Managed fund liquidity risk a global regulatory concern

In Corporate Trustee Services’ final article of 2022, we provide an update on managed fund liquidity risk management (LRM) from a global perspective, primarily through the eyes of the International Organization of Securities Commissions (IOSCO). The article includes an overview of the relevant IOSCO reports that undoubtedly exert significant influence on how LRM is treated in New Zealand by the FMA.

In November 2022, IOSCO published a final report entitled Thematic Review on Liquidity Risk Management (Thematic Review). The Thematic Review was the result of IOSCO surveying member regulators on progress with implementing the recommendations (Recommendations) of its February 2018 final report, Recommendations for Liquidity Risk Management for Collective Investment Schemes (LRM Report). The LRM Report can be regarded as the “bible” for LRM best practice principles that fund managers (called “responsible entities” or “REs” in the report) should follow.

The 2018 report in turn was a development from the IOSCO final report Principles of Liquidity Risk Management for Collective Investment Schemes of March 2013. Linked with the 2013 report is the IOSCO final report Principles on Suspensions of Redemptions in Collective Investment Schemes of January 2012, which addresses issues arising when a fund manager has to suspend all investor redemptions due to a liquidity problem. It is clear from the above sequence of documents published over the course of the last ten years that IOSCO regards LRM conducted by REs as a very serious matter for securities market regulators worldwide. 

In addition, the LRM Report draws upon the Financial Standards Board (FSB) report of January 2017 entitled Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (FSB Report), which sets out a series of 17 recommendations, of which eight concerning liquidity are addressed to IOSCO. The FSB Report describes the kinds of liquidity events that would constitute reasons for LRM best practices to be applied by fund managers:

“A key structural vulnerability from asset management activities is the potential mismatch in open-ended funds between the liquidity of fund investments and daily redemption of fund units. Open-ended funds offer short-term (often daily) liquidity to their investors notwithstanding that the liquidity of fund investments varies across different open-ended funds and also varies over time for any particular fund. Some fund investors may overestimate the liquidity of the assets held by the funds in which they invest, and may not expect the high cost or difficulty associated with funds exiting their positions or rebalancing their portfolios in a stressed environment. As a result of unanticipated large losses in such a situation, investors may make significant redemptions from underperforming funds to minimise further negative returns. Funds’ sale of portfolio assets required to meet these redemptions could result in greater market volatility with the potential to result in negative spillovers (e.g. increased redemptions and asset sales). During prolonged periods in which highly accommodative monetary policies affect asset valuations, investors may reach for yield and under-price credit and liquidity risks. This could interact with a decline in secondary market liquidity, so that a shift in market expectations could produce repricing of assets, liquidity strains in certain markets, and the potential for contagion across asset classes.

“Although historical evidence suggests that non-money-market open-ended funds have not generally created global financial stability concerns in recent periods of stress and heightened volatility, developments in the sector and the increasing holdings of fixed income assets by investment funds suggest that risks may have increased in recent years. In response to investor demand, some open-ended funds have increased their exposures to a broader range of asset classes, including some that are less actively traded. They have also increased investment in asset classes that, while liquid under current market conditions, may become less liquid as risk perceptions and underlying credit conditions change. These developments may amplify fragilities that, if left unaddressed, may in turn amplify market stress as funds sell across asset classes to meet unanticipated large redemptions. To this end, there is some evidence that phenomena such as investor herding and momentum trading can contribute to the amplification effects. It is important to address these vulnerabilities before they manifest themselves as realised threats to financial stability.”

(FSB Report, p. 11)

IOSCO’s Recommendations for fund managers to incorporate into their LRM

The LRM Report sets out 17 Recommendations to REs (see Appendix 1 for the full list), which are supplemented by the IOSCO final report Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration of February 2018. New Zealand’s managed investment scheme (MIS) managers could do well to study these two reports and incorporate the Recommendations, as relevant to their circumstances, into their LRM policies and processes.

The main purpose of the Thematic Review was to survey the extent to which member regulators had put in place requirements for RE’s to implement the LRM Report’s Recommendations:

“This report sets out the results and observations of the Thematic Review (Review) by the International Organization of Securities Commissions (IOSCO) of the extent to which participating IOSCO member jurisdictions have implemented regulatory measures regarding the key recommendations in IOSCO’s 2018 Recommendations for Liquidity Risk Management for Collective Investment Schemes (LRM Report). The Review helps to monitor whether IOSCO members have put in place appropriate regulatory requirements for LRM processes to be set up by entities responsible for the overall operations of open-ended collective investment schemes (Responsible Entities or REs), and conduct appropriate oversight of RE’s LRM processes, in both normal and stressed market conditions. Money market funds and exchange-traded funds have been excluded from the scope of funds/CIS covered by the Review due to their unique characteristics.”

(Thematic Review, p. 1)

The Thematic Review surveyed regulators on ten of the LRM Report’s 17 LRM Recommendations as follows:

Collective investment scheme design process:

• Recommendation 1: The responsible entity should draw up an effective liquidity risk management process, compliant with local jurisdictional liquidity requirements;
• Recommendation 2: The responsible entity should set appropriate liquidity thresholds which are proportionate to the redemption obligations and liabilities of the collective investment scheme (“CIS”);
• Recommendation 3: The responsible entity should carefully determine a suitable dealing frequency for units in the CIS;
• Recommendation 4: The responsible entity should ensure that the CIS’ dealing (subscription and redemption) arrangements are appropriate for its investment strategy and underlying assets throughout the entire product life cycle, starting at the product design phase;
• Recommendation 7: The responsible entity should ensure that liquidity risk and its liquidity risk management process are effectively disclosed to investors and prospective investors.

Day-to-day liquidity management:

• Recommendation 10: The responsible entity should regularly assess the liquidity of the assets held in the portfolio;
• Recommendation 12: The liquidity risk management process should facilitate the ability of the responsible entity to identify an emerging liquidity shortage before it occurs;
• Recommendation 14: The responsible entity should conduct ongoing liquidity assessments in different scenarios, which could include fund level stress testing, in line with regulatory guidance.

Liquidity contingency planning:

• Recommendation 16: The responsible entity should put in place and periodically test contingency plans with an aim to ensure that any applicable liquidity management tools can be used where necessary, and if being activated, can be exercised in a prompt and orderly manner;
• Recommendation 17: The responsible entity should consider the implementation of additional liquidity management tools to the extent allowed by local law and regulation, in order to protect investors from unfair treatment, amongst other things, or prevent the CIS from diverging significantly from its investment strategy.

Thematic Review survey and results

The survey group of regulators was divided into two groups:

Fourteen IOSCO member jurisdictions (Participating Jurisdictions), together comprising over 92% of global assets under management (AUM), who detailed their LRM regulatory requirements in place as of December 2021 (Review Date) in relation to the ten Recommendations surveyed.

Eleven IOSCO members (Additional Jurisdictions) who self-assessed the relevant domestic regulatory measures adopted in their respective jurisdictions as of the Review Date and also in relation to the ten Recommendations.

Participating Jurisdictions were assessed on both adoption of and consistency with the Recommendations surveyed, whereas Additional Jurisdictions were assessed on adoption only. New Zealand was not included in either cohort.

The countries represented in the Participating Jurisdictions were: Australia, Brazil, Canada, China, France, Germany, India, Ireland, Japan, Luxembourg, Spain, Switzerland, United Kingdom, and United States. Seven of these jurisdictions scored as fully consistent with the Recommendations, including the emerging market of China. Six were scored broadly consistent, with three scored partly consistent. No jurisdiction was scored as not consistent. Of the Participating Jurisdictions, Australia was given the overall weakest scoring with broadly or partly consistent scores allotted for seven of the ten Recommendations surveyed.

Included in the Additional Jurisdictions were Argentina, Hong Kong, Indonesia, Italy, Korea, Mexico, Netherlands, Saudi Arabia, Singapore, South Africa, and Turkey. Of this grouping, only four reported having all final adoption measures taken and in force in relation to the ten Recommendations surveyed. Seven jurisdictions reported that they were at the stage of draft adoption measures not published for between two and nine Recommendations, with Argentina and Turkey tied for the poorest scores. One respondent, Indonesia, also reported three instances of draft adoption measures published.

A third leg of the Thematic Review entailed surveying “Market Participants” on their implementation of the LRM Recommendations. IOSCO distributed a voluntary Market Participants Survey widely, and received responses from 76 entities, including from REs operating across 17 jurisdictions, of which ten were classified as Large Global REs because they each managed assets worth around $USD 1 trillion.

The Thematic Review reports a high degree of awareness of the LRM Report’s Recommendations among the REs who responded to the Market Participants Survey, although that could be an artifact of self-selection bias in the voluntary survey. All the RE responses taken collectively indicated implementation for a given RE, across all Recommendations, at over 93%.

Of interest to New Zealand’s MIS managers, the Thematic Review devotes its section 6 (pp. 36 to 55, but note that the sections and subsections therein are in many instances misnumbered as 5) to more detailed analysis of the experiences of REs with implementing the Recommendations into effective LRM. Of special note is subsection 6.3. Observations on Trends and Issues in Implementation (pp. 53-5, but mistakenly headed up as section 5.3 on p. 53), wherein the following topics are covered off concerning problematic areas for implementing the Recommendations and undertaking effective LRM:

• Assumptions about the liquidity of asset classes
• Limitations on data availability for liquidity risk assessment and stress-testing certainty
• Challenges calculating and interpreting liquidity risk
• Flexibility and the need for human discretion and judgment
• Frequent use of the same third-party provider for liquidity metrics
• Market participant responses regarding March 2020 market turmoil

In respect of the last topic listed above, the Thematic Review refers for more information to the FSB progress report entitled Enhancing the Resilience of Non-Bank Financial Intermediation from November 2021.

IOSCO’s Thematic Review survey analysis provides contemporary insights into LRM implementation and issues, even if the Review Date cut off for survey responses took place one year ago. Changes have no doubt occurred in the lapse of time between when the survey’s data was collected and when the final report was published. Nonetheless there is material to consider for New Zealand’s MIS managers who are developing, refining or reviewing their own LRM best practices. 

FMA resources available

Although New Zealand’s jurisdiction did not make it into the Thematic Review, the FMA has nonetheless provided its own input as the local market regulator to assist MIS managers with their LRM needs.

In April 2020, the FMA published Liquidity risk management, subtitled A good practice guide for Managed Investment Schemes. This document was followed up in June 2021 by MIS liquidity risk management review. These two documents can be taken as expected LRM reading for MIS managers.

Conclusion

“LRM is evidently taken very seriously by financial markets regulators around the world,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.

“IOSCO’s Thematic Review indicates an increasing trend for financial markets regulators to be entrenching the 2018 LRM Report’s Recommendations into the managed fund regulatory infrastructure of their jurisdictions.”

“New Zealand will not be an outlier to this trend, given the FMA’s membership of IOSCO.”

“It can be taken for granted that the FMA has kept abreast of the reports on LRM that have emanated from out of IOSCO over the past decade, including the latest published in November of this year.”

“The FMA has itself published two resources on LRM that MIS managers should be well familiar with and reflect in their LRM policies and processes.”

“The Thematic Review offers some practical insights for MIS managers into the experiences and problems of responsible entities abroad as they grapple with integrating the Recommendations into LRM best practice.”

“As a Supervisor, Corporate Trustee Services will be taking close interest in the LRM policies and practices of its MIS manager clients.”

“There will be an expectation that these clients refer to the FMA’s own resources published on LRM and have access to IOSCO’s LRM Recommendations as a model for compliance at minimum.”

“We will be inspecting the LRM policies and processes that our supervised MIS managers have developed to protect their investors’ best interests in the event of liquidity problems.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt at [email protected].

Appendix 1: Full list of IOSCO’s 17 LRM Recommendations

1. The responsible entity should draw up an effective liquidity risk management process, compliant with local jurisdictional liquidity requirements;
2. The responsible entity should set appropriate liquidity thresholds which are proportionate to the redemption obligations and liabilities of the collective investment scheme (“CIS”);
3. The responsible entity should carefully determine a suitable dealing frequency for units in the CIS;
4. The responsible entity should ensure that the CIS’ dealing (subscription and redemption) arrangements are appropriate for its investment strategy and underlying assets throughout the entire product life cycle, starting at the product design phase;
5. The responsible entity should consider liquidity aspects related to its proposed distribution channels;
6. The responsible entity should ensure that it will have access to, or can effectively estimate, relevant information for liquidity management;
7. The responsible entity should ensure that liquidity risk and its liquidity risk management process are effectively disclosed to investors and prospective investors;
8. The responsible entity’s liquidity risk management process must be supported by strong and effective governance;
9. The responsible entity should effectively perform and maintain its liquidity risk management process;
10. The responsible entity should regularly assess the liquidity of the assets held in the portfolio;
11. The responsible entity should integrate liquidity management in investment decisions;
12. The liquidity risk management process should facilitate the ability of the responsible entity to identify an emerging liquidity shortage before it occurs;
13. The responsible entity should be able to incorporate relevant data and factors into its liquidity risk management process in order to create a robust and holistic view of the possible risks;
14. The responsible entity should conduct ongoing liquidity assessments in different scenarios, which could include fund level stress testing, in line with regulatory guidance;
15. The responsible entity should ensure appropriate records are kept, and relevant disclosures made, relating to the performance of its liquidity risk management process;
16. The responsible entity should put in place and periodically test contingency plans with an aim to ensure that any applicable liquidity management tools can be used where necessary, and if being activated, can be exercised in a prompt and orderly manner;
17. The responsible entity should consider the implementation of additional liquidity management tools to the extent allowed by local law and regulation, in order to protect investors from unfair treatment, amongst other things, or prevent the CIS from diverging significantly from its investment strategy.