In response to the Financial Stability Board's 2017 Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (see our blog), the International Organization of Securities Commissions (IOSCO) has published two documents:
- Recommendations for Liquidity Risk Management for Collective Investment Schemes, which updates its 2013 Principles of Liquidity Risk Management for Collective Investment Schemes; and
- Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration, which provides practical information and good practice examples of measures that may be taken to address liquidity risk management.
In updating its recommendations for liquidity risk management for open-ended funds, IOSCO has focussed on the following key areas:
- the alignment between asset portfolio and redemption terms;
- fund stress testing;
- additional liquidity management tools;
- contingency planning; and
- disclosures to investors.
Overall, IOSCO's recommendations are line with existing supervisory expectations in the EU but they add more detail in some areas. It is now up to national and EU regulators to consider how these recommendations should be implemented locally. We think that this could lead to more detailed rules or guidance in certain areas, potentially including fund stress testing and contingency planning. Both the ECB and ESMA and have recently commented on the potential systemic risks associated with the growing asset management sector, while in the UK the FCA has published a discussion paper on illiquid assets and open-ended investment funds.
Alignment between asset portfolio and redemption terms
IOSCO notes that asset managers may be subject to market pressure to provide very frequent dealing options even for funds that invest in illiquid assets. IOSCO recommends that before launching a new fund, an asset manager should set out why the design features of the proposed fund constitute an appropriate structure within which to manage liquidity risk in both normal and stressed market conditions. This assessment should be approved by senior management or the board and should be regularly reviewed. As part of the assessment, the asset manager should engage with potential distributers to understand the types of investors likely to invest in the fund, and should consider the potential use of liquidity management tools (e.g. limits on illiquid assets) and additional liquidity management tools for use in stressed market conditions (e.g. exit charges).
IOSCO stops short of specifying what type of assets are appropriate to be held in funds that offer daily redemptions. However, in its accompanying "Good Practices" document it notes that in many jurisdictions funds investing in certain types of illiquid assets (e.g. real estate) are required to be closed-ended. In the UK, the FCA is reviewing how open-ended funds may invest in inherently illiquid assets and has published a discussion paper on this. However, it does not propose to ban open-ended funds from holding illiquid assets or to prevent retail investors from acquiring units in open-ended property funds.
Fund stress testing
IOSCO has expanded its recommendations relating to fund stress testing. It states that stress testing is an important component of an asset manager's risk management process, although it notes that stress testing arrangements should be proportionate taking into account the size, investment strategy, nature of the underlying assets and investor profile of the fund. IOSCO recommends that stress testing should be supported by strong and effective governance. For example, the performance and oversight of stress testing should be sufficiently independent from the portfolio management function. Scenarios should include backward-looking historical scenarios and forward-looking hypothetical scenarios, and where practical should take into account the expected behaviour of other market participants.
In the EU, alternative investment fund (AIF) managers are already required to conduct fund stress tests and to report the results to regulators, while UCITS fund managers must carry out stress tests where appropriate. IOSCO's recommendations could lead to more detailed stress testing requirements or guidance for firms, although regulators are unlikely to prescribe detailed test scenarios such as those used in the banking sector because funds have very diverse risk profiles. Asset managers will, however, need long-term strategic and governance plans that provide the capability to carry out effective fund stress testing.
Additional liquidity management tools
IOSCO has expanded its recommendations on the use of additional liquidity management tools to be used in stressed market conditions. It recommends that asset managers consider in the design of a fund an appropriate range of these tools to protect investors from unfair treatment or prevent the fund from diverging significantly from its investment strategy. In considering whether to use specific tools, asset managers should, IOSCO highlights, take into account factors such as the types of investors in the fund, any operational complexities (e.g. in calculating anti-dilution levies), and how they should disclose to investors the conditions which would trigger the use of these tools.
In the UK, the rules allow a wide range of additional liquidity management tools, including swing pricing, redemption fees, anti-dilution levies, redemption gates (for non-retail funds), in-kind redemptions, side pockets and suspensions of redemptions. In its recent discussion paper on illiquid assets and open-ended investment funds, the FCA noted that it might give more guidance on when and how such tools might be used to encourage their use where appropriate.
IOSCO has added new recommendations on contingency planning. It recommends that asset managers should periodically test contingency plans to ensure that all available liquidity management tools can be used where necessary, including in stressed market conditions, and exercised in a prompt and orderly manner. This includes testing their operational capacity to implement and unwind any such tools in a transparent, fair and orderly manner, and ensuring that they have clear internal processes for deciding when such tools should be used. Current EU rules do not specifically require asset managers periodically to test their contingency plans for liquidity management tools. We think that this recommendation could result in new rules or guidance for firms in this area.
Disclosure to investors
In its 2013 publication, IOSCO recommended that asset managers disclose to investors the liquidity risks associated with a fund and the types of liquidity management tools that may be used. IOSCO now recommends that in addition to this asset managers should consider periodically disclosing aggregated information on the fund's investment portfolio so that investors can assess its liquidity risk. These disclosures may be useful where the fund invests in assets which have significantly varying liquidity.
In the EU, AIF managers are already required to disclose periodically the current risk profile of the AIF, while UCITS fund managers must disclose information about the types of securities held in the fund. IOSCO's recommendation may therefore lead to further focus, whether through rules, guidance or day-to-day supervision, on the type of information that firms are disclosing.
Implications for firms
IOSCO has set out more detail on how international regulators expect asset managers to manage liquidity risk in their funds, as well as examples of good practice. In the EU, there are existing requirements in many of the areas covered but we may see additional requirements, guidance or supervisory focus in these areas. To meet supervisory expectations, firms will need to demonstrate strong governance processes, particularly in the areas of product design, fund stress testing, and the use of additional liquidity management tools. Firms may see new requirements on contingency planning for stressed market conditions and increased supervisory attention on their periodic investor disclosures.
IOSCO intends to assess the implementation of these recommendations across the relevant jurisdictions in 2-3 years' time.
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