FSB recommends addressing structural liquidity mismatches and greater use of anti-dilution tools in open-ended funds

At a glance

• The Financial Stability Board (FSB) has published a progress report on enhancing the resilience of non-bank financial intermediation (NBFI). This includes its latest recommendations on liquidity risk management in open-ended funds.
• In its report, the FSB signals its intention to carry out policy work to:
  • address structural liquidity mismatches, by requiring funds investing significantly in illiquid assets to offer less than daily dealing or have long notice/settlement periods to redeem shares (unless they can demonstrate that they can use anti-dilution tools to make redeeming investors pay for the full cost of redemptions);
  • promote greater use of liquidity management tools, especially anti-dilution tools which include both the explicit and implicit costs of redemptions;
  • promote the use of fund- and system-level stress testing; and
  • increase availability of data for financial stability monitoring.
• If funds investing significantly in illiquid assets are required to offer less than daily dealing or long notice/settlement periods to redeem shares, this is likely to reduce their attractiveness to investors, especially retail investors, who may not want to lock their money up for long periods. In addition, there can be operational challenges associated with notice periods in retail investment markets. These funds would need to consider how to continue to make themselves attractive to investors, and how they could continue to distribute their funds.
• Anti-dilution tools which include both the explicit and implicit cost of redemptions can be challenging to implement, since determining implicit transaction costs can be difficult, especially in illiquid markets or during stressed market conditions. Firms seeking to impose the full cost of redemptions on redeeming investors will need to develop their methodology carefully.
• Asset managers may see increased regulatory and supervisory focus on fund stress testing. They may benefit from the sharing of experiences with designing and using fund liquidity stress tests, but they may face an increased data burden if authorities intensify their system-wide stress testing.
• The ultimate impact of the FSB’s policy work on firms will depend on how it will be translated into local laws and regulations, which is yet to be seen. However, this progress report provides a useful insight into the direction of travel of policymaking, and it may influence ongoing reviews of fund liquidity rules in the EU and the UK, as well as current supervisory priorities.

Overview

The FSB has published a progress report on enhancing the resilience of NBFI. This includes its latest recommendations on liquidity risk management in open-ended funds.

In 2017, the FSB published its Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, which was followed by IOSCO’s updated Recommendations for Liquidity Risk Management for Collective Investment Schemes in 2018. IOSCO’s recent thematic review found a high level of compliance with these recommendations, however concerns about liquidity risk continue to be raised. For example, the ECB recently reported that liquidity mismatch is prevalent in euro-area open-ended bond funds and has not declined since the FSB recommendations were published in 2017. The ESRB also recently warned that close attention should be paid to structural liquidity mismatches in certain types of investment funds.

The FSB’s latest report signals its intention to carry out policy work in the following areas:

• Address structural liquidity mismatch: The FSB's Policy Recommendations should be revised to say that funds that allocate a significant proportion of assets under management (AUM) (e.g. 30-50% or more) to assets that are illiquid would need - even in normal market conditions - to offer liquidity to investors less frequently than daily and/or require long notice/settlement periods to redeem shares. However, these funds may offer daily dealing if fund managers are able to demonstrate that they can implement anti-dilution tools that pass on to redeeming investors the explicit and implicit cost of redemptions, including any significant market impact of sales.
• Promote greater use of liquidity management tools: The FSB's Policy Recommendations should be strengthened to achieve:
  • greater inclusion in funds’ constitutional documents of anti-dilution tools designed to pass on to redeeming investors the explicit and implicit costs of redemptions, including any significant market impact of asset sales to meet those redemptions;
  • greater use, and consistency in use, of anti-dilution tools in both normal and stressed market conditions; and
  • increased awareness among investors on the objectives and operation of anti-dilution tools.
• Promote the use of stress testing: The FSB will promote use of fund- and system-level stress testing, including sharing of experiences on the design and use of such stress tests.
• Increase availability of data for financial stability monitoring: The FSB intends to set up a pilot programme among member jurisdictions to examine how to improve data availability and prioritise data gaps to close.

In addition to its workstream on liquidity risk management in open-ended funds, the FSB intends to carry out additional work in 2023 on hidden leverage related to NBFI, including in hedge funds/family offices and liability-driven investing (LDI) by pension funds. Hidden leverage related to NBFI is also a current focus in the UK following the recent crisis in the LDI market. IOSCO is also collecting aggregated fund leverage data and assessing leverage trends in asset management. Other workstreams include policy work on margining practices and taking stock of reforms to money market funds.

Redemption terms

If funds investing a significant proportion of their AUM in illiquid assets are required to offer less than daily dealing or long notice/settlement periods to redeem shares, this is likely to reduce their attractiveness to investors, especially retail investors. Many investors may not feel comfortable locking their money up for long periods, especially in the current challenging economic conditions. In addition, there can be operational challenges associated with notice periods in retail investment markets. For example, in the UK, the FCA noted in its feedback statement to its consultation on liquidity mismatch in authorised open-ended property funds that there was significant work to be done before notice periods could be operationally supported across the retail investment ‘ecosystem’ i.e. fund managers, platforms, advisers etc. Notice periods also affect eligibility for inclusion in UK individual savings accounts (ISAs). If funds are forced to give up daily dealing, they will need to consider how to continue to make themselves attractive to investors, and how they can continue to distribute their funds.

In the EU, under the Commission’s proposals on the review of AIFMD and UCITS, regulatory technical standards are expected to set out criteria for the selection and use of liquidity management tools, including notice periods. It remains to be seen whether this will be left as a principles-based assessment with significant discretion for the fund managers, or will introduce more prescription on which tools firms should select. The FSB’s recommendations could influence the negotiations towards a more prescriptive approach on notice periods.

Liquidity management tools

The FSB suggests that funds investing in illiquid assets may be exempted from the requirement to offer less frequent dealing or notice/settlement periods if they can demonstrate that they can implement anti-dilution tools that pass on to redeeming investors the explicit and implicit cost of redemptions, including any significant market impact of sales. Examples of anti-dilution tools that pass redemption costs onto redeeming investors include swing pricing, dual pricing, anti-dilution levies and redemption fees. Given that many fund managers will not want to move to less frequent dealing or notice periods, they may prefer to make use of this option. However, implementing anti-dilution tools can be far from straightforward, since determining liquidity costs can be difficult. As noted by the IMF, the calibration of anti-dilution tools can be challenging for funds holding very illiquid assets (such as real estate) even in normal times. The IMF suggests that such funds use alternative measures, such as limiting the frequency of redemptions.

Currently, anti-dilution tools are commonly used in some jurisdictions, with the most prevalent being swing pricing. However, the IMF has found that price adjustments are often capped at insufficient levels, especially in times of market stress. Last year the Bank of England and FCA suggested a potential framework for swing pricing under which firms would apply a “full swing” which included both explicit transaction costs (e.g. bid ask spreads and fees) and implicit transaction costs (e.g. the market impact of sales). The Bank-FCA survey had found that most fund managers did not factor implicit transaction costs into their swing factors.

Experience with PRIIPs KIDs provides evidence of these challenges. When calculating implicit transaction costs for the purposes of disclosure in PRIIPs KIDs, there have been challenges in disentangling the market impact of a trade from random market fluctuations that occur at the time that the order is being executed. Under PRIIPs, transaction costs are calculated across all transactions for a product over a three-year period and, as the FCA points out, the random element should average out to approximately zero. However, when calculating implicit transaction costs for the purposes of swing pricing, a much shorter time period is being considered, so the random element may well not be zero, especially in a downturn. Firms wanting to pass implicit transaction costs onto redeeming investors will need to develop their methodology carefully.

The FSB also wants to promote the use of anti-dilution tools more generally. It recommends that anti-dilution tools designed to pass on to redeeming investors the explicit and implicit costs of redemptions should be included in funds’ constitutional documents and used more consistently in both normal and stressed market conditions. Currently, there is significant variation in the availability of such tools across Europe, with jurisdictions such as Ireland, Luxembourg and the UK having a wide variety of tools available but some smaller markets having no anti-dilution tools available under their national rules. The current review of AIFMD and UCITS aims to increase the availability of tools across the EU.

Within markets where anti-dilution tools are allowed, there is a significant variation in how many funds include them in their constitutional documents. For example, in the UK, 83% of single-priced funds in the FCA’s sample (which consisted primarily of corporate bond funds) had the option to use swing pricing while 14% had the option to use dilution levies. In Luxembourg, 65% of UCITS funds in the CSSF’s sample could use swing pricing (including 80% of high yield bond funds), while 17% could use anti-dilution levies. In France, only 7% of unit classes representing 10% of French collective investment undertaking assets could use swing pricing or anti-dilution levies. According to the FCA and CSSF studies, swing pricing was widely used during the turmoil of H1 2020 by funds that had the option available. However, some funds only use swing pricing when a certain level of net redemptions or subscriptions is reached (partial swing), rather than for a net flow of any size (full swing). The FSB’s recommendation may result in regulators asking more funds to include anti-dilution tools in their constitutional documents, and fund managers to use them more regularly in normal as well as stressed market conditions.

The FSB also recommends increased awareness among investors on the objectives and operation of anti-dilution tools. 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. For UK firms selling funds investing in illiquid assets to retail investors, communications on liquidity risk and liquidity management tools may need to be included in communications testing under the Consumer Duty.

Fund stress testing

The FSB will promote the use of fund- and system-level stress testing, including sharing experiences on the design and use of such stress tests. In the EU and UK, UCITS and AIFs are already required to carry out fund-level liquidity stress testing. One of the key challenges in carrying out these stress tests is obtaining good quality market data on liquidity for some asset classes. And as noted by the Bank of England following the recent crisis in the LDI market, stress tests need to consider the system and market dynamics and not just the firm’s own atomistic actions. Given the challenges associated with designing and using stress tests, the sharing of experiences is likely to be useful for firms.

System-wide stress testing is for authorities to carry out, but it will require information from individual firms, so increased testing is likely to impose an increased data burden on asset managers. The FSB’s work to improve data availability for financial stability monitoring is also likely to increase the number of data requests that firms receive.

Next steps

The FSB paper outlines the following next steps:

• The FSB plans to consult on revisions to its 2017 Recommendations in mid-2023, with a final report in late 2023. IOSCO will then operationalise the revised FSB Recommendations through amendments to the 2018 IOSCO Recommendations and supporting good practices.
• IOSCO, in consultation with the FSB, will consult on detailed guidance on liquidity management tools in mid-2023, with a final report in late 2023.
• The FSB, in consultation with IOSCO, will initiate a pilot programme in 2023 focused on closing identified data gaps relating to open-ended fund liquidity mismatch, the use of liquidity management tools, and attendant financial stability risk. Follow up work will be done as needed in 2024.
• The FSB and IOSCO will organise a workshop on experiences among authorities on design and use of stress tests for open-ended funds in late 2023/early 2024.

The ultimate impact on firms will depend on how the new FSB and IOSCO recommendations and guidance will be translated into local laws and regulations. In the EU, fund liquidity risk management is one of the key areas being discussed under the current review of AIFMD and UCITS, and the FSB’s direction of travel may influence these negotiations. In the UK, the Bank of England and FCA have already signalled their support for greater use of swing pricing that considers both explicit and implicit transaction costs, and the FSB’s recommendations may encourage action in this area. The FCA is still considering whether to require redemption notice periods for open-ended property funds, but seems to support this provided that the operational challenges can be overcome.

More immediately, these FSB recommendations may reinforce the current supervisory focus on fund liquidity risk management, including on redemption terms, anti-dilution tools, and fund stress testing. Asset managers need to ensure that they can demonstrate to supervisors that their funds’ redemption terms are aligned with the liquidity of the underlying assets and that they have effective liquidity management processes in place.