As noted in previous articles, liquidity management in open-ended funds (OEFs) has been on the regulatory radar for several years. We are now seeing a raft of analyses and proposals from a wide range of regulators and policymakers, which point to this topic being high on the regulatory agenda for the remainder of 2022 and beyond. However, it appears that central banks and securities regulators have different views on the extent of vulnerabilities and the appropriate policy response.
The repercussions of the March 2020 “dash for cash” for OEFs in general, and money market funds (MMFs) in particular, are still being considered by policy makers. MMF reform has progressed most quickly. Following the finalisation of the FSB's proposals last autumn, consultations are now underway. OEFs more broadly have been subject to a longer debate — reviews by the FSB and IOSCO are due to conclude this year but outcomes are less certain. The regulation of exchange-traded funds (ETFs) has also been revisited by IOSCO, but no fundamental changes have been proposed. Existing recommendations have been complimented with proposed good practices.
More recently, Russia's invasion of Ukraine impacted markets and funds with exposure to Russian, Belarussian and Ukrainian assets. Supervisors have therefore been reiterating their expectations and considering additional options and guidance.
The volatility in capital markets in spring 2020 and the Ukraine crisis have underlined the need for fund managers to have sufficient expertise, resources and plans to respond quickly to unexpected developments and meet regulators' expectations in a robust manner.
Questions for CEOs:
Are we tracking all regulatory developments in this area and considering their potential impacts, both individually and in aggregate?
Do we understand the range of policy options that are being considered and consulted on? How might they impact the operation or viability of the types of MMFs we manage or invest in?
Have we critically analysed our experience during the 2020 market stress and reassessed our liquidity risk management framework for each fund?
Do our policies, controls, governance arrangements and documentation need to be augmented to ensure they continue to meet regulatory expectations?
Have we thoroughly analysed and considered all the factors arising from the war in Ukraine in the context of our portfolio holdings and application of liquidity management tools?
Money Market Funds
Regulators are responding to the reform agenda in different ways and at different rates. Some have already proceeded to the consultation stage.
The FSB's October 2021 final policy proposals to enhance MMF resilience set out a policy framework for regulators to assess and address vulnerabilities in their jurisdictions. The IMF also set out its own policy considerations in September 2021. Its policy priorities include better aligning investors' incentives, strengthening MMF risk management and addressing “market frictions” in short term funding markets.
To progress the FSB's proposals, in December 2021 the SEC proposed amendments to rules that govern US MMFs. The EU authorities have also published recommendations (ESRB, January 2022), an opinion (ESMA, February 2022) and a consultation on targeted amendments to the EU Money Market Fund Regulation (European Commission, April 2022). The FSB has committed to completing a “stocktake” of the measures adopted by its members by the end of 2023.
Overall, the SEC, ESRB and ESMA proposals are largely aligned, which is not surprising given that they flow from the options in the FSB's policy proposals. The US and EU proposals seek to strengthen asset-side liquidity requirements, to reduce so-called “threshold effects” resulting from MMFs breaching liquidity limits (and therefore implementing liquidity fees, gates, or suspensions), and to require or facilitate the use of liquidity management tools (LMTs), including swing pricing1. The reforms also seek to amend MMF reporting requirements and stress testing frameworks.
The EC’s consultation gathered further information and views from MMF managers and investors. Although it did not represent a final policy position, the questions gave an indication of the potential direction of travel. For example, the EC has asked about the impact on stakeholders if Low Volatility Net Asset Value (LVNAV) and public debt Constant Net Asset Value (CNAV) MMFs were no longer available.
In the UK, the FCA and the Bank of England have just published a joint Discussion Paper on MMF reform. After gathering feedback, the authorities will consult on policy measures to strengthen the resilience of MMFs, reduce the need for extraordinary central bank intervention and support the provision of cash management services. The FCA has also published guidance relating to liquidity thresholds and MMFs’ portfolio requirements.
The analysis of the March 2020 events on OEFs more generally, and the corresponding policy response, is at an earlier stage. Central banks and securities regulators will need to reach agreement on the nature and scale of vulnerabilities arising from liquidity mismatch in OEFs to conclude the debate. The nature of any amendments to liquidity risk management practices and the application and availability of LMTs will become clearer over the remainder of 2022.
In November 2021, the FSB set out initial observations in its Non-Bank Financial Intermediation (NBFI) progress report. Amongst its conclusions, it found that vulnerabilities can arise from liquidity mismatch in OEFs, LMTs were used inconsistently, and OEFs' asset sales contributed to stress in underlying markets.
In parallel, the IMF published its own report with policy considerations regarding investment funds and financial stability in September 2021. The IMF proposed expanding the availability of LMTs and noted the benefits of swing pricing. It also suggested that a conclusive move away from daily liquidity for funds investing in illiquid assets would be beneficial, and that enhanced reporting and disclosure on OEF liquidity is “vital”. In its recently completed financial stability assessment of the UK, the IMF recommended that UK authorities “should continue to push for a more consistent use of LMTs”.
In its 2022 work programme the FSB indicated that it intends to complete the work following on from its 2020 “holistic review” this year, including work on OEFs.
Most recently, in April 2022, the FSB published a report (PDF 1.1MB) with the IMF on US dollar funding and emerging market economy vulnerabilities. The report found that during the “dash for cash”, some fixed income emerging market funds that had “invested in less-liquid assets” experienced large outflows, and that the behaviour of fund managers may have added to selling pressures. It also found that emerging market funds made extensive use of swing pricing. The FSB noted that the findings would inform wider FSB and IOSCO work on OEFs (see below).
The remainder of this year will be critical in deciding the direction of policy on liquidity risk management and LMTs. IOSCO is reviewing (PDF 169KB) the implementation of its 2018 recommendations (PDF 364KB), whilst the FSB is assessing the effectiveness of its 2017 recommendations from a financial stability perspective. To progress discussions and gather more evidence, both have also issued a call for papers regarding vulnerabilities arising from liquidity mismatch and policy proposals to address them. These will be discussed at a conference in June.
In the meantime, central banks and securities regulators have conducted their own analysis and tentatively set out their own proposals. For example, the Bank of England and FCA have proposed a framework to enhance swing pricing and to improve asset-side liquidity classification. In France, the AMF has proposed measures2 to promote a wider adoption of liquidity management tools. And as part of the EU AIFMD review, the EC has proposed harmonising the availability of LMTs for UCITS and AIFs.
Importantly, regulators' ongoing focus is not limited to the policy space. Following its previous common supervisory action, ESMA recently completed a supervisory engagement. It found “room for improvement” and the need for continued monitoring on liquidity stress testing as well as the valuation of less liquid assets.
Although the international policy focus has mainly been on traditional open-ended mutual funds, given the significant growth in ETFs and new product launches, IOSCO has taken the opportunity to review its principles for the regulation of ETFs.
Following on from the publication of its August 2021 thematic note (PDF 1MB) that reviewed the operations and activities of ETFs during the COVID-19 market turmoil, in April 2022 IOSCO published a consultation report (PDF 751KB) setting out “good practices for consideration”.
Overall, IOSCO concludes that its 2013 principles (PDF 825KB) remain relevant and appropriate with “no major gaps” and that the ETF structure has proven resilient. However, due to differences among jurisdictions, IOSCO saw a benefit in supplementing its 2013 principles with good practices. Its consultation runs until July, after which it will publish a final report.
Impact of the war in Ukraine
As well as the terrible humanitarian impact of Russia's invasion of Ukraine, the war has had consequences for financial markets and the real economy. In the fund management space, in addition to increased volatility, the situation created challenges for funds with exposures to Russian, Belarussian and Ukrainian assets that have become illiquid, hard to value and/or subject to sanctions.
Various European regulators have published communications setting out their expectations on this topic and potential new rules. For example:
- The FCA published a consultation paper to address the potential harm caused by UK authorised funds' exposure to such assets. The limited, emergency measures would allow authorised fund managers to create side pockets to hold affected investments and separate them from a fund's other investments.
- The CSSF published frequently asked questions (PDF 139KB) to provide clarification regarding temporary and structural measures available to Luxembourg fund managers (including the use of LMTs).
- In a news article3, the AMF reminded asset managers of their obligations regarding risk management, and that they have liquidity management tools to protect clients' interests as well as to ensure financial stability and guarantee market integrity.
- ESMA has just released a statement to promote convergence in the way that fund managers and regulators respond to the crisis, to provide clarity and to remind fund managers of their obligations. ESMA set out general principles in case of material liquidity issues and valuation uncertainties and considered the permissibility of side pockets and similar arrangements. ESMA concluded that AIFMs can consider using side pockets where it is in the best interest of investors, and that side pockets in UCITS “could be permissible”.
- The CBI wrote (PDF 98KB) to certain market participants (including fund management companies), emphasising that the liquidity position of funds must be reviewed on an ongoing basis and be aligned with the fund’s redemption policy, and an appropriate suite of LMTs should be deployed. Following ESMA’s statement, the CBI published a notice (PDF 92KB) of intention, permitting the creation of side pockets in UCITS under certain circumstances and establishing a streamlined authorisation and approval process.
Connect with us
1 “Swing pricing” refers to adjusting the price of a fund to reflect the transaction costs associated with buying and selling securities for subscribing and redeeming investors.
2 AMF website - “The AMF proposes measures to promote a wider adoption of liquidity management tools by fund managers” - web page link: https://www.amf-france.org/en/news-publications/news-releases/amf-news-releases/amf-proposes-measures-promote-wider-adoption-liquidity-management-tools-fund-managers
3 AMF website - “Consequences of the Ukrainian crisis: the AMF alerts asset management companies” - web page link: https://www.amf-france.org/en/news-publications/news/consequences-ukrainian-crisis-amf-alerts-asset-management-companies