Tuesday November 5 2019
News Source: Fund Regulation
Focus: Liquidity Risk Management
Following the FCA feedback to CP18/27 and the new rules for investing in inherently illiquid assets, the FCA has published a letter to Authorised Fund Managers (AFM) regarding their responsibility of ensuring effective liquidity management in funds.
In the letter the FCA state that it remains the AFMs responsibility even if they have delegated investment management to another person. Good fund governance ensures the liquidity of the funds’ underlying assets is appropriately considered.
However, the letter goes on to state that, open-ended funds are not always able to liquidate assets sufficiently quickly to meet increased redemption requests from investors. This issue can be more acute in daily dealing funds, which make up most of the retail market in the UK. Firms can prevent this leading to harm through suitable portfolio composition, effective fund governance, including by independent directors, understanding investor base, as applicable, and investors’ redemption rights, and using liquidity tools appropriately, particularly in times of market volatility and stress.
What the FCA are doing
On 30 September 2019, the FCA published a policy statement (PS19/24) on illiquid assets and open-ended funds, outlining measures to strengthen the regulatory framework in this area. These included mandating temporary suspension of dealing in certain circumstances, improvements in liquidity management processes for impacted funds and increased disclosure to customers. This policy statement focused on non-UCITS retail schemes (NURS), however firms should recognise that effective liquidity management is an irreducible, core function for all open-ended funds. Although the new rules do not come into force until September 2020, fund managers (and depositaries) may wish to consider whether it would be in investors’ interests to adopt some of the measures, such as improved liquidity management, ahead of the coming into force date, where these do not conflict with the rules in force before then.
AFMs of UK authorised funds must consider the appropriateness of assets they invest in. See the Collective Investment Schemes (COLL) sourcebook for requirements for asset managers and authorised funds.
- COLL 5.2.7AR outlines the criteria which transferable securities must fulfil to be an eligible asset for a UCITS scheme. These criteria also apply to transferable securities held by NURS (see COLL 5.6.5AR).
- COLL 5.2.3R requires that AFMs should ensure UCITS funds have a prudent spread of risk (see COLL 5.6.3R for NURS). This requirement to consider the spread of risk is in addition to the specific provisions on spread for UCITS in COLL 5.2.11R, such as the requirement that no more than 10 per cent of scheme property should consist of transferable securities issued by any single body.
- Meeting the requirements in COLL 5.2.11R may not, in itself, ensure a prudent spread of risk in a fund.
- AFMs must at all times during a dealing day comply with their obligations to redeem units at the request of qualifying unitholders under COLL 6.2.16R(3).
In particular, AFMs should consider the requirements under COLL 5.2.7AR, including that the liquidity of a transferable security does not compromise their ability to redeem units in the fund. Assessing the liquidity of an asset may require the consideration of several factors. This could include considering whether a security is, in practice, sufficiently liquid, even where it is admitted to trading on an eligible market.
Where assets are less liquid, robust valuation practices are vital. The FCA 2017 review into hard to value assets highlighted the need for firms to have expertise and independence in their valuation process, as well as that firms need to be able to demonstrate meaningful adherence to their valuation policies.
Liquidity management for investment firms: good practice
Firms must have appropriate systems, controls and governance to oversee and manage liquidity risks. The FCA paper Liquidity management for investment firms: good practice outlines good practice for dealing, and disclosing, overseeing and implementing liquidity tools.
Key features of robust liquidity management include:
- processes to ensure that the fund dealing (subscriptions and redemptions) arrangements are appropriate for the investment strategy of the fund
- regular assessment of liquidity demands
- an ongoing assessment of the liquidity of portfolio positions
- using liquidity buckets for liquidity risk management
- an independent risk function that monitors portfolio bucket exposures regularly and reports breaches to the set limits
- stress testing by fund managers to assess the impact of extreme but plausible scenarios on their funds
These fundamental features are particularly beneficial when combined with a formal policy of liquidity thresholds and triggers that prompt escalation to an appropriate risk committee or action in themselves. Particularly for less liquid funds and funds investing in less liquid assets, the FCA see clear benefits to setting liquidity triggers for considering fund suspension, which are discussed in detail with fund boards and their depositaries.
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