FMA frames tasks for fund managers and Supervisors

Late April 2024 the FMA released its long-awaited Guidance, Liquidity risk management guide, (Guide) which updates and replaces the April 2020 good practice guide, Liquidity risk management. The Guide builds on at least several other prior documents of note:

1. MIS liquidity risk management review, published by the FMA in June 2021
2. Consultation: Proposed liquidity risk management guidance, published by the FMA in September 2023
3. Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds, published by the FSB in December 2023
4. Anti-dilution Liquidity Management Tools – Guidance for Effective Implementation of the Recommendations for Liquidity Risk Management for Collective Investment Schemes, published by IOSCO in December 2023.

Liquidity risk management (LRM) is described in the Guide as follows:

Fund liquidity is about how fund assets can be sold without negatively impacting the price of those assets or needing to secure funding (if applicable). Good management of fund liquidity is an important part of delivering fair outcomes for consumers and markets. It is critical to ensuring investors are treated equitably, and that funds perform and operate in line with the information given to investors. It also plays an important role in supporting orderly and stable markets, particularly during volatile conditions.

Scheme managers must manage withdrawal and transfer requests effectively under all market conditions. This helps to ensure investors are treated equitably. Poorly managed liquidity risk may mean some investors unfairly bear the costs of others leaving the fund, or force managers to sell fund assets for a lower price than would otherwise be the case.

(Guide, p. 4)

The description above essentially sets an objective for fund managers to be able to liquidate managed fund assets and return or transfer resulting investor money in an orderly and equitable manner, whatever the state of the markets. The Guide’s primary concern is to ensure that fund managers and their Supervisors will cooperate in implementing this objective effectively. The Guide clarifies that it “focuses on managed funds but is intended to assist all licensed managers of managed investment schemes” (Ibid.). This is a notable qualification of the Guide’s applicability for all managed investment scheme (MIS) managers. The Guide is written not just for the benefit of managers and Supervisors of retail managed funds and KiwiSaver schemes, but also the managers and Supervisors of other MIS variants such as mortgage, property, and forestry schemes. A MIS manager would be rash to assume in advance that LRM is not relevant to its own financial products.

The Guide effectively says that all MIS financial products should be viewed through the lens of LRM compatibility and that it is the legal obligation of MIS managers to do so in relation to their own financial products. Potentially every MIS manager could come under the ambit of the Guide with respect to LRM practices. After careful consideration, a MIS manager might be able to certify truthfully that its products are not subject to LRM, but if the manager is issuing managed funds, then this outcome would seem to be highly improbable. The Guide also encourages managers of wholesale schemes to consider its guidance. Furthermore, the Guide states that LRM is expected to be considered “at all stages of fund management – from fund design to day-to-day liquidity” (Ibid.). This point is highly impactful on the design and development of new managed fund products, including closed (i.e., not continuously offered) funds typically issued for large-scale real assets such as commercial property and forestry plantations.

With the Guide’s broad ambit of potential application across all MIS financial products at all stages of their life cycles, it is quite likely that some MIS managers have unknown, unrecognised, or unmanaged liquidity risks attached to their financial products. Perhaps for some MIS managers, it will be news that they have LRM to consider. A substantial annual workload lies ahead for MIS managers to comply with what the Guide prescribes. It is not just MIS managers who the Guide addresses, but also their Supervisors, who will need to adapt to the demanding new LRM environment and heighten their vigilance and activity in monitoring LRM compliance by the MIS managers they supervise.

A central regulatory plank for the Guide is the technical definition of “managed fund”, to be found in the FMC Regulations’ r 5 (1) (see Appendix 1 for full text of the regulation). The FMA expects fund managers to refer to that definition when considering their LRM obligations. The Guide sums up the regulator’s position on LRM, fund managers, and Supervisors in relation to the definition as follows:

To meet the definition of a managed fund, the managed investment products must be offered in the ordinary course of business on the basis they are continuously offered and redeemed on a basis calculated wholly or mainly on the value of the scheme property or least 80% of the scheme’s assets meet liquidity requirements in regulations. This requires sufficient liquidity management to ensure the service can be offered.

Given these clear statutory requirements, we expect all managed funds to have appropriate LRM-related policies, processes and tools. Failure to do so is likely to mean Managers and Supervisors are not meeting their statutory duties.

(Ibid., p. 5)

To drive the point home, the Guide terminates with a discussion of the FMA’s regulatory responses and concludes:

Supervisors are the frontline regulators of MIS and have primary responsibility for ensuring Managers are implementing effective LRM. Having effective LRM is integral for a Manager to show that it is meeting its statutory duties to exercise appropriate care, diligence and skill, and act in the best interests of scheme participants and treat them equitably. 

In our engagements with industry, we will look to understand how Supervisors have engaged with Managers and how Managers have considered their own liquidity risks and implemented appropriate LRM in the context of the funds they manage.

(Ibid., p. 20)

Laying out a workplan for fund managers

The greatest part of the Guide is concerned with setting out what is expected of fund managers with respect to LRM. A large prospective workload for fund managers is evident, although managers should not be starting from scratch given that the FMA commenced issuing guidance on LRM back in April 2020. The Guide lists as its core content eleven “features of effective LRM” (Ibid., p.10) that it requires fund managers to respond in detail to. These features are subdivided within four categories as shown in Table 1.

Table 1: Categories and features of effective LRM

*Features listed for “key improvements” in the Guide (Ibid., p. 9)

Table 2: FMCR Reg. 5(1) managed fund definition and FSB section 3.3 liquidity categorisations

Plainly, blends of the above asset types with different liquidity characteristics held within a managed fund could impact how total fund liquidity is categorised, as the FSB envisages in its managed fund categories, as described in the Policy’s section 3.3.

Feature 7.2: “In assessing conditions under which LMTs might be deployed, the Manager has a graduated strategy for the use of LMTs. For example, swing pricing will usually be applied during normal market conditions. Where market conditions deteriorate, the Manager may move to deploy reactive tools, such as a notice period for redemptions and redemption gates, before progressing in a crisis to consider suspending redemptions” (Ibid., p. 15).

An implication of Feature 7.2 is that trust deeds for managed fund schemes may need to be reviewed and amended if they do not offer sufficiently “graduated” LMT responses to liquidity events. The typical trust deed allows for redemption suspension and limited borrowing as LMTs. However, Feature 7.2 reveals that redemption suspension is the last cab off the rank to deploy in the FMA’s view and that there should be prior, less drastic options available for fund managers to select from. Feature 7.2 also has implications for changes to established unit pricing practices if the likes of buy-sell spreads or swing pricing are introduced, with knock-on effects for disclosure and governing documents.

Feature 8.4: “Stress testing has an appropriate governance structure with clear objectives and upwards reporting lines, and is reviewed regularly by the oversight body (e.g., the MIS’s board, executive committee, or senior management)” (Ibid., p. 17). This feature is included in the Guide under the subheading Governance and oversight and indicates how important LRM stress testing activities rank within funds management operations. It shows that the FMA expects the relevant oversight body of a fund manager to know, understand, and receive reports on what is happening within the organisation at the fund liquidity stress testing level and undertake regular reviews of that activity.

Clearly, the Guide provides much for fund managers to get along with in perfecting their LRM practices. A useful place to start the process could be the gap analysis recommended in Feature 11.1.

A parallel workstream for Supervisors

Reprising the theme that “Supervisors are the frontline regulators for MIS”, the Guide declares that “Supervisors are responsible for overseeing Managers’ LRM” (Ibid. p. 8). A significant set of work requirements are outlined for Supervisors to follow. The core task involves deep-dive, risk-based assessments of managed funds to determine the fitness for purpose of their LRM mechanisms:

Chart 1: The LRM-related “must haves” hierarchy

Supervisors are expected to oversee proactively the three “must haves” across their supervised fund managers and ensure that each level of the hierarchy shown in Chart 1 is effectively integrated with the others. Ideally, the hierarchy should operate like an efficient, well-oiled machine that anticipates the potential occurrence of liquidity events and crises within asset markets and managed funds and is always poised to swing into appropriately responsive and effective action as and when required.

Supervisor assessment of LRM fitness for purpose will penetrate right down to the individual fund level. These LRM assessments must be risk-based, meaning that Supervisors will need to be able to identify liquidity risks accurately, including the types of funds and investments that could harbour problematic levels of liquidity risk that actually or potentially pose challenges for effective LRM and require timely availability of appropriate LMTs to eliminate or at least mitigate. Supervisors are additionally expected to augment their fund-centric LRM microanalysis with wider-based macroanalytics of LRM-related information sourced from their supervised fund managers – including the manager’s fund liquidity stress testing results – and other external origins.

The FMA explicitly expects Supervisors to be prepared to report under section 203  cases of possible or actual contraventions related to an issuer’s LRM obligations. This expectation serves as a clear warning to fund managers that they should take their issuer obligations seriously and keep their Supervisors well-informed and up-to-date on LRM matters.

The Guide specifies that the FMA will engage directly with Supervisors as its primary means of monitoring fund managers’ LRM practices and how LRM itself relates to overall systemic risk within New Zealand’s financial markets. In particular, the FMA will expect that Supervisors are on top of the three mutually interrelated “key improvements” (Ibid., p. 9) that the regulator wants to see from fund managers in respect of LRM, as shown in Chart 2.

Chart 2: The FMA’s desired LRM key improvements

Conclusion

“The FMA’s Guide on LRM sets out expectations that will potentially result in substantial workloads for all fund managers and their Supervisors,” said Matthew Band, General Manager of Trustees Corporate Supervision at Trustees Executors.