Fund liquidity, like a mirage in the desert, can disappear in an instant if not monitored and managed correctly. Events throughout this year have brought fund liquidity to the forefront – as we approach the end of 2019, it is clear we haven’t seen the last of liquidity risk in the headlines.
Most recently, the suspension of M&G’s property fund has raised further questions on whether illiquid assets should be held in an open-ended structure.
“It is not sensible to provide for daily dealing and redemption in open-ended funds that hold a large exposure to illiquid assets, including those that while listed are not regularly traded.” – Andrew Bailey, chief executive officer of the U.K. Financial Conduct Authority
Furthermore, the Bank of England’s Financial Policy Committee has said that the “mismatch between redemption terms and the liquidity of some funds’ assets has the potential to become a systemic issue”. If there is potential of a systemic issue, what are regulators doing to address it?
Most recently, Steven Maijoor, Chair of the European Securities and Markets Authority (ESMA), delivered his keynote address at the EFAMA Investment Management Forum focusing on fund liquidity. In his address, he discussed the issues with fund liquidity, ESMA’s activities in relation to fund liquidity and the main requirements regarding liquidity risk management under the UCITS framework.
Mr Maijoor emphasised that the UCITS framework already includes a broad range of risk management provisions designed to ensure that all relevant risks, including liquidity risks, are identified, measured and effectively managed.
Of note however, he announced that ESMA will facilitate common supervisory action with national regulators across Europe on liquidity management by UCITS. EU NCAs will agree to simultaneously conduct supervisory activity in 2020 on the basis of a common methodology to be developed together within ESMA. It has been felt that EU rules on UCITS liquidity risk management have not been consistently applied across Europe. It is hoped that this development will assist in remedying the issue.
With a number of high profile UK funds suspending redemptions due to liquidity issues, it is only natural that the FCA play a prominent role in addressing the issue. In September, the FCA confirmed new rules which apply to certain types of open-ended fund investing in inherently illiquid assets such as property. The new rules apply to non-UCITS retail schemes (NURS). They require that investors are provided with clear and prominent information on liquidity risks, and the circumstances in which access to their funds may be restricted. They place additional obligations on the managers of funds investing in inherently illiquid assets to maintain plans to manage liquidity risk.
Furthermore, the new rules which come into effect on 30 September 2020 require:
- A NURS holding property and other immovables to suspend dealing when there is ‘material uncertainty’ about the valuation of at least 20% of the scheme property.
- Managers of funds investing mainly in illiquid assets to produce contingency plans for dealing with liquidity risks.
- Depositaries to undertake a specific duty to oversee the processes used to manage the liquidity of the fund.
It is hoped that the new rules will assist in reducing the potential for harm to investors in funds that hold illiquid assets, particularly under stressed market conditions.
Following the new rules, in November 2019, the FCA published a letter to Authorised Fund Managers (AFM) regarding their responsibility of ensuring effective liquidity management in funds. In the letter the FCA state that it remains the AFMs responsibility even if they have delegated investment management to another person. Good fund governance ensures that the liquidity of the funds’ underlying assets is appropriately considered.
In the letter the FCA highlighted key features of robust liquidity management which include:
- Processes to ensure that the fund dealing (subscriptions and redemptions) arrangements are appropriate for the investment strategy of the fund
- Regular assessment of liquidity demands
- An ongoing assessment of the liquidity of portfolio positions
- Using liquidity buckets for liquidity risk management
- An independent risk function that monitors portfolio bucket exposures regularly and reports breaches to the set limits
- Stress testing by fund managers to assess the impact of extreme but plausible scenarios on their funds
CENTRAL BANK OF IRELAND
In response to the liquidity crisis in the UK created by the Woodford fund, the Central Bank of Ireland (CBI) published a letter reminding Fund Management Companies of the importance of ongoing, effective liquidity management and ensuring the compliance with relevant legislation and regulatory obligations of UCITS and AIFs.
In early 2019, the Central Bank increased its monitoring of investment fund liquidity and redemption activity. This involved increasing the frequency of data collection, performing analysis of the factors driving redemptions and seeking insight into the management of those redemptions.
Furthermore, last month, Gerry Cross, Director of Policy & Risk and the CBI, said that recent events have “raised questions as to whether existing rules in respect of liquidity risk are sufficient. In light of this it is needed to reflect on whether the rules and guidance currently in place are sufficient or whether they need to be further developed.” This is clearly an area the Central Bank will continue to focus on over the coming period.
With all the recent developments highlighted above, it is clear that fund liquidity is set to remain a regulatory and supervisory priority both domestically and at an EU level over the coming months and throughout 2020.