The Securities and Futures Commission (SFC) has conducted a survey of a number of Hong Kong managers of SFC authorised funds and conducted inspections of some of them to assess compliance with its circular of 4 July 2016 on liquidity risk management and the revised Fund Manager Code of Conduct. On 23 August 2019 the SFC published its findings in a circular (the Circular) which identified numerous deficiencies (examples of which are set out in the appendix to the Circular).
The Circular directs managers to review their current policies, procedures, systems and processes in light of the regulatory requirements and the observations noted in the Circular and its appendix, and take immediate action to rectify any inadequacies or deficiencies. This is a typical flag and managers who fail to act accordingly can expect to feel the full force of SFC enforcement action.
While some of the SFC’s observations relate to the expected standards in the July 2016 circular on liquidity risk management, most of them are also useful references for fund managers of non-SFC authorised funds.
The SFC is clearly concerned about the possibility of another liquidity crisis, and reminds managers that when markets are unstable they should perform more frequent and enhanced liquidity stress testing to assess the potential impact on fund liquidity and how they will deal with it. Managers should have written policies setting out the action they plan to take to meet the fund’s liquidity needs should any of the stress scenarios materialise.
We have set out below a summary of some of the deficiencies identified in the appendix to the Circular.
Overall liquidity risk management framework
Managers need to assess how liquid the portfolio needs to be to meet redemption requests and other payment obligations in an orderly fashion, how the liquidity of the portfolio is likely to be affected is different market conditions, and what steps need to be taken in different market conditions and/or when met with higher than expected levels of redemptions. The liquidity risk of each portfolio needs to be monitored by the manager on an ongoing basis. Managers should define what circumstances would trigger escalation (for example, exceeding certain risk targets or indicators) and map out action plans to meet redemption requests under both normal and stressed market conditions.
In some cases internal liquidity targets were not set to assess and monitor liquidity risk. Even when such targets had been set, the managers did not regularly review them to ensure they remained valid. In other cases, no clear guidance was provided to staff on how to handle exceptional events.
A number of managers had the power to use certain liquidity risk management tools such as (i) limiting the number of units to be redeemed on any dealing day; (ii) borrowing to meet redemption requests; and (iii) suspending redemption or delaying the payment of redemption proceeds during any period in which the determination of a fund’s net asset value is suspended. However, there were no clear internal procedures for (i) determining the circumstances under which these tools would be implemented; and (ii) the responsibilities of the parties involved in making this determination and implementing the appropriate measures.
Some fund managers did not establish any procedures to enable them to assess, review and decide on the actions required to meet liquidity demands at short notice under exceptional stressed conditions.
Some fund managers had implemented risk management measures but they were not adequate to identify potential risks and pressure points. For example a manager conducted stress testing but did not set any internal liquidity targets or indicators to monitor and assess the results.
One manager monitored the weighted average number of days it took to liquidate individual investments but did not classify funds' assets into liquidity categories. In other words, the manager was not monitoring the percentage of the portfolio which could be realised within different time periods, and did not set liquidity targets in the form of minimum or maximum amounts which should be invested in each liquidity category, taking reference to the fund's asset and liability profiles and other relevant factors.
Assessment of liquidity profiles of fund assets
Some managers did not conduct any liquidity assessments of certain assets held by the funds, and others conducted inadequate assessments. For example, in assessing the liquidity of listed stocks held by a fund, one manager only compared the total number of shares held by the fund against the total number of the listed company’s issued shares in the market, without taking into account market conditions such as the stock’s average daily trading volume.
Some managers assumed that certain assets, such as government bonds, could be liquidated within five business days. However, these managers could not demonstrate that proper assessments were performed before making these assumptions. In particular, it was noted that the last traded price of certain government bonds in their portfolios had been stale for over 100 days (implying that the bond had not been traded over that period), which called into question the reasonableness of the assumptions.
One manager assumed that all underlying funds held by a fund of funds could be redeemed on a daily basis and had not taken into account the actual dealing frequencies and redemption-related restrictions of the individual underlying funds.
Assessment of liquidity profiles of fund liabilities
Managers need to assess likely levels of redemptions and prepare for any potential delivery and payment obligations. They need to understand the types of underlying investors in the funds they manage and the historical and future redemption patterns associated with each type of investor; and consider the liquidity demands which the funds will likely face, taking into account historical demands as well as reasonable and prudent estimates of expected demands.
One manager assumed a fixed percentage of redemption over certain periods. However, no assessment had been conducted by the manager to ensure the ongoing validity of this assumptions.
One manager estimated the redemption trends of funds by reference to the turnover of major stock exchanges and capital flows in the market without taking into account the funds’ historical redemption patterns.
Stress testing is a key risk management tool which allows fund managers to assess the impact of stressed situations on the liquidity of the funds’ assets and liabilities and take appropriate steps to respond to such situations.
Some fund managers had not conducted ongoing stress tests or the stress test scenarios were not sufficiently comprehensive.
Some of the scenarios used by some managers did not take into account or did not include:
- Historical market conditions;
- Comprehensive testing of the portfolio assets,. In one case, stress test scenarios were only developed for listed stocks even though the funds also invested in bonds and other assets;
- Changes in liability profiles of the funds such as a rise in expected redemption levels; or
- An assessment of a combination of multiple stress factors, for example, a simultaneous rise in redemption and fall in portfolio liquidity.
Governance structure for risk management
Managers’ should maintain an appropriate risk management governance structure should reflect including, where practical having regard to the size and resources of the manager, an independent liquidity risk management function.
Risk management reports
There were cases where the frequency of managers’ risk management reports did not match the frequency of dealings, and cases where the reports were based on incorrect calculations or were not prepared in accordance with the managers’ policies.
There were numerous deficiencies in managers’ maintenance of written records, ranging from failure to establish any written policies and procedures for liquidity risk management, through failure to document the implementation of written procedures, failure to document the rationale for the adoption of various assumptions in assessing liquidity risk, to failure to document the rationale behind decisions whether or not to exercise powers to limit redemption requests or utilise other liquidity management tools available to them.