As discussed in previous blogs, later this year new FCA rules for open-ended funds investing in inherently illiquid assets enters into force. The new rules concern non-UCITS retail schemes (NURS) that invest in inherently illiquid assets.
Although the new rules are relevant to anyone with an interest in open-ended investment funds that are likely to hold illiquid assets, here we will be focusing on the enhanced oversight of depositaries.
Following a number of fund suspension in 2016, the FCA found that the quality of liquidity monitoring and management varied between different property funds. They also found that depositaries in the most part, provide an effective, independent check of fund managers’ adherence to the COLL sourcebook under normal market conditions. However, under stressed market conditions as seen in 2016, there was confusion surrounding the extent of the depositary’s role and responsibilities.
Whilst current rules require authorised funds’ depositaries to provide cash flow monitoring, oversight duties and safekeeping or verification of assets, it was felt that the current rules do not provide clear responsibilities and enough detail to ensure that the liquidity risk and the monitoring of the liquidity profile of the funds is conducted in an appropriate manner.
For this reason, the FCA introduced new rules to ensure the implementation of greater consistency in depositaries’ oversight practices.
Oversight of the Liquidity Management of a FIIA
To improve liquidity risk oversight, the FCA updated its rules to impose new duties on depositaries of Funds Investing in Inherently Illiquid Assets (FIIA). This includes the requirement to assess the liquidity profile and liquidity risks presented by the fund’s scheme property. New rule COLL 6.6.4BR has been included which states the depositary of a FIIA must “regularly make its own assessment of the liquidity profile of the FIIA and the liquidity risks presented by the scheme property of a FIIA”.
Additionally, the new rules require depositaries to devise procedures for overseeing the liquidity management by the fund manager. A depositary must take reasonable care to oversee the authorised fund manager’s liquidity management systems and procedures on an ongoing basis and ensure that the FIIA is managed in accordance with the COLL rules.
Furthermore, the rules provide that the depositary of a FIIA managed by a small authorised UK AIFM must not delegate the above functions to one or more third parties, except in relation to supporting administrative or technical tasks that are linked to these functions.
Role of Depositary in Suspensions
The new rules require NURS holding property and other immovables to suspend dealing when there is ‘material uncertainty’ about the valuation of at least 20% of the scheme property.
Although the FCA assume suspension will generally be the most appropriate course of action during the existence of material uncertainty, the FCA are introducing the possibility for the fund manager to continue dealing in a fund, where they have agreed with the fund’s depositary that to do so is in the best interests of investors.
For the suspension to take place as quickly as possible, and in any event, within 2 business days of a fund being subject to material uncertainty, the fund manager will not need the depositary’s agreement to suspend.
However, if the fund manager wishes to continue dealing, the depositary’s consent is required. Where the depositary disagrees with the fund manager’s judgment, or fails to agree within the time limit, dealing in the fund must be suspended.
Additionally, regarding the resumption of dealing, there is a requirement to seek depositary agreement.
The new rules enter into force September 2020. The enhanced depositary oversight will provide additional scrutiny on fund managers’ liquidity risk management processes. Firms impacted by these changes should consider how they are currently managing liquidity risk which should include open discussions with the depositaries and administrators of the funds to ensure they fully understand their duties as highlighted above.
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