to start us off, we will review the liquidity risk management regime in Hong Kong and their regulatory response to COVID-19.
The Securities and Futures Commission (SFC) has been very proactive in the liquidity risk management space for some time. In 2016, the SFC issued a circular to management companies of SFC-authorised funds on liquidity risk management.
The following year, the SFC published a circular containing common instances of non-compliance in managing funds and discretionary accounts. Included in the examples of instances of non-compliance was the failure to put in place proper liquidity risk management processes to ensure that liquidity risks of funds and discretionary accounts under management are adequately addressed.
Fund Manager Code of Conduct
In 2018, the amended Fund Manager Code of Conduct (FMCC) became effective. On liquidity risk management, it provides that a Fund Manager should:
- Establish, implement and maintain appropriate and effective liquidity risk management policies and procedures to monitor the liquidity risk of the fund, taking into account the investment strategy, liquidity profile, underlying assets and obligations, and redemption policy of the fund;
- Integrate liquidity risk management in investment decisions;
- Regularly assess the liquidity of the assets of a fund;
- Regularly assess the liquidity profile of the fund’s liabilities;
- Regularly conduct assessments of liquidity in different scenarios, including stressed situations, to assess and monitor the liquidity risk of the funds accordingly; and
- Disclose the liquidity risks involved in investing in the fund, the liquidity management policies, and an explanation of any tools or exceptional measure that could affect redemption rights in the fund’s offering document or otherwise make such information freely available to fund investors.
The FMCC also provides suggested risk-management control techniques and procedures for funds which provides that a Fund Manager should set and enforce concentration limits with respect to the funds’ investments, collateral, markets and business counterparties, taking into account the respective liquidity profile and the fund’s approved liquidity risk policies.
Furthermore, it provides that a Fund Manager should establish and regularly monitor measures of liquidity mismatches between the funds’ underlying investments and their redemption obligations using quantitative metrics or qualitative factors.
In assessing the liquidity of the assets of a fund, a Fund Manager should consider:
- Obligations to creditors, counterparties and third parties;
- The time to liquidate assets;
- The price at which liquidation could be effected;
- Financial settlement lag time; and
- The dependence of these considerations on other market risks and factors
Enhanced Fund Data Reporting
In June 2018, the SFC announced the launch of enhanced reporting requirements requiring SFC-authorized funds to provide quarterly reports on:
- The liquidity profile of the Fund’s assets with reference to the liquidity categories;
- The Fund’s subscription and redemption amounts; and
- The Fund’s asset allocation (with reference to a breakdown of major asset classes by country, asset quality and listing venue etc.).
Code on Unit Trusts and Mutual Funds
The Code includes a general obligation for management companies to maintain and implement effective liquidity risk management policies and procedures (including stress testing, where applicable) to monitor the liquidity risk of the scheme, taking into account factors including the investment strategy and objectives, investor base, liquidity profile, underlying obligations and redemption policy of the scheme.
It also includes a number of requirements that promote liquidity, including the requirement that the value of a scheme’s investments in securities and other financial products or instruments that are neither listed, quoted nor dealt in on a market may not exceed 15% of its total net asset value.
SFC Regulatory Response to COVID-19
More recently, in response to the COVID-19 pandemic, the SFC issued a Circular to management companies and trustees and custodians of SFC-authorized funds reminding them to:
- Closely monitor the dealing and trading of the funds under their management.
- Keep investors informed at all times and immediately report to the SFC any untoward circumstances relating to the funds under their management, including without limitation, the use of liquidity risk management tools.
- Consider the need for any fair value adjustment (particularly in respect of less liquid or suspended securities such as high yield bonds or fixed income instruments and suspended stocks).
- Exercise due care, skill and diligence in managing liquidity of funds, in particular, ensuring that actions taken in meeting redemption obligations should not have any material adverse impact on the fund and its remaining investors.
- Use appropriate liquidity risk management tools (such as swing pricing or anti-dilution levy) to properly allocate the costs of redemption (such as transaction costs for liquidation of assets) to the redeeming investors, and to ensure fair treatment to investors who remain in the funds.
This liquidity risk blog series aims to demonstrate how liquidity issues are addressed in different jurisdictions. It highlights the importance of strong liquidity risk management policies and liquidity monitoring. Firms must ensure they have a solution which allows them to meet the liquidity requirements which are currently under such scrutiny from regulators. This scrutiny is only going to intensify in the future.
Funds-Axis offers an automated liquidity risk management solution 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.