21 Mar 2023
Liquidity in the spotlight
The economic downturn, war in Ukraine and the aftermath of the UK government’s mini-budget have coalesced to ramp up the regulatory focus on fund liquidity.
Liquidity management has been on the regulatory radar for several years in the UK and Europe, where new monitoring and reporting requirements have been imposed on funds to protect investors and consumers.
Following a turbulent few years, markets are now braced for even greater scrutiny. A raft of analyses, discussions and proposals have emerged from a wide range of regulators and policymakers in an attempt to manage funds’ liquidity risk.
Most notably, policymakers have proposed reforms to EU rules on alternative investment funds, including a specific focus on liquidity management. This builds on the existing guidelines from ESMA on liquidity stress testing and IOSCO’s 2018 recommendations on liquidity risk management, which were reviewed to assess the implementation of selected recommendations.
In the wider financial markets, 2022 saw the introduction of guidance around Operational Resilience and Consumer Duty.
“Liquidity is getting a lot of attention,” says Peter Capper, Senior Adviser, International Fund Regulation at the Investment Association (IA). “A lot of the regulatory and policy work is to ensure that there is a proper toolkit available to manage liquidity across all European jurisdictions.”
The IA has long called for a broader suite of liquidity management tools for those responsible for managing fund liquidity. Such a move will ensure that investors’ interests are protected and that liquidity is managed appropriately, even in stressed market conditions.
Growing scrutiny on liquidity
In the UK, liquidity remains a particular focus for the FCA in the wake of recent disruptive events.
From the Covid-19 pandemic, which caused a squeeze on money market funds in March 2020, to Russia’s invasion of Ukraine and the UK’s mini-budget, the importance of liquidity monitoring came into even sharper focus in 2022.
In its Dear CEO letter in March 2022, the FCA warned depositaries to enhance their oversight and effectively challenge fund liquidity. The UK’s network of 11 depositaries, following the market challenges arising from the Brexit referendum, have agreed to notify the regulator when a fund exceeds 10% net redemptions. Furthermore, the Bank of England highlighted liquidity as a serious risk for markets this year.
Peter adds: “If we look at the experience from 2020, and more recently in 2022, investment funds have been largely resilient, daily dealing property funds aside, yet it is necessary to have the right toolkit available ready to use when these periods of crisis come.”
The impact of war in Ukraine
Notwithstanding the human cost, Russia’s invasion of Ukraine created a global economic crisis with profound ramifications for international markets.
Funds with exposure to Russian, Belarusian and Ukrainian assets have faced liquidity challenges this year and new mechanisms have been introduced to allow sanctioned assets to be ring-fenced.
Last year, ESMA released a public statement on the implications of the invasion on investment fund portfolios and reminded fund managers to take “appropriate action in case of exposures to Russian, Belarusian and Ukrainian assets, given valuation and liquidity uncertainties”. The FCA subsequently authorised fund managers to create side pockets — a way to separate a fund's highly illiquid sanctioned assets (read our previous article on side pockets for more).
“Even if fund managers do not actively invest directly into Russia, the war in Ukraine is factoring into their investment decisions,” Peter says.
Around the same time, in the UK, Liz Truss’ mini-budget catalysed large-scale investor redemptions by pension funds, particularly impacting bond and property funds. These redemptions were largely driven by defined benefit pension schemes trying to raise additional liquidity to meet increased collateral calls.
While redemption levels have to some extent plateaued, institutional investors and defined benefit pension funds are still reducing their exposure to property funds — an ongoing trend since Brexit — and this looks likely to continue as the global economic outlook worsens.
Woodford: a lesson in governance
While much of the current discussions around liquidity relate to external economic factors, robust liquidity management can also safeguard against potential governance failings.
“In the years since the suspension of the LF Woodford Equity Income Fund (WEIF), governance practices around fund liquidity have strengthened enormously,” adds Rachel Ellison, Retail Fund Compliance Specialist at the IA.
The FCA’s Asset Management Market Study, which concluded in 2017, encouraged firms to revaluate their approach to liquidity monitoring and management. Fund boards must now appoint independent directors, for example, and undertake an annual assessment of value. The FCA is still investigating multiple parties in relation to the suspension of WEIF.
The big data drive
UK funds continue to evaluate their processes and fund compositions in the wake of recent market disruptions and, for many, this requires a greater reliance on data and technology.
Rachel adds: “Data definitely has a large part to play in liquidity monitoring but you do have to accept that unprecedented things do seem to keep happening so there will always be that shock that is difficult to prepare for.”
It is difficult to quantify a direct impact on resiliency or liquidity, but the move to electronic platforms and digitalisation of operational processes should improve data quality across the board. This will be particularly welcome in the fixed income market, the money market and short-term funding markets.
“Improved transparency in the underlying markets, where data quality can vary, will help firms to price their bonds, for example, or understand how quickly they can sell a bond at a particular price,” says Rachel.
Educating the markets
When a fund is gated or suspended, press activity invariably results in market panic. Therefore, educating the wider financial industry and consumers about liquidity and what it means in practice will protect some funds from herd mentality in times of economic stress.
“Generally speaking, actions such as fund suspensions are taken to protect investors’ interests,” says Peter. “With the exception of money market funds, most funds are designed to be long-term investments and not withdrawn from frequently.”
Residential property offers a simple but helpful analogy. Everybody knows that if you put your house on the market, you are unlikely to sell it tomorrow and, if you do, you may have to accept a discount.
The 2023 outlook
In terms of regulatory milestones, 2023 is unlikely to deliver any unexpected headlines relating to regulation or even new liquidity guidelines, considering the delays related to Covid-19 and Ukraine that most regulators are encountering.
However, the FSB will be doing further work on open-ended funds liquidity mismatch, while a WEIF discussion and an FCA discussion paper are likely at some point this year. The FCA has also hinted that it may publish a policy statement on notice periods for property funds.
We could also see the first Long-Term Asset Fund launch, potentially investing in infrastructure. Positioned at the illiquid end of the liquidity spectrum, these funds are key to funding the UK government’s infrastructure ambitions, yet they pose a conundrum for markets given their inherently illiquid nature.
The FCA is currently anticipated to review a handful of applications — take-up has been light to date — and it remains to be seen whether these funds will drive further discussion and regulatory developments around liquidity across the rest of the market.
What is certain, however, is that funds will increasingly need to provide evidence that they are paying due consideration to liquidity management and that the FCA will continue to request data from a wide range of firms.
Ultimately, regulators want to know how funds are monitoring liquidity, what the governance structure is and how a portfolio is being managed.
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