At a Glance
- On 13 July 2021, the Bank of England (BoE) published a report on assessing the resilience of market-based finance alongside its Financial Stability Report. This report concludes the joint BoE and Financial Conduct Authority (FCA) review into liquidity management in open-ended funds. It sets out possible frameworks for liquidity classification and swing pricing. The report does not contain any rules but gives an important indication of the direction of travel of policymaking. The frameworks apply to both retail and institutional funds.
- The framework for liquidity classification is intended to increase the consistency and accuracy of how firms classify liquidity, which currently varies substantially. The classification is intended to play a role in the design of the fund (including redemption terms) and could be used to enhance internal risk management (including stress testing). After a period of implementation, public disclosure could also be considered.
- The framework on swing pricing is intended to make it reflect the true marginal cost of fund redemptions. Swing pricing adjustments also need to be subject to periodic review. The framework also considers whether the actual use of swing pricing should be disclosed to investors ex-post.
- Assuming the rules that result from the review follow its overall conclusions, firms can expect to have to obtain more market data on asset liquidity and implicit transaction costs. If more public disclosure on liquidity risk and swing pricing is required, this may increase investor awareness of liquidity. This will in turn make it important for firms to have clear client communications on how they manage liquidity risks in their funds.
On 13 July 2021, the BoE published a report on assessing the resilience of market-based finance alongside its Financial Stability Report. This concludes the joint review carried out by the BoE and FCA on liquidity management in open-ended funds. That review focused on mismatches between the redemption terms and the liquidity of some funds’ assets, which can lead to a “first-mover advantage”, where investors can have an incentive to redeem ahead of others in stressed market conditions. First-mover advantage could be a source of investor harm and systemic risk.
After surveying 272 authorised funds investing in less liquid assets, the joint BoE-FCA review had set out three priority areas to address liquidity mismatches: pricing adjustments for redeeming investors, liquidity classification and notice periods/redemption frequency. This new report sets out possible frameworks for liquidity classification and swing pricing (which is the most commonly used pricing adjustment). The proposal on notice periods/redemption frequency is being taken forward separately by the FCA, which is consulting on the potential introduction of 90 or 180 day redemption notice periods for authorised open-ended property funds, and on a new regime for long-term asset funds.
The possible frameworks for liquidity classification and swing pricing are intended to facilitate discussion, and to feed into international work. In particular, the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) are examining the availability and effectiveness of liquidity risk management tools for open-ended funds following the March 2020 market turmoil. While this new FCA and BoE report does not set out any rules, it gives an important indication of the direction of travel of policymaking in this area.
This blog briefly discusses the practical implications of these frameworks for open-ended fund managers (hereafter “firms”), should they become mandatory.
Liquidity classification framework
The BoE-FCA survey found that most corporate bond funds may be overestimating the liquidity of their holdings, and their allocation of bonds to different liquidity categories varied substantially. The new framework sets out key principles for a consistent and realistic liquidity classification. It says that an effective liquidity classification should:
- capture the full spectrum of liquid and illiquid assets and consider both normal and stressed conditions;
- play a role in the design of a fund and in determining appropriate redemption terms;
- be used to enhance funds’ internal risk management practices, particularly stress-testing;
- be sufficiently granular and available for regulatory reporting purposes.
One of the key challenges in meeting these criteria will be obtaining sufficient market data to assess liquidity in a granular way in different market conditions. The extent of data required will in part depend on whether the liquidity classification uses a “top down” approach (where liquidity is classified by asset class) or a “bottom up” approach (where funds allocate individual securities to specific liquidity categories). It is not yet clear how prescriptive regulators will be on this.
ESMA noted in its 2019 guidelines on fund liquidity stress testing that it can be difficult to obtain good quality market data on liquidity for some asset classes. ESMA’s guidelines suggest that firms can overcome data limitations by avoiding optimistic assumptions, justifying any reliance placed on third parties’ models and exercising expert qualitative judgement. These principles could also be applied in the context of this framework.
The framework says that for funds invested in inherently illiquid assets, notice periods may be a more appropriate liquidity management tool than pricing adjustments. Currently, much of the operational infrastructure around the retail distribution of open-ended funds only supports daily dealing funds. However, the FCA is currently working with the industry to see how this infrastructure could support funds with notice periods. The FCA is currently consulting on notice periods for authorised property funds, and its proposed regime for long-term asset funds includes notice periods.
The framework also suggests that after a period of implementation, public disclosure might be considered. If this is taken forward, firms will need to think about how to explain liquidity classification to retail investors and communicate clearly how this may affect the use of liquidity management tools.
Swing pricing framework
Swing pricing is designed to ensure that subscribing and redeeming investors bear the cost of their trading activity, so that other investors are protected from a potential dilution of value of their investments. The BoE-FCA survey found that swing pricing was widely used but there were large variations in how it was applied. Firms had different thresholds for applying swing pricing, and in many cases the swing factor was insufficient to capture the full cost of trading.
Under the framework, firms should enhance the application and calculation of swing pricing to reflect the true marginal cost of fund redemptions. This could be achieved if funds applied a “full swing” rather than a “partial swing” and if it included both explicit transaction costs (e.g. bid-ask spreads and fees) and implicit transaction costs (e.g. market impact). In stressed market conditions, other measures may be included (e.g. bid-ask spreads or NAV discounts on comparable exchange-traded funds (ETFs)). The swing should reflect the prevailing market conditions, and swing pricing adjustments should be subject to periodic review.
The report does not say how implicit transaction costs will need to be calculated or whether this will be specified. There has been some debate about the best way of calculating these in the context of the Packaged Retail and Insurance-based Investment Products (PRIIPs) Regulation. If a similar methodology is used, firms will already have much of the data that is needed, although looking at comparable ETFs may be new.
The BoE-FCA survey found that the ex post use of swing pricing was only disclosed to investors in some cases. The report suggests that disclosing this can help investors better assess the risks of investing in a particular fund. This might make investors more aware of liquidity risks, so firms would benefit from clear messaging about how they are managing these risks in their fund.
The possible frameworks on liquidity classification and swing pricing give an important indication of the direction of travel of policymaking. While the final rules are not yet clear, firms can expect that they will need to obtain more market data on asset liquidity and implicit transaction costs. More public disclosure on liquidity risk and swing pricing may also increase investor awareness of liquidity, so it will be important for firms to have clear client communications on how they manage liquidity risks in their funds.