Liquidity management in authorised funds – FCA steps up the pressure

The FCA has advised Authorised Fund Managers (AFMs) to review their liquidity management practices to ensure that they are appropriate.

Overview

The FCA is keen (and keen to be seen) to encourage good practice in managing fund liquidity and is urging pro-active examination of AFMs’ liquidity management practices in the light of Woodford.

As a result, it has written to all Chairs of AFMs to remind them that ensuring effective liquidity management in the funds they manage is one of their central responsibilities, even when investment management has been delegated to another person. It expects AFMs to review their practices as soon as practicable to ensure that the Chairs and their fellow AFM board members “are comfortable they are appropriate”.

The letter follows hard on the heels of the rule changes for non-UCITS retail schemes (NURS) investing in illiquid assets which the FCA announced in PS19/24 (on which we reported here) as well as its ongoing work in the wake of the Woodford problems.

What does the letter say?

The FCA remains concerned that open-ended funds cannot always liquidate assets sufficiently quickly to meet increased investor redemption requests and comments that the problem is more acute in funds which (like the majority of the UK’s retail funds) deal daily.
The measures set out in PS19/24 to strengthen the regulatory framework for NURS include

• mandating the temporary suspension of dealing in certain circumstances
• improving liquidity management processes for affected funds and
• increased investor disclosure.

These new rules come into force in September 2020. Even so, since it sees effective liquidity management as “an irreducible, core function for all open-ended funds”, the FCA is encouraging AFMs to consider that adopting some of the rules ahead of this date (to the extent that this doesn’t cause a conflict with the existing rules) would be in the investors’ interests.

The FCA’s letter asks AFMs to consider the obligations they have regarding (a) portfolio composition, (b) asset eligibility and (c) liquidity management as well as reviewing their liquidity management arrangements against the good practice that the letter then sets out.

Portfolio composition

The FCA reminds AFMs of UK authorised funds that they must consider the appropriateness of assets in which they invest and take into account the rules and guidance in the Collective Investment Schemes (COLL) sourcebook - in particular, the requirements under COLL 5.2.7AR, which include the rule that the liquidity of a transferable security mustn’t compromise the AFM’s ability to redeem units in the fund.

Where assets are less liquid, the FCA emphasises that “robust valuation practices” are vital and points AFMs to its 2017 review into hard to value assets, which highlighted that firms need to have expertise and independence in their valuation process, as well as being able to demonstrate that they adhere to their valuation policies to a meaningful degree.

Liquidity management for investment firms: good practice

The FCA’s paper Liquidity management for investment firms: good practice outlines good practice for disclosing, overseeing and implementing liquidity tools and AFMs should review their own arrangements against it, improving them where necessary. The letter also sets out a number of key features of robust liquidity management which AFMs should take notice of.

For less liquid funds and for funds investing in less liquid assets, in particular, the FCA notes that its sees “clear benefits” to setting liquidity triggers for when the fund should consider suspension and that these triggers are discussed in detail with fund boards and their depositaries.

The FCA also draws AFMs’ attention to IOSCO’s 2017 Final Report, Recommendations for Liquidity Risk Management for Collective Investment Schemes. This contains 17 recommendations for those responsible for managing fund liquidity to ensure that investors’ interests are protected and that liquidity is managed appropriately even in stressed market conditions.
The FCA recommends that AFMs review the IOSCO recommendations as part of their liquidity management review and that they consider the extent to which their arrangements align with them.

In related work, the FCA has been working since July 2019 with the Bank of England’s Financial Policy Committee (FPC) on a review of how an open-ended fund’s redemption terms can best be aligned with the liquidity of its assets, with the FPC warning that the mismatch between the two 'has the potential to become a systemic risk'.

A statement issued jointly by the FCA and Bank of England in December 2019 noted that, if greater consistency is to be achieved between the liquidity of a fund’s assets and its redemption terms, the following principles should apply:

• the liquidity of fund assets should be assessed either (a) by reference to the discount in price that would be needed for a quick sale of a representative sample of those assets or (b) the time frame needed to achieve a sale which avoided a material price discount;
• to ensure an outcome that is fair for both redeeming and remaining investors, those investors who want to redeem their units should receive a price that reflects the discount which would be needed to sell the required portion of the fund’s assets in the specified redemption notice period; and
• redemption notice periods should reflect the time that would be needed to sell the required portion of a fund’s assets without a discount beyond that captured in the price which redeeming investors would receive.

The review will now go on to consider how these principles might be implemented in a way that is both proportionate and effective. The FCA will use the conclusions of the review (which will be published in 2020) in the development of its rules for open-ended funds.