The SFC published the “Circular to management companies of SFC-authorized funds on liquidity risk management” dated July 4, 2016 (the “Circular”), designed to provide guidance to the management companies (each a “Fund Manager”) of SFC-authorized funds (each a “fund”) on liquidity risk management of funds. The Circular sets out principles with which the Fund Managers are expected to comply and sets out a number of nonbinding illustrative examples of good practices.
Generally, Fund Managers should at all times exercise due care, skill, and diligence in managing the liquidity of funds under their management and ensure that funds are able to meet investors’ redemption requests in accordance with the terms set out in the fund offering documents and that investors are treated fairly. In this connection, the SFC highlighted five key areas for liquidity risk management as summarized below:
- Internal governance
Liquidity risk management is an integral part of the Fund Manager’s overall risk management program. A Fund Manager should establish and regularly maintain liquidity risk management policies and procedures for the funds that it manages. In respect of internal governance, a Fund Manager should have a liquidity risk management function that is independent from its day-to-day portfolio investment function for monitoring the implementation of the said policies and procedures. This liquidity risk management function should be subject to oversight by the Fund Manager’s designated committee or senior management. In addition, a Fund Manager should have appropriate procedures in place to determine on the appropriate actions required for satisfying liquidity demands on funds under certain abnormal conditions.
- Investment product design and disclosure
At the product design stage, a Fund Manager should consider the potential liquidity risk of the fund and ensure that its dealing arrangements are appropriate throughout its entire lifecycle. In particular, the Fund Manager should understand (i) the liquidity profile of the fund’s assets under different market conditions and the liquidity profile of the fund’s liabilities and appropriately align it with that of the fund’s assets, and (ii) the profile of the fund’s investors and evaluate their redemption patterns. The Fund Manager should identify the appropriate liquidity management tools for the fund, and the Fund Manager should determine an appropriate dealing frequency, notice period, and fund size, taking into account the aforementioned factors. Appropriate disclosures on the liquidity risk of the fund and the relevant risk management tools and procedures should be stated in the fund’s offering documents to keep the investor informed.
- Ongoing liquidity risk assessment
After a fund has commenced operations, Fund Managers should regularly assess the liquidity profile of the fund’s assets and liabilities (including the fund’s investor profile, analysis on redemption patterns, and other potential sources of liquidity risk). Fund Managers should classify the fund’s underlying assets into different liquidity categories, as well as set internal liquidity targets or indicators as limits for assets allocation, with reference to current and potential future market conditions. Fund Managers should exercise their professional judgement, read together with quantitative metrics or appropriate qualitative factors, when carrying out the liquidity risk assessment. When a Fund Manager manages multiple funds by adopting a similar investment strategy or underlying assets allocation, the liquidity profile of these funds should be assessed in the aggregate, if appropriate.
- Regular stress testing
Fund Managers should assess their funds’ liquidity risk by performing regular stress testing so to assess the impact of various adverse changes in market conditions on the liquidity of the funds and the adequacy of the Fund Managers’ action plans and liquidity risk management tools. Stress test scenarios should be developed based on historical market conditions and investors’ redemption pattern. Forward-looking hypothetical scenarios may also be used where appropriate. Stress test results should be reviewed by the appropriate liquidity risk management team or senior management of the Fund Manager so to determine whether further action is warranted. Fund Managers should be able to provide rationale for the choice of stress testing scenarios and keep records of such testing.
- Liquidity risk management tools
Fund Managers should have sufficient liquidity risk management tools in place to protect interests of investors as priority. The liquidity risk management tools should be subject to ongoing review, taking into account the results of the liquidity risk assessment and stress testing, as well as the changing market conditions. The Fund Manager should consult with the trustee/custodian before using liquidity risk management tools, and should maintain clear internal procedures relating to such tools. Offering documents of the fund should disclose (i) descriptions of the liquidity risk management tools, (ii) explanation of when the tools may be used, (iii) the tools’ impact on the fund and investors, and (iv) any attendant risks to investors.
All Fund Managers licensed by or registered with the SFC that manages SFC-authorized funds should enhance their internal liquidity risk management process in accordance with the Circular by January 1, 2017, whereas Fund Managers that are based in a jurisdiction that is subject to an acceptable inspection regime or a mutual recognition of funds arrangement should comply with the liquidity risk management requirements of their respective home jurisdictions.
All Fund Managers of existing SFC-authorized funds should review and update their offering documents if necessary. In respect of new fund applications, it is anticipated that the SFC will closely scrutinize the fund’s liquidity risk management measures before granting authorization.