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Thursday, July 18
2019 04:00 PM / IOSCO
Liquidity problems which have recently affected some investment funds have been the subject of extensive media coverage. The Bank of England published a Financial Stability Report of the Financial Policy Committee (FPC), a committee of the Bank of England, earlier this month, which discusses potential mismatches between the liquidity of fund assets and redemption terms offered by funds to their investors. These developments have led some to question whether recommendations previously issued by the International Organization of Securities Commissions (IOSCO) on the liquidity management of open-ended investment funds (OEFs) adequately address risks in OEFs which could disadvantage investors or lead to broader financial system contagion.
In particular the FPC has stated that “This is a global issue. For that reason, the FPC supported the Financial Stability Board’s 2017 recommendation that funds’ assets and investment strategies should be consistent with their redemption terms. However, subsequent work by IOSCO did not prescribe how this should be achieved.”
IOSCO issued its Liquidity Risk Management Recommendations in February 2018 (2018 LRM Recommendations) following an
extensive public consultation exercise. This statement explains why these
recommendations do, in fact, provide a comprehensive framework for regulators
to deal with liquidity risks in investment funds, as explained below.
Suspension of fund investors’ ability to redeem for cash
There have been some recent high-profile instances where OEF managers have decided to suspend or “gate” investor redemptions. Suspensions may follow a determination by an OEF manager that the fund is unable to sell a sufficient quantity of underlying assets, or sell enough assets at acceptable prices, to meet current or anticipated redemption demands from investors or to meet those demands on a fair basis. The concern is that when an OEF has committed a large proportion of its portfolio to relatively illiquid assets (possibly in a “reach for yield”), existing promises to investors that they can redeem their investments for cash very quickly – even on a daily basis – become inherently unreliable.
Against this background it is reasonable to
ask whether the 2018 LRM Recommendations provide sufficient guidance to enable
funds and regulators to achieve an appropriate alignment between funds’ assets
and their investment strategies, whether they leave too much discretion to
national regulators leading to differences of approach between jurisdictions,
or whether they give too much leeway to fund managers to resort to suspensions
or gating of redemptions rather than properly aligning liquidity and redemption
terms in the first place.
IOSCO recommendations stress a proper alignment of fund assets and redemption terms
The 2018 LRM Recommendations are unequivocal that, throughout the entire lifecycle of the fund (design, pre-launch, launch and subsequent operations), there should be an appropriate alignment between portfolio assets and redemption terms. In particular, the recommendations make clear that OEFs should not be managed in such a way that the investment strategy relies on any additional ex-post measures such as suspensions. These measures are not a substitute for sound liquidity risk management from the outset, so that the dealing frequency of units meets the anticipated liquidity needs of the fund under normal and foreseeable stressed market conditions.
Annex 1 refers to some of the 2018 LRM Recommendations which address these expectations. They cover, among other matters, the need to ensure that OEFs with daily redemptions should have stricter liquidity requirements than those with longer- term redemptions and that OEFs invested in real estate (or other illiquid assets) with more frequent redemptions should hold a stock of relatively more liquid assets.
The 2018 LRM Recommendations make clear,
however, that ex-post liquidity management measures such as suspension and
swing pricing are important and necessary components of a comprehensive OEF
risk management toolbox that should be available for use in exceptional
circumstances. Use of these measures might also alleviate selling pressure in
the underlying asset class when markets are severely stressed. It would be
unrealistic to expect that fund managers will be able to match a fund’s
liquidity with dealing periods at all times and in all circumstances, no matter
how extreme, so as to eliminate any possibility of needing to suspend
redemptions.
Principles-based or prescriptive global standards for fund liquidity?
It would be impractical to pursue, as some
have suggested, a global “one size fits all” prescriptive approach which tries
to match different asset classes, fund investment strategies and redemption
periods according to universally applicable standards. This is because the fund
management industry (compared to, for example, the banking sector) is extremely
diverse. Funds employ a multitude of different investment strategies and
encounter varying degrees of liquidity amongst a huge variety of investable
asset classes and as between jurisdictions.
Liquidity within one asset class can change over time in response to
external factors affecting that class. Funds target different types of
investors, the sizes of individual funds also vary relative to the markets in
which they invest and funds differ in the ways in which they are distributed
across global markets.
The 2018 LRM Recommendations do, however,
contain practical, actionable principles which support those domestic
regulators who may wish or need to pursue a prescriptive approach responsive to
the nature of particular OEFs they supervise directly and/or specific
characteristics of the local markets in which they operate. Domestic regulators
may also need to address related conduct concerns, such as those which may
arise from the way in which individual funds are managed or marketed, including
material disparities between legitimate investor expectations of liquidity (as
per a fund’s disclosure materials or regulatory classification) and the
reality.
Conclusion and Next Steps
The 2018 LRM Recommendations are directed at
preventing liquidity and redemption mismatches from arising in the first place,
rather than just mitigating problems as they crystallise. And they deal with
attendant benefits and risks when OEFs may exceptionally look to use other
liquidity management tools (such as suspensions and swing pricing) in the face
of untoward redemption pressures, including the need to treat investors fairly
and to consider any broader market implications. They also allow domestic
regulators to apply the recommendations in a prescriptive manner to manage
specific or idiosyncratic liquidity risks.
Securities regulators are, however, expected
to ensure effective implementation of the 2018 LRM Recommendations. Some
domestic regulators have adopted, or are consulting on, liquidity management
regimes consistent with the recommendations. IOSCO intends to conduct a robust
assessment exercise beginning in 2020 which will review how the 2018 LRM
Recommendations have been implemented in practice.
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