On 29 February 2016, the FCA published an update on liquidity management for investment firms.
The update flows from information gleaned by the FCA from “a number of large investment management firms” as part of its assessment of the risks posed by open-ended investment funds investing in the fixed-income sector.
The purpose of the update is for the FCA to “share good practice of what we observed.” However, in our view, UK asset managers should treat the update as an expression of the FCA’s expectations on liquidity management.
We set out below practical considerations and action points for asset managers in light of the update.
Particular areas of focus for the FCA
The FCA highlights three areas of focus for firms to evaluate when assessing their liquidity management.
High priority action points for managers – ensure that you can:
- re-assess and update processes and underlying assumptions continuously to ensure they remain suitable for market conditions.
- provide a high degree of reassurance that tools, particularly extraordinary measures, can be implemented smoothly when required.
- make clear and full disclosure to fund investors on liquidity risks and the tools available to the fund to manage those risks, such as swing pricing, deferred redemption and suspension.
Why managing liquidity risk is important
The FCA highlighted the fact that investors in funds expect to be able to redeem their investments in line with the commitments made in the fund prospectus – for the vast majority of open-ended funds this means daily dealing. Good liquidity risk management that ensures redemption requests can be met in varied market conditions is a key requirement in our rules relating to the operation of open-ended funds.
The FCA also highlighted the importance of the IOSCO Principles for Liquidity Management.
Action point for managers: Ensure that you:
- take the purpose of a good liquidity risk management into account.
- design liquidity risk management processes to comply with the IOSCO Principles.
Disclosure of liquidity risks to investors
The FCA expressed the view good liquidity management limits the impact of the difference between:
- the liquidity indicated by the subscriptions and redemptions arrangements described in the fund prospectuses; and
- the liquidity characteristics of the underlying securities held by the fund.
Managing these differences ensures that the risks to fund investors’ ability to redeem are low.
However, the FCA emphasised that, as fund investors bear the liquidity risks, proper disclosure is important to inform investments about the nature and size of these risks through the fund documentation. This better prepares investors to make sound decisions during market stresses and is less likely to heighten redemption pressures on the funds in which they invest.
Action point for managers: your fund disclosure should describe clearly:
- the potential impact of low liquidity in portfolio holdings on the volatility of fund investment returns.
- the ability of the fund manager to use specific tools or exceptional measures. which could affect investors’ redemption rights.
- the situations in which the tools or measures would be used.
- the nature of the tools and measures.
- the potential impact of the tools and measures on fund investors.
Good practice on liquidity risk management and oversight
The FCA encountered a range of liquidity management processes and tools tailored to the specific requirements of individual funds or strategies.
Action points for managers: you should put in place the following:
- Processes to ensure that subscription and redemption arrangements are appropriate for the investment strategy of the fund and that requests for redemption can be met throughout the entire lifecycle of the fund - a key factor being any material change in liquidity characteristics of securities.
- A regular assessment of liquidity demands, including those arising from redemptions, collateral calls and other fund obligations, with the assessment including the development of a range of potential redemption scenarios and risks, on the basis of:
- an analysis of the composition of fund investors;
- the historic pattern of net fund flows; and
- other factors, such as the experience of similar funds.
- An ongoing assessment of the liquidity of portfolio positions noting that, for many portfolio holdings, such as corporate bonds that trade infrequently, it can be difficult to obtain reliable estimates of their liquidity. In these circumstances you should use a range of sources to assess the liquidity of holdings, including external data feeds and input from internal trading functions. Liquidity characteristics can vary significantly over different periods and market conditions. You need to update portfolio liquidity assessments accordingly.
- The use of liquidity “buckets” determined by the estimated time that would be needed to dispose of a holding in that “bucket”: (a) indicating whether the liquidity of the securities is “high”, “medium” or “low”; (b) applying limits indicating the allowed ranges of total portfolio exposure to each bucket; and (c) adjusted these limits over time to take into account changes in market conditions.
- An independent risk function that monitors portfolio bucket exposures regularly and reports breaches to the set limits with your response to breaches varying according to circumstances, e.g. (a) “‘hard” limits, where immediate action is taken to correct the breach, and (b) “soft” limits where the position is reviewed and the limit over-ruled where appropriate and subject to the required approval process.
- Stress testing to assess the impact of extreme but plausible scenarios on your funds supplementing other elements of your liquidity risk management process to assess the impact of a range of factors, both in isolation and in combination, on your funds and (in particular) on their ability to meet redemption requests. Common factors used in making the assessment would include:
- volume of redemptions, including scenarios based on historical experience, and other extreme, but plausible, scenarios that have not yet been experienced; and
- market conditions, including stress situations which could severely reduce the ability of the fund to transact with other market participants.
For the FCA, good management of liquidity extends to how a fund manages redemptions and transaction costs related to redemptions. Good practices minimise the costs that remaining investors bear and protect them as much as possible from changes to the portfolio following redemptions.
Action points for managers: you should put in place the following:
- Portfolio adjustment mechanisms following redemptions, e.g. through the application of a “vertical slice” to the portfolio when it is faced with significant redemptions in order to leave the characteristics, including the liquidity, of the portfolio unchanged following the sales.
- An established governance process that ensures the interests of all investors are protected setting out internal guidelines on when it is appropriate to implement exceptional tools and measures in the face of large redemption demands and including: (a) the fixing of the threshold of net redemption flows which would trigger the application of such tools and measures; and (b) assigning responsibility for a final decision to a committee, independent of the portfolio management, whose primary focus is customer protection.
Exceptional liquidity tools and measures
The FCA identified a number of good examples of liquidity tools and measures.
Action points for managers: you should consider the following:
- Swing pricing and dilution levies to protect investors from bearing the additional costs associated with the redemptions (and subscriptions) of other investors.
- Mechanisms for deferred redemptions and suspension of dealing, the preparation of which includes the following:
- the maintenance of a procedures manual detailing the steps required to implement each tool and measure, as well as the responsibilities of the parties involved; and
- reassurance that the operational aspects of implementing these tools and measures work in practice, including exercises to test these procedures under simulated live conditions.