This week the Financial Stability Board highlighted the risk that an open-ended fund holding sufficient illiquid assets that has not effectively managed its liquidity risk may not be able to meet significant redemption requests without harming the interests of its investors. As we set out in our 2020 Financial Markets Regulatory Outlook, this issue has received a lot of attention from EU and UK regulators as well as international bodies, and we expect this to intensify still further in 2020.
The European Securities and Markets Authority's (ESMA) guidelines on fund liquidity stress testing apply from 30 September 2020. Since different types of funds face different risks, ESMA has taken a principles-based approach, allowing investment managers to determine the specific stresses applied to each fund. ESMA will expect firms to take this exercise seriously; otherwise it may apply a more prescriptive approach in the future. A key challenge will be sourcing high-quality data and setting appropriate assumptions, especially for simulating redemptions as some firms have limited data on underlying investors.
ESMA intends to facilitate a common supervisory action on Undertakings for Collective Investment in Transferable Securities (UCITS) fund liquidity management in 2020. While the details have not been announced, this is likely to include high-yield bond funds, given that ESMA’s stress simulation work has found that 40% of such funds could experience a liquidity shortfall if they face weekly redemptions of 5-10% of their net asset value. ESMA may also take into account the European Banking Authority's finding that that leveraged bond funds experience larger outflows than unleveraged ones. In addition, in 2020 the International Organization of Securities Commissions (IOSCO) intends to review how its 2018 liquidity risk management recommendations have been implemented.
In response to the European Systemic Risk Board's 2018 recommendation on liquidity and leverage risks in investment funds, we expect the European Commission to propose legislation in 2020 on the availability and use of liquidity management tools, the role of national regulators in suspending redemptions, the prevention of excessive liquidity mismatches, and UCITS liquidity reporting. These issues may be considered as part of the upcoming reviews of UCITS 5 and the Alternative Investment Fund Managers Directive.
Central bankers remain concerned about potential systemic risks posed by investment funds. For example, the European Central Bank has said that in a broad-based market downturn, large fund redemptions could trigger forced asset sales and amplify stress in less liquid markets.
Mark Carney, current Governor of the Bank of England, has said that daily dealing funds investing in illiquid assets are “built on a lie” and could pose systemic risk. We think central bankers are likely to push for fund liquidity monitoring and measurement requirements to become more broadly aligned to those applied to banks, and that they will work closely with conduct regulators to achieve this.
In the UK, the Bank of England and the Financial Conduct Authority (FCA) are conducting a joint review on liquidity in open-ended funds. As part of this, the Financial Policy Committee has established that there should be greater consistency between the liquidity of a fund’s assets and its redemption terms, and has set out principles for liquidity measurement, redemption pricing and redemption notice periods. In 2020 the review is expected to make recommendations on how these principles could be implemented.
Meanwhile, the FCA has introduced new requirements for non-UCITS retail funds to suspend dealing when there is material uncertainty about the valuation of immovables that account for at least 20% of the fund’s assets.
Funds investing mainly in illiquid assets will also need to include risk warnings in financial promotions, produce contingency plans for a liquidity crisis, and have their liquidity management processes overseen by their depositary. Firms must comply by 30 September 2020, and should start updating prospectuses and promotional materials early to allow sufficient time.
Overall, we are likely to see significant regulatory scrutiny of fund liquidity management in 2020, as well as scrutiny by investors and distributors. Investment managers will need to review their liquidity stress testing procedures to ensure that their scenarios are sufficiently severe, their assumptions are robust and their tests are conducted sufficiently frequently. They will also need to review their use of liquidity management tools in light of the results of these tests, and their fund redemption terms to ensure that these are realistic in a stressed scenario. Investor disclosures will also need to explain clearly the fund’s liquidity risks and the liquidity management tools that may be used.