Fund liquidity risk management

Introduction

As we highlighted in June 2022, regulators are increasingly focused on fund liquidity risk management. Almost three years on from the high market volatility in spring 2020, and market stress in 2022, all fund managers should have critically evaluated their liquidity management frameworks and controls and implemented any required enhancements.

Regulators' expectations are now evolving. Whilst little further has been published regarding Money Market Funds (MMFs), work has progressed on Open-Ended Funds (OEFs) more broadly. Further work has been teed up for this year, which will eventually have implications for OEF managers in terms of the structuring and day-to-day management of their funds. Fund managers should be tracking regulatory developments to understand the policy direction of travel.

International developments

Reviews of recommendations published by the Financial Stability Board (FSB) in 2017 and IOSCO in 2018 regarding liquidity risk management in OEFs have now been completed. This concludes the latest phase of significant work in this area, with the publications setting out follow-up work for this year and beyond.

IOSCO's Thematic Review

IOSCO's 2018 recommendations were addressed to fund managers and regulators. They covered liquidity considerations to be built into the fund design process, day-to-day liquidity risk management and contingency planning.

Its review, which concluded in November 2022, tested how well the recommendations had been implemented in practice. Overall, the findings were positive. IOSCO found that in larger jurisdictions, there was a "high degree of implementation" of the regulatory requirements. However, it identified certain "gaps and shortcomings.” Ongoing challenges relate to the calculation and interpretation of liquidity risk, the availability and quality of data for liquidity analysis and stress testing, and potentially misplaced assumptions about the liquidity of certain types of assets. IOSCO therefore suggested that jurisdictions and fund managers consider further steps to improve implementation of the recommendations. It did not propose enhancements to the recommendations, but the findings informed the FSB's assessment.

The FSB's assessment

The FSB's 2017 recommendations were originally put in place to address “structural vulnerabilities” from asset management activities that the FSB considered could potentially present financial stability risks.

Compared with the largely positive findings in IOSCO's review, the FSB's review of its own recommendations, published in December 2022, found there is room for improvement in terms of identifying and mitigating financial stability risks from OEFs. The FSB has proposed various follow-up work to:

• Reduce structural liquidity mismatch.
• Increase the uptake and consistency in use of liquidity management tools (LMTs).
• Enhance disclosure to investors.
• Close data gaps to improve authorities' ability to monitor financial stability risks.
• Promote further the use of fund- and system-wide stress testing.

Given the significant work already done to date, none of these findings is a complete surprise. However, the granular nature of the FSB's proposed framework to reduce structural liquidity mismatch, including the potential use of thresholds relating to the liquidity of assets and corresponding LMTs to be used, may go further than some had expected. Also, the difference in tone between the two sets of findings indicates that the views of global policy makers are still not fully aligned.

The FSB's review of the OEF recommendations forms part of a much wider package of reforms in the non-bank sector, focussing on OEFs, MMFs, margining practices, bond markets and US dollar funding in emerging markets. In November 2022, the FSB published a progress report to the G20 on these initiatives.

Regional and national developments

Regional and national regulators have pushed ahead with their own initiatives.

• Discussions to finalise the EU AIFMD review continue, but final negotiations are not expected to start until the second quarter of 2023. The relevant EU Parliament committee approved its position on the proposals in January 2023. As expected, it agreed that AIFMs and UCITS Man Cos should select at least two appropriate LMTs in addition to fund suspension, and supported guidelines to ensure harmonisation. Additionally, under certain circumstances, regulators may be able to request LMT activation by fund managers where there are financial stability risks. The potential introduction of harmonised regulatory reporting for UCITS could have a more significant impact.
  
• In its February 2023 “portfolio letter”, the UK Financial Conduct Authority confirmed that fund liquidity management remains a supervisory priority and that it is currently concluding a multi firm review on the topic. This emphasises that fund managers need to be aware of supervisory activity as well as new policy developments. For the first time, the Bank of England plans to conduct a stress test of the non-bank sector this year.  Additionally, the FCA has published a discussion paper on the future UK regulatory regime. It is seeking stakeholder views on amending its rules and guidance around liquidity stress testing and clarifying its rules on certain liquidity management tools. The FCA is also considering what additional liquidity reporting or public disclosure for UK UCITS could be necessary.
  
• The French regulator clarified its requirements in updates published over October and November 2022, signalling a clear policy goal to increase the availability of LMTs in French funds. It aims to do this by facilitating the integration of certain liquidity tools, providing more guidance, increasing disclosure requirements to investors and the regulator where funds do not use LMTs, and aligning its approach to different LMTs where possible.
  
• Although new LMTs were made available to German fund managers by law in spring 2020, a survey by the regulator found that most fund managers had not introduced any new LMTs as at May 2022. The regulator will therefore continue to actively monitor developments.
  
• In November 2022, the Central Bank of Ireland (CBI) introduced measures to impose leverage limits on certain Irish real estate funds. The move signalled the CBI's growing determination to introduce a macroprudential framework for the non-bank sector. In a subsequent speech, the CBI noted the imperative need to “re-double our efforts globally to develop and operationalise the macroprudential framework for non-banks, especially investment funds".
• Also in November 2022, the US Securities and Exchange Commission (SEC) proposed three enhancements to the OEF liquidity framework.

1.  Improving existing liquidity classifications by establishing new minimum standards, including incorporating stressed conditions. The changes are designed to prepare funds better for such conditions and prevent them over-estimating the liquidity of their assets. Certain funds will also be required to maintain a minimum amount of highly liquid assets of at least 10 percent of net assets.
   
2. OEFs (excluding MMFs and Exchange Traded Funds) will be required to use swing pricing (incorporating specific information in the swing factor), and to implement a cut-off time for investor orders (a “hard close”). The SEC's decision to increase the uptake of swing pricing may have wider consequences for its uptake in other jurisdictions where it is not already widely used.
3. The monthly regulatory reports of OEFs will need to be filed to a tighter deadline, and all monthly reports will become public 60 days after month-end (at present, only the reports for the third month in each quarter are made public).

Next steps

At international level, the direction of travel for follow-up work on fund liquidity risk management is clear. In the meantime, some regulators are already looking to advance their own standards or conduct reviews to keep pace.

Fund managers should review IOSCO's and the FSB's findings, and consider the FSB's policy proposals. Managers will need to have a coherent approach to regulatory change to keep track of these developments in the context of a wider and busy regulatory agenda.

This year, the FSB may turn to leverage as the next key area of focus in the non-bank sector.