Regulators renew their focus on liquidity

In last month's edition, we noted that work on money market funds (MMFs), and liquidity management in open-ended funds more generally, feature in IOSCO's latest work programme. European regulators have since issued various survey findings and consultations on these subjects, which indicate both potential rule changes and renewed supervisory focus and action.

All the documents refer to the period of acute market stress in March 2020, during which some open-ended funds experienced significant liquidity issues. ESMA's latest report (PDF 3.6 MB) on trends, risks and vulnerabilities in EU securities markets provides a view as at end-2020. It notes that the fund industry continued to expand in the second half of 2020, reflecting strong flows and valuation effects. In particular, and in contrast to the significant outflows experienced during the market stress, bond funds recorded the highest inflows. And the size and composition of EU MMFs remained stable, with liquidity buffers plateaued at high levels, substantially above regulatory requirements. ESMA also notes that corporate credit ratings fell sharply during March/April 2020 but have since steadily recovered, and that margin calls by central counterparties rose and have since decreased.

Despite this remarkable story of resilience and recovery, regulators are concerned that lessons should be learned from experiences in early 2020, by both fund managers and supervisors. Fund managers will need to evidence that they have critically analysed the experience of their funds during the market stress and that their policies, processes, controls and documentation are in full compliance with the rules and meet supervisory expectations.

For further thoughts on these issues see KPMG's Ensuring stable capital markets, in our new reality publication series.

ESMA is seeking (PDF 528 KB) views by end-June on the EU Money Market Fund Regulation (MMFR), to inform the review of the Regulation that the Commission must undertake by July 2022. MMFR provides for three main types of MMFs: public debt constant net asset value (CNAV), which represent 7 percent of EU MMFs; low volatility NAV (LVNAV), which represent 48 percent of EU MMFs; and variable NAV (VNAV), which represent 45 percent of EU MMFs.

The review will be heavily influenced by experience during the period of acute market stress in March 2020, when several EU MMFs faced significant liquidity issues, with large redemptions by investors and a severe deterioration of the liquidity of underlying money market instruments. This was particularly the case for some LVNAV MMFs in USD and some VNAV MMFs in EUR. Following actions by central banks to support money markets through outright purchases of commercial paper, lending facilities for banks to buy assets from MMFs or extending eligible collateral to unsecured banks bonds, redemptions slowed as liquidity improved in money markets.

No EU or US MMFs had to implement liquidity fees on redemptions or redemption gates or to suspend redemptions, but ESMA notes that this episode shows that MMFs, and more broadly money markets, remain subject to a range of vulnerabilities: liquidity of underlying markets, regulatory requirements and the role of credit rating agencies in rating MMFs.
ESMA is considering reforms in three broad areas:

• On the liability side (e.g. swing pricing, redemptions in kind, holdbacks, minimum balance at risk, or removal of stable NAV)
• On the asset side (e.g. restrictions on asset holdings, increase liquidity buffers and/or make them usable/countercyclical, decouple regulatory thresholds from suspensions/gates)
• External to MMFs themselves (issues related to e.g. sponsor support, enhance liquidity of underlying instruments in which MMFs invest, a liquidity exchange bank, enhanced MMF reporting for and stress testing by authorities)

The policy aim is to improve the resilience of EU MMFs and not all reforms may apply equally to all three types of funds. It is important that both MMF managers and MMF investors (which include other funds and asset managers on behalf of clients) engage in the consultation process, which could lay the ground for significant changes to MMFR and to EU MMFs.

ESMA has issued the findings of the Common Supervisory Action (CSA) on UCITS liquidity risk management (LRM), which was launched in January 2020. All 30 EU and EEA national regulators (NCAs) participated in the CSA. Overall, they reported that most UCITS managers demonstrated that they have implemented and applied sufficiently sound LRM processes. However, the NCAs identified shortcomings in a few cases:

• Poor documentation of LRM arrangements, processes and techniques
• Poor quality of the written LRM procedures
• Poor quality of LRM mechanisms and methodology
• Over-reliance on liquidity presumptions with regard to listed securities
• Application of liquidity presumptions to financial instruments not admitted to or dealt in on a regulated market
• The entity to which the portfolio management function is delegated also effectively performs the LRM function
• Lack of data quality checks and over-reliance on very few data providers
• Disclosures missing, inaccurate or unclear
• Insufficient governance
• Weak internal controls framework
• External controls not performed by the depositary and external auditors

NCAs are following up these supervisory findings, at individual and collective level – for example, a CBI letter to Irish fund management companies sets out its expectations on firms' liquidity management policies and processes. UCITS managers should critically review their LRM frameworks to ensure that none of these adverse supervisory findings exist in their own frameworks.

Five policy priorities have been identified as regards NCAs' own supervisory practices:

• Supervision of alignment of fund investment strategy, liquidity profile, redemption policy
• Supervision of liquidity risk assessment
• Need for additional specifications for liquidity profiles and reporting
• Increase in the availability and use of liquidity management tools
• Supervision of valuation processes in a context of valuation uncertainty

In the UK, the Bank of England and the FCA have issued the findings of their joint survey of liquidity management in UK-authorised, open-ended investment funds, which covered the period Q4 2019 to Q2 2020. Respondents managed 272 authorised funds investing in less liquid assets - corporate bond funds (including high-yield bond funds), mixed bond funds and a small number of small and medium cap equity funds. All funds were daily dealing and none had a notice period in place. They experienced net outflows in March 2020, with outflows much larger for funds with predominantly professional investors (institutional and/or intermediated) than with direct retail investors.
The authorities found that:

• Funds have a wide range of liquidity tools available to them (and used them more intensively during the stress period), but predominantly use swing pricing. However, tool selection and trigger points for their usage, and some pricing adjustment calculations, tended not to be fund-specific.
• Funds intensified and adapted their use of swing pricing during the stress period. There were large variations in how swing pricing was applied, which were not entirely explained by differences in primary strategies.
• Funds also held liquidity buffers in the form of cash and non-cash liquid assets, the two most common being units in MMFs and UK government bonds.
• Some funds adapted their liquidity management approaches and governance measures temporarily or permanently in response to the stress period.
• Managers of corporate bond funds may be overestimating the liquidity of their holdings, with some managers considering a large proportion of their holdings to be liquid in almost all market conditions, and most considering that the majority of their holdings have high valuation certainty.