Liquidity streams: recent developments in fund liquidity regulation

Within a week in July there has been a stream of regulatory developments in relation to fund liquidity risk management. These developments include two sets of recommendations from global standard-setters, the publication of the FCA’s review of firm’s liquidity management frameworks together with a letter directed to asset management CEOs, and liquidity management as a contested issue in several EU legislative negotiations.

In this note, we briefly summarise what has happened and why, and our recommendation that managers should consider all these developments when reviewing their own arrangements, as regulators are increasingly requiring firms to do.

The FCA's multi-firm review

On 6 July, the FCA published the results of a multi-firm review of liquidity management by Authorised Fund Managers (AFMs) and, alongside the results, a letter to asset management CEOs. The letter directs asset managers to review their liquidity management arrangements against the results of the review and to make improvements. Although the multi-firm review concerned AFMs, the FCA states that it expects all AIFMs and other asset managers to consider the findings and describes its output as "a warning to all asset managers".

The FCA's review found a disparity in quality among the firms that it surveyed. The tools for effective liquidity management were generally in place but lacked coherence as a process and were insufficiently embedded in practice.

The review also found:

• insufficient governance, oversight, escalation, and challenge especially in stressed market conditions;
• a variety of approaches to liquidity stress testing and some deficiencies in testing methodologies;
• firms typically having arrangements to handle large one-off redemptions but not market-wide or cumulative redemptions; and
• wide variation in the application of anti-dilution tools such as swing pricing, which has an impact on the price that investors can redeem at.

The FCA's review highlights examples of good practice in relation to governance, liquidity stress testing, redemptions, the use of liquidity management tools, and valuation. The FCA also states that the findings should also be considered in relation to good consumer outcomes, as required under the Consumer Duty that took effect on 31 July.

Globally agreed principles

FSB

The Financial Stability Board (FSB) has been working on "Addressing Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds" for some time, having published its recommendations to regulators in 2017. The FSB is now consulting on an update to its recommendations, based on its recent work. The FSB, which is dominated by central banks and finance ministries, is broadly concerned with the potential systemic risk arising from open-ended funds and directing recommendations to securities regulators, and others such as macro-prudential authorities, to undertake mitigatory actions.

Specifically, the FSB makes new proposals in respect of:

• Recommendations 1 and 2 - on transparency: the FSB proposes a pilot programme to identify gaps in supervisory information, and better public disclosures on the use of liquidity management tools consistent with its other recommendations. The core of the FSB's recommendation is support for liquidity "bucketing", an approach like that adopted by the SEC in which managers would be required to group assets and funds into categories based on their liquidity profile. Many managers have concerns about the accuracy, usefulness, and costs of this approach versus traditional methods of liquidity management. Eventually, managers might be required to collect more data about the liquidity of their assets and funds and establish potentially costly administrative systems to monitor and report this data. Managers might also need to amend their disclosures to investors.
• Recommendation 3 - greater clarity on redemption terms: the FSB recommends classifying funds and assets based on their degree of liquidity and setting expectations for redemptions, based on qualitative and quantitative standards. For instance, the FSB suggests that for funds that invest more than 30% of their value in illiquid assets, daily dealing should only be permitted with long notice periods. The FSB's recommendation for longer notice periods conflicts with some existing standards in the market, such as the UK's Fund-of-Alternative-Funds (FAIF) structure which requires managers to offer redemptions at least once every 6 months, but which might be too frequent to achieve the FSB's standard. However, it is important to note that the FSB recommendation is not a requirement, and it is currently under consultation, although there is an expectation that regulators will at least explain divergence if they choose not to comply with the FSB's proposal. It is not yet clear whether any existing regulations will be amended and whether any existing vehicles in the market will need to be changed or made redundant.
• Recommendations 4, 5, 7 and 8 - each recommendation concerns the use of liquidity management tools: broadly, the FSB suggests that managers must ensure a broad set of available tools, the consistent use of tools to mitigate the first-mover advantage in stressed conditions, and greater clarity on the circumstances in which certain tools might be used, such as gates and side pockets. These recommendations might result in a more prescriptive rules around which tools managers might select and must be prepared to use and set stricter parameters around the circumstances and the extent to which tools can be used (as IOSCO has outlined for anti-dilution measures: see below).

Finally, the FSB recommends that IOSCO review its 2018 Recommendations for Liquidity Risk Management by Collective Investment Schemes once the current FSB and IOSCO consultations conclude.

The FSB's consultation will close on 4 September.

IOSCO

In parallel, IOSCO has published a consultation in response to a previous FSB request for more guidance on the use of anti-dilution tools. IOSCO's guidance aims to protect investors when these tools, such as swing pricing are used, but also enhance financial stability by removing the first-mover advantage potentially enjoyed by investors that redeem earlier than others (as the FSB also references in its recommendations).

IOSCO's guidance outlines six guiding principles for managers. It does not seek to determine how anti-dilution tools should be calibrated, such as the degree of "swing" that might be applied to the price, but rather to describe the features of a well-designed system. The six guiding principles are:

1. Appropriate internal systems, procedures, and controls.
2. At least one appropriate anti-dilution tool for each open-ended fund under management.
3. Anti-dilution tools should impose on redeeming and subscribing investors the costs of liquidity (i.e., both explicit and implicit transaction costs).
4. An activation threshold can be imposed to avoid unnecessary costs, but it should not result in material dilution; instead, multiple pre-determined thresholds are encouraged.
5. Adequate and appropriate governance arrangements.
6. Clear disclosure of the objectives, design, and use of anti-dilution tools.

IOSCO's consultation will close on 4 September.

EU negotiations

Liquidity risk management is an ongoing point of contention in EU negotiations on fund-related legislation.

Policymakers have reached a political agreement on the AIFMD Review (AIFMD II) Level 1 text (the primary legislation). The use of liquidity risk management tools by AIFs generally, but also in respect of loan origination funds specifically, has been a point of contention and will be a focus in the Level 2 rulemaking (the detailed secondary legislation).

Liquidity risk management is also a live topic in relation to the ELTIF's Level 2 rules. Policymakers are considering whether a balance can be struck between permitting more open-ended ELTIF structures by mandating a stricter use of liquidity management tools and redemption requirements.

Why now and what next?

The growing regulatory focus on fund liquidity is not new: the recent developments are all reviews of existing rules and guidance. There has been a growing focus on liquidity risks since the gating of UK property funds in 2016 following the Brexit vote, the collapse of the Woodford Equity Income fund, market turbulence during the March 2021 pandemic, and other stress events. Changing market conditions, such shifts in macro-economic fundamentals and policy, are provoking a wider attempt to sure-up the rules.

At the same time, there is a trend of open-ended funds investing in less liquid assets, increasingly in vehicles that permit retail investors. Regulators are trying to balance those investors' interests with appropriate fund risk management and broader financial stability.

We expect policymakers to continue to refine the rules in relation to fund liquidity and an increasing supervisory focus on dealing with managers perceived to be deficient. We recommend that managers review their own arrangements with reference to the FCA's findings and the revised IOSCO and FSB recommendations.