Les Autorités canadiennes en valeurs mobilières (les « ACVM ») ont publié à l'intention des gestionnaires de fonds d'investissement (les « GFI ») des indications sur l'élaboration et le maintien d'un cadre efficace de gestion du risque de liquidité (la « GRL ») pour pareils fonds.
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The Canadian Securities Administrators (the CSA) have issued guidance to investment fund managers (IFMs) on developing and maintaining an effective liquidity risk management (LRM) framework for investment funds.CSA Staff Notice 81-333 Guidance on Effective Liquidity Risk Management for Investment Funds (the LRM Guidance) is aimed at investment funds subject to National Instrument 81-102 Investment Funds (NI 81-102) but may be relevant to LRM considerations of other funds.
The LRM Guidance is based on existing securities regulatory requirements and does not create any legal requirements or modify existing ones.
Background and Existing Regulatory Requirements
Liquidity risk (defined for the purposes of the LRM Guidance as "the risk that a fund is unable to satisfy redemption requests without having a material impact on the remaining securityholders of a fund") is a key focus for securities regulators and other financial regulators. Funds must be able to sell their portfolio assets within a reasonable amount of time to satisfy redemption requests from their investors. Where there is a potential mismatch between the liquidity of a fund's portfolio assets and the redemption terms and conditions offered to investors, there may be negative consequences for both the fund and its investors.
With the growth of open-ended funds that offer daily redemptions to investors and increased investment in less liquid asset classes, liquidity risk poses a significant threat to the Canadian financial system. The international Financial Stability Board (FSB) and the Bank of Canada have identified the mismatch between liquidity and redemptions as a potential source of structural or systemic risk. Following the FSB's publication in 2017 of its policy recommendations to address structural vulnerabilities from asset management activities, the International Organization of Securities Commissions (IOSCO) issued a report entitled "Recommendations for Liquidity Risk Management for Collective Investment Schemes - Final Report" (the IOSCO LRM Recommendations), which noted that there should be an appropriate alignment between portfolio assets and redemption terms throughout the entire lifecycle of a fund.
In Canada, provincial securities legislation generally imposes a duty on IFMs to (i) exercise the powers and discharge the duties of their office honestly, in good faith and in the best interests of the investment fund, and (ii) exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances. The CSA note in the Guidance that, in exercising such duty, it is in both the best interest of the fund and prudent for IFMs to consider investor redemptions and fund liquidity when designing the fund's operation and managing the fund's assets. Section 11.1 of National Instrument 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations requires registered IFMs to have policies and procedures that establish a system of controls and supervision to address liquidity risk.
For funds subject to NI 81-102, the instrument contains rules relevant to a fund's LRM. For example, section 2.4 of NI 81-102 contains restrictions on illiquid assets. In the companion policy to NI 81-102, the CSA note that:
- they expect IFMs to establish an effective LRM policy that considers the liquidity of the types of assets in which the investment fund will be invested and the fund's obligations and other liabilities (such as meeting redemption requests or margin calls from derivatives counterparties); and
- IFMs should regularly measure, monitor and manage the liquidity of the fund's portfolio assets, keeping in mind the time to liquidate each portfolio asset, the price at which the asset may be sold and the pattern of redemption requests.
In light of the potential systemic risk to the Canadian financial system posed by liquidity risks, the CSA have issued the LRM Guidance to assist IFMs in implementing an LRM framework while complying with the foregoing securities regulatory requirements. The LRM Guidance is intended to be flexible and scalable. Given the fund-specific and multi-dimensional nature of LRM, the CSA have not intended the LRM Guidance to be a "one-size fits all" approach. In the press release announcing the LRM Guidance, the CSA also encourage IFMs to consult the IOSCO LRM Recommendations in developing an effective LRM framework.
Elements of an Effective LRM Framework
The LRM Guidance sets out five key areas of an effective LRM framework.
1. Strong and effective governance
The LRM Guidance notes that an IFM's investment committee, governance committee or other group charged with risk oversight may be formed and have primary responsibility for dealing with material LRM matters. The CSA note the following examples of potential responsibilities of an LRM oversight committee:
- establishing reporting and escalation procedures for material liquidity events, portfolio valuation issues and deficiencies in internal controls as they relate to LRM;
- considering those circumstances where a liquidity issue may cause a conflict of interest between the fund and the IFM, and whether such situations require escalation or other internal approvals;
- ongoing review of LRM policies and procedures; and
- reviewing all material exception reports for stress testing and working with the fund's portfolio managers to ensure appropriate remedial steps have been taken.
The CSA expect IFMs to adopt policies and procedures that integrate LRM considerations.
2. Creation and ongoing maintenance
The LRM Guidance sets out principles and related practical implementation strategies that support creating and maintaining an effective LRM framework. In particular, the CSA suggest that funds align the investment objectives, strategy, and redemption policy of the fund with the liquidity profile of the fund's underlying portfolio assets and the redemption demands of the investor base at the design stage and on an ongoing basis. For example, less frequent redemptions may be offered if a fund holds a substantial amount of investments that are thinly traded, have longer clearing periods or are in emerging markets.
As well, the CSA highlight the need for active, ongoing portfolio monitoring using qualitative and quantitative metrics to ensure adequate levels of liquidity exist to meet redemption needs and other obligations. All relevant data should be used to actively manage liquidity risks. Data to be considered include the composition of portfolio assets, past redemption activity, distribution channels, investor base, fund performance, fund ownership and other special considerations (such as changing market or other economic factors). The effects of large redemptions should also be incorporated in liquidity assessments.
The LRM Guidance also suggests that management set internal liquidity thresholds and targets that can be used to assess the liquidity profile of a fund and make any necessary adjustments. Liquidity thresholds should be proportionate to the redemption obligations and liabilities of the fund and monitored on a regular basis.
An effective LRM framework should also provide for timely reporting of material liquidity events to relevant personnel of the IFM. Report material liquidity events in a timely manner for consideration by relevant personnel of the IFM.
3. Stress testing
While stress testing is not specifically required under securities legislation, the LRM Guidance sets forth the following key factors to consider when stress testing is conducted:
- Identification of Risks
- Market and redemption risk are highlighted by the CSA as key risks that should be identified at the beginning of stress testing. Other risks that a fund may choose to incorporate in its stress testing include market stress affecting a class or subclass of assets, interest rate risk, credit risk, reputational risk and geopolitical risk.
- Stress testing is effective if it is proportionate to the liquidity risk profile of the fund.
- Scenario Analysis
- Stress tests may cover a range of scenarios that reflect a single factor or multiple factors but should be diverse and reflect material risks relevant to the fund.
- Stress tests should incorporate reliable and up-to-date market information and may take into account the behaviour of other market participants whose actions may separately or collectively have an effect on the liquidity of the fund and/or its underlying portfolio assets.
- For historical stress testing, the CSA note the following factors that may be relevant considerations:
- comparison of historical cash flows with industry-wide cash flows for funds of similar size and strategy;
- redemption activity of the largest investor or group of investors;
- redemption activity during stress conditions (with varying percentages of redemption requests); and
- historical redemption patterns.
- For hypothetical stress testing, the CSA note the following factors that may be relevant considerations:
- individual or a combination of factors, such as interest rate changes, increased redemption requests and decrease in sales;
- changing investors, markets or investment portfolio composition; and
- the potential for counterparty default.
- Frequency of stress testing
- The frequency of stress testing depends on the specific attributes of a fund such as:
- size of the fund;
- nature of the portfolio assets.;
- redemption frequency;
- investment strategy;
- investor base; and
- market conditions.
- Stress testing results
- Stress testing results and related actions taken (e.g. liquidation of certain portfolio assets) should be communicated to the committee overseeing liquidity risk matters.
4. Disclosure of liquidity risks
Prospectus disclosure. The LRM Guidance emphasizes that material liquidity risks must be included as a material risk in a fund's prospectus
IFMs will need to consider liquidity risks associated with redemptions and the right to suspend redemptions, since the fund's prospectus must also disclose the circumstances when the suspension of redemption rights may occur. For example, if a fund has a small number of large investors, IFMs should consider the need for disclosure regarding large redemption risks and what the fund may do in the event of large redemptions (e.g. sell a significant portion of portfolio assets, make in specie distributions to the redeeming investor or terminate the fund).
AIF disclosure. A fund's annual information form (AIF) requires disclosure concerning certain governance matters, including the group(s) responsible for fund governance and policies and procedures of the fund or its manager relating to risk management controls. The LRM Guidance provides sample AIF disclosure language relating to an LRM committee and LRM policies and procedures.
Negative AIF Disclosure. Contrary to usual disclosure rule that no reference need be made to inapplicable items, the CSA advise that if the manager does not have written policies and procedures around LRM, this must be disclosed. However, as discussed above, the LRM Guidance stresses the importance of implementing such policies and procedures.
Other continuous disclosure. With respect to a fund's continuous disclosure (e.g. management reports of fund performance and material change reports), the LRM Guidance suggests that funds consider disclosing any significant liquidity challenges faced over the relevant period, how those challenges affected the fund and how they were addressed.
5. Use of LRM tools to manage potential and actual liquidity issues
The CSA note that tools to manage liquidity during stressed market conditions (e.g. suspension of redemptions under section 10.6 of NI 81-102) should be used sparingly in exceptional circumstances and only temporarily. Such exceptional circumstances will be rare, such as where a fair and robust valuation of the assets in which the fund is invested is difficult or impossible to carry out, or where redemption demands are such that liquidity cannot be raised in the timeframe required to meet the demands. As well, the CSA stress that the use of such liquidity tools must be in the best interest of the fund investors collectively and maintain the fair and equal treatment of incoming, ongoing and outgoing investors.
For liquidity tools that do not comply with NI 81-102, the CSA expressed their willingness to consider applications for exemptive relief and reiterated their general advice that IFMs should contact their principal regulator on a timely and proactive basis if they are seeking exemptive relief.
In light of continued market disruptions and uncertainty due to the ongoing COVID-19 pandemic, IFMs should review the LRM Guidance and IOSCO LRM Recommendations carefully to develop or evaluate their LRM frameworks.
Final amendments to NI 81-102 that came into force in January 2019 introduced alternative mutual funds (AMFs) that are available to retail investors and permitted to engage in certain riskier investment strategies (e.g. leverage and short selling). Given the liquidity concerns arising from such investment strategies, IFMs should evaluate the current liquidity risks of their AMFs and ensure they have a robust LRM framework that complies with the statutory duties imposed on IFMs and the LRM Guidance.
Finally, while the LRM Guidance is aimed at investment funds subject to NI 81-102, managers of other funds may also wish to consider the guidance. For example, managers of private funds not subject to NI 81-102 may wish to review their funds' redemption rights and conditions for suspension of redemption rights in light of the LRM Guidance to evaluate the liquidity risk facing such funds.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.