Tightening up fund liquidity management

As KPMG in the UK highlighted in March 2023, regulators are reviewing liquidity management in open-ended funds (OEFs) and considering how to enhance the regulatory framework. 

Led by central banks, there is a significant regulatory focus on fund managers in the context of financial stability. With the Financial Stability Board (FSB) and IOSCO¹ having completed their analysis, they are now moving into the policymaking phase. And in the UK, the FCA has reviewed firms' practices.

This article summarises the FSB and IOSCO's consultations and the key points from the FCA's supervisory work, and outlines practical next steps for fund managers.

Following the March 2020 “dash for cash”, the FSB and IOSCO have completed three years of analytical work and finally progressed their work to the policymaking stage. Both organisations have launched consultations that should be considered together (closing on 4 September) and will publish final reports at the end of this year:

• IOSCO is consulting (PDF 113 KB) on principles-based guidance to support greater and more consistent use of liquidity management tools (LMTs) by OEF managers. The proposed guidance adds more detail to IOSCO's 2018 recommendations (PDF 363 KB) — for example, by specifying how LMTs should be calibrated (to capture implicit and explicit transaction costs, and market impact), and how their use should be overseen by appropriate governance arrangements. 
• The FSB is consulting on revising its 2017 recommendations. Its proposals aim to reduce liquidity mismatch by suggesting funds are grouped into categories (depending on the liquidity of their assets), which would then be subject to expectations regarding their redemption terms and conditions — e.g. a fund investing more than 30% of their total in illiquid assets would need to have a redemption frequency less often than daily. Other revisions would promote greater and more consistent use of LMTs by fund managers.

Aspects of the proposals have already been the subject of robust discussions with the industry (for example, defining liquid and illiquid assets, or the extent to which implicit costs and market impact can be meaningfully incorporated into the calculation of LMT factors). 

Once both consultations are finalised, IOSCO will review and revise its 2018 recommendations and good practice next year as needed. Regulators such as the FCA will have regard to the revised FSB and IOSCO recommendations, and IOSCO's LMT guidance, in their policy and supervisory activities.

Enhancing liquidity management practices is already a priority for the UK authorities. The Bank of England and FCA published findings of a survey in 2021, and subsequent policy suggestions on improving liquidity bucketing and enhancing swing pricing. Additionally, an FCA discussion paper invited views on converting ESMA's stress testing guidelines (PDF 298 KB) into rules, clarifying its rules on certain liquidity management tools such as swing pricing, and enhancing liquidity reporting to the FCA and/or the public.

While it considers feedback to the paper, the FCA signalled liquidity management is a supervisory priority in its latest portfolio letter, and has now concluded a supervisory review to check on progress made since its 2019 “Dear Chair” letter(PDF 182 KB). It reviewed liquidity management practices across 14 UK authorised fund managers (AFMs) and published findings alongside a "Dear CEO" letter. 

The FCA found a wide disparity in terms of expertise and compliance with the rules, and that "most firms fell short in some aspects of their framework". Notably, firms should take note of the FCA's highlighted examples of good practice, that it states would be consistent with the new Consumer Duty.

It is clear the FCA believes both AFMs and Alternative Investment Fund Managers (AIFMs) need to do more to meet its standards. With the Consumer Duty deadline now imminent, these firms should have already reviewed their liquidity management policies and procedures in order to deliver good outcomes for investors and to be able to evidence this. 

The FCA's liquidity-specific findings mean that fund managers should consider launching formal reviews of their arrangements to assess their approach and controls against the FCA's expectations (and forthcoming global developments, if desired) in the following areas:

1)  Governance

First and foremost, fund managers should review the integration of liquidity risk within their existing governance frameworks to evaluate:

• Committee arrangements & frameworks — Whether liquidity risks are adequately prioritised and overseen by senior management, and considered by all relevant areas of the firm (including in the product governance framework). The FCA notes that dedicated, separate liquidity committee structures and frameworks are better placed to manage liquidity risks.
• Technical capabilities — Firms should ensure they have sufficient risk management expertise in-house to measure, analyse and report on liquidity risk. Whether risk models are bespoke, or provided by third party systems, there must be a clear understanding of the assumptions and flexibility of those models, including whether they have been specified in line with regulatory standards.
• Documentation — Protocols for escalation must be documented and include mechanisms for more frequent governance checkpoints in times of stress. Firms should have plans in place to handle various liquidity events. 
• Reporting — Whether arrangements are sufficiently detailed, based on realistic assumptions, and subject to effective challenge. Reporting should include deep-dive reviews of low liquidity buckets and incorporate feedback from engagement with portfolio managers.

2) Liquidity Stress Testing (LST)

Integration of ESMA's 2019 stress testing guidelines (PDF 298 KB) is an expectation, rather than a recommendation. Fund managers should review their LST policies and procedures, considering the following:

• Methodologies — These should be clearly documented and based on appropriate assumptions. Firms should aim to use more conservative “pro-rata” methodologies to test fund liquidity (i.e. not relying on selling the most liquid assets first), and incorporate market impact costs. Models should be regularly reviewed and challenged.
• Engagement — Communication and follow-up of stress testing results to committees and boards should be regular and impactful. Reporting should include qualitative analysis and focus on both assets and liabilities. 
• Liability testing — Scenarios should consider investor behaviour and where redemptions could be correlated with concentration risk. Testing should consider not only the impact of a single redemption on a fund, but also the knock-on effect of redemption activity on other investors. 
• Trend analysis — Testing should not be limited to a point in time review, instead providing a clear view of trends in the context of both macro- and micro- economic events as well as investor behaviour.

3) Redemption process

Whilst the FCA recognises most fund managers have in place processes to manage large redemptions, there is not enough consideration of whether investors have been treated fairly, and whether small, cumulative redemptions are effectively monitored. The following should be reviewed:

• Thresholds — Managers should set thresholds to identify large and small but cumulative redemption trends that have the potential to impact the liquidity profile of a fund. 
• Investor outcomes — Remaining investors' interests need to be considered as part of the redemption processes, particularly where funds hold illiquid assets. 
• Oversight — Managers should review and test the actual impact of redemptions on the portfolio and remaining investors. Where redemptions have materially impacted a fund's liquidity profile, especially in less liquid buckets, there must be mechanisms to challenge investment managers. Where third parties are used, firms should implement their own trigger and escalation process.
• Planning — Managers should regularly simulate redemption scenarios and test existing redemption planning. Such exercises should be fed back to the business to communicate lessons learned and recommend enhancements to senior management.

4) Liquidity Management Tools (LMTs)

LMTs are a policy focus for the FSB and IOSCO (see above), as well as under the FCA's supervision:

• A fund-specific focus — Firms should review the liquidity profiles of their fund ranges and strategies, assessing whether existing frameworks for the application of LMTs are appropriate across varied liquidity profiles. Where idiosyncratic liquidity risks exist, consideration should be given to fund- or strategy-specific processes and procedures.
• Calculation of thresholds and dilution factors — Updates to thresholds and dilution factors should be provided regularly to the board and relevant committees. Dilution factors should directly incorporate market impact costs. 
• Back testing — Regular back-testing of redemption outcomes should be performed, including assessing true market impact against forecasts, and outcomes for investors.

5) Securities valuation

Whilst the FCA noted processes were reasonably robust, firms should continue to review and enhance these practices. The FCA recapped the need for an independent valuation committee, internal challenge, sufficient scrutiny, and appropriate MI. It also noted that illiquid assets should not be able to be held in OEFs with short redemption periods.

Liquidity risk management permeates every aspect of an asset manager's business, with stakeholders spread across front, middle and back-office functions. 

Senior management must therefore have a comprehensive overview of liquidity management across their business to be able to effectively monitor and challenge all aspects. Consideration should be given to how individual policies and procedures roll up into a single liquidity risk management framework. And lastly, reporting on both liquidity risk and the application of LMTs should be inter-dependent, with lessons learned through each process feeding up into a single governance framework. 

If you would benefit from an independent review of your liquidity management framework and operating model, or with designing and implementing enhancements and changes, please get in touch.