Friday March 20 2020
News Source: Fund Regulation
Focus: Liquidity Risk Management
The Financial Conduct Authority has published a speech by Edwin Schooling Latter, Director of Markets and Wholesale Policy, to Investment Association members. In the speech Mr Schooling discusses open-ended funds investing in less liquid assets.
Included in his speech are the risks surrounding open-ended funds offering daily redemptions, but where a significant proportion of the assets in which the fund invests cannot be liquidated within a day without material loss of value, providing for a asset-liability mismatch.
He also discusses how these risk can be addressed through the asset side of the balance sheet, or through managing liabilities, i.e. redemption arrangements, in a way that better matches asset liquidity. Addressing the mismatch through the asset side, would mean restricting the assets in which daily dealing open-ended funds may invest to those that can be sold same day without material loss of value – for example highly liquid shares or the highest quality liquid bonds.
Alternatively, Mr Schooling discusses restrictions on the asset side is better to align redemption arrangements with the liquidity of assets, including swing pricing to address first mover advantage and notice periods. These are the two main types of tool on which the FCA and Bank’s joint work has focused.
Regarding swing pricing, he discussed the challenges around it requiring an assessment of the potential sale price of underlying assets before a sale and redemption is made. The magnitude of swing pricing would vary with market conditions and overall redemption pressure, and so may be difficult to calibrate in practice. If swing pricing is used, it must be used fairly.
The alternative tool discussed was notice periods, which offer several benefits, including:
- arguably a simpler and therefore more effective way of promoting investor understanding of the risks associated with investing in less liquid assets through an open-ended structure than the most comprehensive descriptions of liquidity risk and risk management tools in a lengthy prospectus.
- reduce the likelihood of redemption requests at times of market stress. As when redeeming daily-dealing funds, the actual sale value is only determined at the point when the transaction is priced and executed. But, with a notice period, the gap between the last published Net Asset Value (NAV) before receiving the redemption request and the NAV determined at execution of the transaction would be longer. Trying to sell at a time of stress would mean the investor accepting significantly greater uncertainty about the value they would achieve than if they gave notice in a period of more ‘normal’ market volatility.
- Reduction in fire sales. If the fund could, for example, sell its relatively less liquid bonds over a 2-week or 1-month period, rather than having to sell on a single day when markets may be most stressed, this could both be better for investors and reduce amplification of price moves affecting the remainder of the financial system.
He also stresses that Compliance with regulatory requirements for authorised fund managers, such as managing liquidity and treating investors fairly, is part of obligations on relevant staff at firms operating funds to act with due skill, care and diligence. All firms should be clear where this responsibility lies.
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