Background
In 2019, the Bank of England (BoE) and Financial Conduct Authority (FCA) launched a joint review into vulnerabilities associated with the liquidity mismatch. The review built on the FPC’s 2015 assessment; the FCA’s 2019 Policy Statement on funds investing in inherently illiquid assets; and the work by the FSB and the International Organization of Securities Commissions (IOSCO).
On 13th July 2021, the FCA and BoE published the conclusion to the joint review on open-ended investment funds and the risks posed by their liquidity mismatch.
In concluding the review, the Bank and FCA have put forward a suggested possible framework for how a liquidity classification framework for funds could be designed, as well as considerations around the calculation and use of swing pricing.
3 Key Principles
The initial review set out three key principles for fund design that would deliver greater consistency between funds’ redemption terms and their underlying assets:
- Liquidity Classification: The liquidity of funds’ assets should be assessed either as the price discount needed for a quick sale of a representative sample of those assets or the time period needed for a sale to avoid a material price discount.
- Pricing Adjustments: Redeeming investors should receive a price for the units in the fund that reflects the discount needed to sell the required portion of a fund’s assets in the specified redemption notice period.
- Notice Periods/Redemption Frequency: Redemption notice periods should reflect the time needed to sell the required portion of a fund’s assets without discounts beyond those captured in the price received by redeeming investors.
Following the review, the BoE and FCA have now put forward a possible framework for how an effective liquidity classification framework for funds could be designed, as well as for the calculation and use of swing pricing.
Possible Framework
Consistent and realistic classification of the liquidity of funds’ assets
- An effective liquidity classification framework would capture the full spectrum of liquid and illiquid assets, and consider both normal and stressed conditions. Under current rules, fund managers are required to have appropriate liquidity management arrangements to measure and manage a variety of risks. Liquidity risks include, for example, the risk of not being able to fulfil redemption requests without a price discount on the assets sold, or not being able to meet other liabilities such as margin calls. Classifying and measuring liquidity in all market conditions therefore has important benefits in terms of managing liquidity to meet anticipated redemptions.
- An effective liquidity classification framework should play a role in the design of a fund and in determining appropriate redemption terms. A liquidity classification framework, along with other metrics such as investor profile and concentration, could inform the appropriate liquidity management tools as regards redemptions. For example, for funds that primarily invest in inherently illiquid assets, notice periods might be a more appropriate liquidity management tool than pricing adjustments. A consistent framework can therefore also help better identify whether the liquidity tools a fund uses are appropriate for the assets it holds.
- A consistent and realistic classification of the liquidity of funds’ assets could be used to enhance funds’ internal risk management practices, particularly stress testing. Stress testing is already an important aspect of liquidity management frameworks and allows firms to assess the impact of market stresses, anticipate activity in stressed market conditions and identify potential vulnerabilities. However, if funds are overoptimistic about the liquidity of their holdings, this might undermine the value of their stress tests. Better and more consistent liquidity classifications could therefore usefully inform funds’ stress testing processes by providing a more complete view of their liquidity profile.
- The classification should be sufficiently granular and should be available for regulatory reporting purposes. A granular liquidity classification could allow fund managers to account for differences in their actual holdings, but allow sufficient consistency to be used by regulators as a check on fund managers’ own classification of their holdings across liquidity categories.
Enhancing the calculation and use of swing pricing
Swing pricing is an anti-dilution tool which seeks to ensure fairness across investors by protecting existing investors from potential dilution of value of their investments through ensuring that subscribing and redeeming investors bear the costs of their trading activity.
Adjusting the price received by redeeming investors to reflect such transaction costs could also help address the potential financial stability risks stemming from first mover advantage, by removing the incentive to redeem from a fund ahead of other investors, particularly in a stress.
- More consistent and complete swing pricing could be developed in order to better reflect the costs of exiting a fund and also to promote financial stability by reducing first mover advantage.
- Swing pricing adjustments should be based on the following principles:
a. Swing pricing adjustments should, as far as possible, take into consideration the full cost of meeting investor flows. Overall, swing pricing adjustments should be a reflection of liquidity classification, the size of investor flows, and market conditions.
b. Swing pricing adjustments should reflect the prevailing market conditions and associated costs of net flows. For example, in stressed market conditions, a higher swing factor will be required, while in liquid markets with low transaction costs, the appropriate swing factor may be very small. - Swing pricing adjustments should be subject to periodic review to assess whether they remain valid and ensure reasonable levels of confidence around estimates.
- Consideration should be given to the adequate level of transparency regarding the approach to and effects of swing pricing.
Market liquidity and its resilience are important for financial stability and real economic activity. Further ways to reduce both liquidity mismatches and the first-mover advantage at mutual funds have been on the agenda for some time now, as jurisdictions recognise that existing liquidity tools have not been sufficient to resolve the “dash for cash”.
With liquidity continuing to be high on the agendas of regulators, and with a plethora of regulatory change increasing scrutiny, managers must ensure they are in continued compliance with the ever-changing liquidity landscape.
To assist mangers with their liquidity risk management monitoring, our automated solution is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into product governance, throughout the product lifecycle.
Our cloud-based Liquidity Risk Management monitoring platform integrates data, analytical methodologies, and provides interactive reporting of liquidity risk through a comprehensive suite of dashboards.
Additionally, we offer a full package of supporting documentation, including:
- Liquidity RMP Template
- Liquidity calculation methodologies
- Checklists assessing compliance with ESMA, IOSCO
- Stress test calibrations
- Liquidity stress testing simulation forms and templates
