FSB & IOSCO publish anti-dilution Liquidity Management Tool recommendations

At a glance

Following the Financial Stability Board (FSB) and the International Organization of Securities Commissions’ (IOSCO) publication, local regulators are expected to implement new recommendations on Liquidity Management Tools by 2026. Asset managers might be required to use anti-dilution mechanisms and monitor them, particularly focusing on disclosure, governance and effectiveness in reducing dilution.

A closer look

In recent years, Swing Pricing gained prominence in Europe as the predominant anti-dilution technique. Over time, various regulators and financial associations have published different regulations, guidelines, and publications concerning Swing Pricing or Liquidity Management Tools (LMTs).

In December 2023, FSB and IOSCO issued recommendations to regulators on the use of LMTs, including Swing Pricing.

In this final version, both FSB and IOSCO proposed 6 points of guidance for the design and the utilization of anti-dilution LMTs:

1. Entities must maintain systems, procedures, and controls in compliance with regulatory requirements for the use of anti-dilution LMTs to monitor and manage liquidity risk and prevent first-mover advantages in case of liquidity mismatch in Open Ended Funds (OEFs);
2. Entities should incorporate at least one appropriate LMT into their liquidity risk management framework for each OEF subject to significant dilution to mitigate potential first-mover advantage (appropriate when funds are not Exchange Traded Funds (ETFs) or Money Market Funds (MMFs));
3. Estimated cost of liquidity including explicit, implicit costs, and market impact should be supported by subscribing and redeeming investors. Entities must be able to demonstrate the LMTs' calibration suitability for both normal and unusual market conditions;
4. If entities set anti-dilution thresholds to trigger the LMTs, these should prevent material dilution impacts in the fund;
5. Entities should have proper governance arrangements for their liquidity risk management, including clear decision-making processes for LMTs utilization;
6. Entities should have a clear disclosure of the objectives and operations of LMTs to improve transparency and investor awareness. This would enlighten investors before taking their investment decisions.
   

Potential impacts for the fund industry

The recommendation of FSB and ISCO might be transposed by the different regulators for application. Regardless of the outcome, it will increase the trend toward more controls on LMTs.

Here are a few anticipated outcomes for the fund industry as a whole:

1. Wider use of LMTs on OEF as IOSCO would recommend that “less liquid” daily funds have at least one LMT implemented or to be demonstrate why the fund would be scoped out;
2. More control from regulators on the methodology and the calculation of the dilution adjustment. IOSCO recommends that entities should demonstrate the appropriateness of the dilution applied both in normal and stressed market. This would demonstrate a big shift from the current situation of assessing only the correct application of the calculated anti-dilution.
3. More control from regulators on the threshold used for the LMT, (if applicable). The entities should be able to demonstrate that the applicable threshold is protecting the investors from material dilution.
4. IOSCO recommends regulators to obtain proof of a strong governance process. Entities could be required to demonstrate that they have implemented a clear decision-making process.
   
5. IOSCO defined clear disclosures to investors to ensure awareness of the potential dilution they might bare without LMT, the operational function of LMT, and its impact on their investment decision.

The implementation of recommendations from both FSB and IOSCO would represent a challenge for the fund industry, yet it fits into to the growing push on the market toward more transparency, stronger governance and a fairer treatment of investors.

Next steps

The updated recommendations are directed toward financial regulatory and supervisory authorities.

FSB and IOSCO will monitor the progress made by the member jurisdictions in implementing their respective revised recommendations and guidance.

This oversight will begin with a stocktake, to be completed by the end of 2026, of the measures and practices adopted and planned by FSB member jurisdictions. IOSCO will aim to coordinate a stocktake of its recommendations and guidance to provide a comprehensive picture.

By 2028, FSB and IOSCO will assess whether the implemented reforms have sufficiently addressed risks to financial stability. This assessment may involve, if appropriate, evaluating if the existing tools need amendments or if additional tools are required for use by fund managers or authorities.

How can Deloitte help?

With more than 10 years of experience on anti-dilution LMT, Deloitte developed a deep knowledge and understanding of the techniques used in Europe, but also globally.

We can provide assistance in:

1. Designing the LMT for your funds, including:

• Benchmarking market practices to define the most suitable solution based on each setup
• Defining applicable governance, roles and responsibilities
• Executing quantitative analysis of the funds in scope to define the computation methodology
• Performing project management assistance with regard to the implementation

2. Reviewing your current LMT model, including:

• Benchmarking market practices to identify potential competitive gaps
• Operating a gap analysis of the governance currently in place to identify loopholes or risks
• Analyzing the current calculation methodology to improve the accuracy of the factors computed
• Back-testing the values historically used to assess the dilution avoided

3. Provide ongoing assistance to help your clients operate LMT programs, including:

• Periodically computing the dilution adjustment
• Periodically computing the dilution threshold
• Conducting periodic back-testing reviews to assess the effectiveness of the LMT used

Guidelines:

• FSB: Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds
• IOSCO: Anti-dilution Liquidity Management Tools – Guidance for Effective Implementation of the Recommendations for Liquidity Risk Management for Collective Investment Schemes