Oversight October 2016 - SFC Circular to Managers of retail funds on liquidity risk management

On 04 July 2016, the Investment Products Department of the Securities and Futures Commission (SFC) published the Circular to management companies of SFC authorised funds on Liquidity Risk Management (Circular). The aim of this Circular is to provide management companies of SFC authorised funds (Managers) guidance to ensure effective liquidity risk management of retail funds, by listing a set of principles and a range of suggestions which the SFC considers to be good practice. The guidance seeks to be in compliance with international standards issued by the International Organization of Securities Commissions (IOSCO), including the Principles on the Suspension of Redemptions (2012), Principles on Liquidity Risk Management (2013) and Principles on the Valuation of Collective Investment Schemes (2013). In addition, the SFC issued a circular to Managers and trustees/custodians of SFC authorised funds on fair valuation of fund assets in 2015, which aimed to provide guidance to Managers on the valuation policies and procedures of SFC authorised funds, particularly where the market value of a fund asset is unavailable or unreliable or becomes illiquid or hard to value as a result of significant market events.

The SFC says in the Circular that it recognizes that effective liquidity risk management is crucial not only because it can minimise the risk of inability to meet redemption requests but also because it can safeguard the interests and fair treatment of investors. Accordingly the Circular identifies principles and suggested practices for managing liquidity risk based on the results of a recent review by the SFC of the liquidity risk management policies of a number of fund managers. Managers are expected to review and, where necessary, enhance their internal liquidity risk management processes in view of the Circular by no later than 01 January 2017.

This Oversight provides a brief summary of the Circular including the SFC’s recommendations. It should be noted that in theory Managers covered by the Circular are not limited to those licensed by the SFC for Type 9 (asset management) regulated activity but include overseas Managers, such as those Managers of UCITS funds which are authorised in Hong Kong. However, the Circular in effect deems Managers regulated in acceptable inspection regimes to be in compliance based on their home jurisdiction meeting “international standards”.

Manager’s internal governance

The SFC affirms in the Circular that liquidity risk management is a responsibility of Managers and should be an integral part of the overall risk management programme of Managers. As a general principle, Managers should at all times exercise due care, skill and diligence in managing the liquidity of funds, and ensure that investors’ redemption requests are able to be met whilst remaining investors are treated fairly. Moreover, the SFC expects that Managers should establish effective and well documented liquidity risk management policies and procedures which are reviewed periodically and as needed.

The SFC has identified certain minimum components in relation to a Manager’s internal governance structure:

• First, there should be a liquidity risk management function to monitor the liquidity risk on a day to day basis. This may be a part of the overall risk management function, but should be functionally independent from the day to day portfolio investment function.
• „„Second, there should be an appropriate degree of oversight over the liquidity risk management function by either senior management or a designated committee responsible for liquidity risk management. Again, the majority of the members in the committee or those performing the oversight role should be independent from the day to day portfolio investment function.
• Third, an appropriate mechanism and process should be in place to enable proper responses upon change in market conditions so that Managers can assess, review and decide on actions required at short notice to meet the liquidity demands on the funds under sudden and stressed conditions.

Accordingly, the SFC indicates that it is good practice to have a hierarchically and functionally independent risk management function that regularly communicates with the relevant portfolio manager on a fund’s liquidity risk issues and which can escalate problems identified to the liquidity risk management sub-committee. Such sub-committee should oversee liquidity risk management and should have regular meetings as well as ad hoc meetings under certain conditions (such as periods of market stress) to determine any appropriate action in order to safeguard the interests of investors. Where a Manager is small and does not have a separate liquidity risk management department or committee, the SFC proposes that the Manager designate staff who are functionally independent from the day-to-day portfolio investment function to carry out the day-to-day liquidity risk monitoring function.

Product design and disclosure

Another key area which the Circular touches on is that of product design. The SFC states that Managers should consider liquidity risk management issues throughout a fund’s life cycle in order to minimise liquidity risk and should formulate measures to ensure that the fund’s subscription and redemption arrangements are appropriate for its investment strategy and underlying assets.

The Circular sets out some guidance on the factors which the SFC believes that Managers should take into account when designing a new fund. In general, Managers should:

• Understand the liquidity profile of a fund’s assets (and collateral holdings where relevant) under different market conditions, in particular where such assets amount to a significant percentage of a fund’s net asset value. Managers should also be mindful that assets that are generally considered to be liquid may become illiquid under certain circumstances.
• Understand the liquidity profile of the fund’s liabilities (including its ability to meet redemption requests) and appropriately align the liquidity profile of the fund’s liabilities with that of the fund’s assets.
• „„Understand the profile of the fund’s investors and their historical and expected redemption patterns, so that Managers can seek to better align the liquidity profile of the fund’s liabilities with its assets. The SFC recognises that liquidity risk may be more prominent where a fund has several large institutional investors, where large and unexpected redemptions are often a key source or liquidity risks. Practically, however, many Managers may not have much visibility on investor profile information due to the fund’s distribution arrangements. In such cases, the SFC expects Managers to take reasonable steps to obtain investor profile information when assessing liquidity risk. Other steps to manage liquidity risk may be taken, for example by maintaining the size of the fund at a level commensurate with the Manager’s professional and prudent assessment of the size and liquidity of the relevant investments and the size of other similar funds under its management.
• „„Determine an appropriate dealing frequency, notice period and fund size (where appropriate) in accordance with the liquidity profile of the fund’s assets and liabilities, investor base and liquidity risk management tools that are in place.
• Identify appropriate liquidity risk management tools and include in the fund’s constitutive documents the ability to use such tools.
• „Make appropriate disclosure in the fund’s offering documents, and in particular highlight the significance and potential impact of liquidity on a fund and its investors.

Ongoing liquidity risk assessment

• „„The Circular also highlights the importance of ongoing liquidity risk management. When a fund is in operation, the liquidity risk profile of a fund should be monitored and reviewed regularly by its Manager, including the fund’s liabilities and assets, investor base and historical and expected redemption patterns.

In order to regularly monitor and assess the liquidity of the fund’s assets under current and likely future market conditions, the Circular recommends Managers to classify a fund’s assets into different liquidity categories, and exercise its professional judgement in determining appropriate metrics or factors for liquidity assessment and categorisation (such as quantitative metrics or qualitative metrics).

Managers should set internal liquidity targets or indicators in the form of minimum or maximum amounts that should be invested in assets under each liquidity category. Such targets or indicators should be based on the fund’s investment strategy, asset and liabilities profiles, market conditions, the design and disclosure of the product and any relevant factors. The Manager should continually assess the fund’s liquidity position against such internal liquidity targets or indicators and take appropriate action in accordance with internal liquidity risk management protocol. Where a fund is unable to meet the targets or indicators, there should be liquidity risk management policies and procedures to escalate the incident to those responsible for liquidity risk management for consideration in a timely manner.

Overall, the SFC expects Managers to perform liquidity assessment, categorisation and set targets or indicators in a holistic manner and use their own professional judgement to assess the liquidity of the fund’s assets. The Circular advises Managers to avoid making presumptions on the liquidity of assets based solely on a single metric or factor and should recognise that although some assets tend to be more liquid (such as large cap listed equities or short term government bonds), the liquidity profile of such assets may change in certain market conditions. Where a Manager needs to make assumptions in performing the liquidity assessment, it is necessary to ensure that the assumptions are reasonable and prudent.

The SFC says that it requires Managers to maintain good records of the Manager’s ongoing liquidity risk assessments, whether any actions have been taken and the respective underlying considerations.

Stress testing

The Circular requires Managers to perform liquidity stress testing on their funds on an ongoing basis in order to (i) assess the impact of plausible severe adverse changes in the markets conditions on the liquidity of the funds and (ii) the adequacy of the Manager’s action plans and liquidity risk management tools. To do so, the SFC states that Managers should develop both backward looking (based on historical market conditions and redemption demands) and forward looking (based on hypothetical market conditions) stress test scenarios.

Managers should also perform stress testing regularly (although the Circular does not impose any minimum frequency requirements). To this end, the SFC suggests that Managers should use their professional judgement and perform more frequent stress tests on funds with more rapidly-changing portfolio profiles, market conditions and investors. In addition, where there are major changes to the markets in which the fund invests, or the structure or strategy of the fund or to its investor base, the Manager should also perform more frequent stress tests.

Stress test results should be reviewed by the internal liquidity risk management committee or senior management who perform the oversight role to determine whether further action is warranted. Stress test results should be adequately integrated into the fund’s investment decision-making and risk management processes, and even if no immediate action is warranted, the Manager should have in place action plans on how to meet a fund’s liquidity needs should the stress scenarios materialise.

Managers are expected to be able to articulate for the SFC the rationales behind the choice of stress test scenarios. Appropriate documentation recording stress testing are also expected to be maintained by Managers, and in particular whether any actions are taken in light of the stress test results.

Liquidity risk management tools

Liquidity risk management “tools” should be used to protect the interests of investors. Managers should also ensure that the investment strategy and portfolio profile of a fund are consistently maintained as much as possible when using these tools.

The Circular provides guidance on some tools which the SFC thinks that Managers may use to manage the liquidity risk of a fund. These include the following:

• Tools and practices to delay and/or limit redemption, and/or allow Mangers to process redemptions in an orderly manner. Examples of these may include “gating”, the ability to suspend redemptions, imposing notice periods and lock up periods.
• „„Tools to allocate the costs of redemption to redeeming investors and to mitigate first mover advantage to minimise the impact on a fund and its remaining investors where there is a large redemption. Examples include the imposition of swing pricing and an anti-dilution levy in cases where a fund experiences major redemptions (where such mechanisms are employed, the Manager is expected to maintain an audit trail of its decisions).
• Other sources of liquidity for the fund, such as access borrowings or credit lines.

Liquidity risk management tools chosen by a Manager should, the SFC opines, be subject to ongoing review, with reference to the liquidity risk assessment and stress testing results, as well as the changing market conditions.

Managers should consult the trustee/custodian before using any liquidity risk management tools and should ensure that there are clear internal procedures on the circumstances under which each liquidity risk management tool will be implemented, as well as the responsibilities of the parties involved in deciding and implementing the relevant tools. Moreover, the fund’s constitutive documents should allow Managers to use the relevant liquidity risk management tools.

To provide greater transparency to investors, the Circular requires disclosure in the fund’s offering documents, which should include appropriate disclosure on (i) the liquidity risk management tools adopted, (ii) an explanation of when the tools may be used, (iii) the tools’ impact on the fund and investors and (iv) any attendant risks to investors.

Whilst such tools above are helpful guidance it is unclear how much flexibility a Manager will usually have in the context of the SFC’s Code on Unit Trusts and Mutual Funds (Code) requirements as to dealing and settlement. In particular, Chapter 6.14 of the Code provides that the maximum interval between the receipt of a properly documented request for redemption of units/shares and the payment of redemption money generally should not exceed one calendar month. Hong Kong domiciled trusts are required to include this settlement deadline in their trust deeds.

Implementation and action plan for Managers

Managers licensed by or registered with the SFC should enhance their internal liquidity risk management process to implement the minimum requirements set out in the Circular by no later than 01 January 2017.

In respect of existing funds, Managers should ensure that the relevant offering documents are up to date and contain all information necessary for investors to make informed investment decisions. Managers should also make necessary updates and revisions in view of the Circular as soon as practicable. This means Managers need to disclose in the offering documents the relevant liquidity risk management policies and procedures, as well as the liquidity risk management tools that may be used by the fund.

In respect of new fund applications, the SFC may seek further information from applicants regarding the existing or proposed liquidity risk management measures before granting authorization of the funds under section 104 of the Securities and Futures Ordinance.

Conclusion

Liquidity risk management has received increased focus from regulators of major financial centres since 2008. In addition, the China A-share market crash in 2015 (where a significant number of equities which were traditionally considered as highly liquid securities were suspended and could not be disposed of) has further highlighted the need for Managers in Hong Kong to maintain good liquidity risk management procedures. The Circular aims provide an overall framework for liquidity risk management which is in line with international practices and standards, and to guide Managers in Hong Kong on how to put in place policies and procedures that will enable them to better deal with liquidity risk issues and market shocks with regard to their retail funds. While many Managers may already have liquidity risk management policies and procedures in place, the practices recommended by the Circular provide some detailed guidance on the SFC’s expectations in this area and so would likely be the minimum benchmark to be satisfied by a Manager in addressing investor concerns or SFC questions with regard to illiquidity events.