LOOKING BACK ON 2019
Last year clearly displayed there is a big issue in the industry concerning the liquidity mismatch. The Neil Woodford crisis in the UK put the spotlight on how products are being sold and regulated – the flagship fund managed by Neil Woodford was suspended in June 2019 due to the high concentration of illiquid assets in the portfolio. Six months later, M&G suspended its £2.5bn property funds due to redemption concerns.
Both these cases highlighted the liquidity mismatch issue – they both offered daily dealing, enabling investors to buy and sell units in the fund every day, and both held underlying assets difficult to sell quickly. It was this inability to sell the underlying assets quickly which led to the funds being forced to be suspended whilst assets were liquidated in order to meet withdrawals.
“$30 trillion is tied up in difficult-to-trade investments” – Mark Carney, the incumbent Governor of the Bank of England.
The Bank of England says open-ended investment funds pose a potential “systemic risk”. In the BoE’s Financial Stability Report for 2019, they argued that the mismatch between redemption terms and the liquidity of some funds’ assets means there is an advantage to investors who redeem ahead of others, particularly in times of stress. As part of the ongoing review by the Bank and FCA of open-ended funds, they have established that there should be greater consistency between the liquidity of a fund’s assets and its redemption terms.
In September 2019, the FCA announced new rules which enter into force 30 September 2020, requiring that investors of NURS are provided with clear and prominent information on liquidity risks, and the circumstances in which access to their funds may be restricted. This placed additional obligations on the managers of funds investing in inherently illiquid assets to maintain plans to manage liquidity risk. The rules also aimed at reducing the potential for some investors to gain at the expense of others, and reduce the likelihood of runs on funds leading to ‘fire sale’ of assets which disadvantage fund investors.
The new rules also require that NURS investing in inherently illiquid assets suspend dealing where an independent valuer determines there is ‘material uncertainty’ regarding the value of more than 20% of the fund’s assets. The lack of clarity around the definition of “material uncertainty” may result in numerous interpretations of the rules. It is therefore paramount that the reasoning behind any suspension is well documented. Although the true impact of this rule has yet to be seen, it could result in more funds being suspended, which could in turn damage investor confidence in the asset class and discourage investors from allocating to open-end property funds.
ESMA also published in September the final guidance regarding liquidity stress tests of investment funds for both AIFs and UCITS. The Guidelines become applicable on 30th September 2020 and require fund managers to stress test the assets and liabilities of the funds they manage. This includes redemption requests by investors which is the most common and important source of liquidity risk.
In November 2019, the FCA published a letter sent by the head of its Asset Management Department, Nick Miller, to the Chairs of Authorised Fund Managers (AFMs) in relation to good practices for effective liquidity management.
“Ensuring effective liquidity management in funds is a central responsibility for any Authorised Fund Manager (AFM) and it remains their responsibility even if they delegate investment management to another person.” – Dear AFM Board letter from the FCA
The letter stated that AFMs should consider their obligations on portfolio composition, asset eligibility, and liquidity management. Firms must have appropriate systems, controls and governance to oversee and manage liquidity risk. They should also review their liquidity management arrangements against the 2016 FCA good practice paper. Some felt the wording “please consider your obligations” in the letter was weak – it will be interesting to see how tough stance the FCA take to ensure good liquidity management throughout 2020 and beyond.
Similarly, the Central Bank of Ireland issued a letter to all fund management companies on 7 August 2019 issuing a timely reminder of their ongoing obligations regarding liquidity management and compliance with legislative and regulatory obligations for UCITS and AIFs. They stated that each fund under management must be appropriately calibrated to take into account dealing frequency, investment strategy, portfolio composition and investor profile, which may require daily and intra-day monitoring.
It’s not just on the UK and Irish shores that liquidity is in the spotlight, a similar concern about bond and loan mutual funds was highlighted by the US Federal Reserve in May 2019.
Furthermore, towards the end of 2019, the CSSF in Luxembourg published Circular 19/733 on liquidity risk management for open-ended undertakings for collective investment. The objective of the Circular is to implement recommendations and good practices of the International Organization of Securities Commissions on liquidity risk management for undertakings for collective investments.
Additionally, ESMA’s Steven Maijoor speaking at the EFAMA Investment Management Forum, has said that the issue of fund liquidity is at the core of ESMA’s activities.
2020 AND BEYOND
Following Steven Maijoor’s comments on liquidity at the EFAMA Investment Management Forum, ESMA have stated that in order to foster convergence and promote consistent supervision with regard to liquidity risks, they will facilitate a common supervisory action on liquidity management by UCITS. This is an exercise under which EU NCAs will agree to simultaneously conduct supervisory activity in 2020 on the basis of a common methodology to be developed together within ESMA. This initiative, along with the 2020 liquidity stress tests and the related sharing of practices across NCAs, should represent a significant supervisory effort which is expected to help ensure consistent application of EU rules on liquidity management and ultimately enhance the protection of investors across the EU.
This month the FCA published a letter outlining their view of the key risks of harm that Asset Managers pose to their customers or the markets in which they operate. In the letter, the FCA reiterate the importance of effective liquidity management and that they expect firms to take any necessary or appropriate actions. Furthermore, where the FCA identify potential liquidity issues in funds, including through regular interaction with depositaries, they will ensure that AFMs take prompt action to mitigate or resolve them.
It would appear national supervisors across Europe are taking an active stance on liquidity with the French AMF proposed review and analysis of macro-stress tests in asset management. The Belgian and Dutch regulators are also investigating how to deal with funds not having sufficient emergency liquidity tools to deal with volatile markets.
Further afield Hong Kong’s Securities and Futures Commission emphasised the importance of sound risk management for fund managers during times of market volatility. Specifically, in the bulletin also published this month, liquidity associated with exposures to illiquid assets is highlighted along with precautionary responses and good risk management practices.
“Fund managers should conduct stress tests and closely monitor the liquidity profiles of their fund portfolios throughout the entire life cycle of their funds,” said Ms Julia Leung, SFC’s Deputy Chief Executive Officer and Executive Director of Intermediaries
The liquidity mismatch is a serious risk to investors and the suspension of funds damages investor confidence. A report from the rating agency Moody’s reveals that an extended burst of volatility could ensure that even supposedly liquid vehicles, such as exchanged traded funds, cannot be immune to underlying market illiquidity. As a decade-long equity bull run starts to waver, liquidity risk will only become more prevalent. Regulators must ensure that the liquidity risk does not develop into a liquidity crisis.
- Fund Liquidity Risk Assessment
- Automated Classification based on Asset Type
- Market Depth Analysis
- Derivatives – Liquid Cover Monitoring
- Monitoring the highly liquid investment minimum established for the fund
- Liquidity Classification into the 4 SEC buckets of liquidity
- Exception Process
- Stressed Liquidity Monitoring
- Ongoing Monitoring
- Monitoring percentage in illiquid assets (restricted max 15% NAV)