FCA joins growing regulatory call to action on fund liquidity

At a Glance

• The Financial Conduct Authority (FCA) has published the results of its multi-firm review of fund liquidity management frameworks, with an accompanying Dear CEO letter. The FCA found significant shortcomings in firms’ management of fund liquidity and expects to see a step change in how Boards and governance committees engage on this topic to ensure that investors are treated fairly in both normal and stressed market conditions. The FCA expects CEOs to share its letter with their firm’s Board and to review their firm’s liquidity management arrangements and make any necessary improvements. The implication of the letter is that, based on its findings to date, the FCA anticipates that many firms will have to undertake significant additional work to demonstrate they are managing fund liquidity effectively.

• In our view, Boards should satisfy themselves that their firm undertakes a detailed gap analysis and puts in place a comprehensive remediation programme where necessary. The result should be a coherent, end to end liquidity management framework which is fully embedded in the firm’s operations and which works effectively in practice. The FCA is likely to scrutinise fund liquidity management arrangements closely going forward. Having robust liquidity management arrangements will also be essential for firms to demonstrate good customer outcomes under the Consumer Duty.
• We think that firms should pay particular attention to their governance arrangements, since a common theme throughout the FCA’s findings was insufficient escalation and challenge. In our view, it is good practice for firms to have a dedicated liquidity risk management committee which is a sub-committee of its product governance committee or investment risk committee, with MI sent to the Board risk committee. The liquidity risk management committee should pay particular attention to model governance and validation (including on models for stress testing, swing pricing and asset valuation), and to providing enhanced governance in times of market stress. Another important area will be oversight of third parties e.g. delegated investment managers and third-party administrators, to ensure that they have appropriate liquidity risk management tools and processes and that their liquidity triggers are in line with the firm’s own liquidity risk appetite.
  

Overview

On 6 July, the FCA published the results of its multi-firm review of fund liquidity management frameworks, with an accompanying Dear CEO letter. The FCA found significant shortcomings - even when firms had put in place the building blocks and tools for effective liquidity management, which was often the case, they did not amount to a coherent end to end process and were not always well embedded. The FCA found shortcomings in firms’ governance and MI, liquidity stress testing, redemption processes and anti-dilution tools such as swing pricing.

The FCA’s findings have informed its contributions to the work of the FSB and IOSCO on liquidity in open-ended funds. On 5 July the FSB consulted on its recommendations to address structural vulnerabilities from liquidity mismatch in open-ended funds, while IOSCO consulted on guidance on anti-dilution liquidity management tools. These are part of the FSB/IOSCO workstream on non-bank financial intermediation. The FSB and IOSCO recommendations are not yet applicable to firms but indicate the direction of travel of global policymaking. The FSB’s recommendations could require funds holding illiquid assets to move away from daily dealing, which could make them less attractive to investors - our previous article discusses how this could affect firms. IOSCO’s proposed guidance will be relevant to firms as they consider how to incorporate market impact cost into swing factors. UK authorities also plan to consult on reforms for money market funds in H2 2023 to implement the FSB’s policy proposals to enhance money market fund resilience.

This article discusses what asset managers need to do to address the shortcomings found in the FCA’s review and our views on good practice in fund liquidity management.

Governance

The FCA found that many firms did not attach sufficient weight to managing liquidity within their existing frameworks and governance structures, with liquidity risks often flagged only on an exceptions basis. The FCA noted that firms with a separate liquidity risk management committee generally do a far better job at managing liquidity risk. In our view, it is good practice for a firm’s fund liquidity risk management committee to be a sub-committee of its product governance committee or investment risk committee, with MI sent to the Board risk committee.

In our view, the importance of robust governance and MI on liquidity will increase further as firms implement the Consumer Duty, which places an increased onus on firms to evidence good customer outcomes. Firms should pay particular attention to the need for committees to receive high quality information about liquidity risks regularly, but also be able to make decisions quickly in times of stress. It will also be important for firms to have sufficiently granular fund liquidity risk appetite statements which are embedded across the business.

Since many asset managers use external agents such as delegated investment managers or third-party administrators, we think it will also be important for them to have sufficient resources and expertise to ensure that third parties have appropriate systems and controls to manage liquidity effectively, especially in times of stress. This will include understanding what level of monitoring external parties are doing on their mandate and receiving MI that is specific to each fund’s strategy.

Stress testing

The FCA found that many firms assumed in their stress testing models that the most liquid assets would be sold first, creating a false sense of security, and affecting portfolio composition if executed. The FCA advocates a ‘pro-rata’ approach, where a proportionate ‘slice’ of every asset comprising the portfolio is sold to accommodate the redemption. Firms will need to consider their approach on a fund-by-fund basis, taking into account each fund’s liquidity profile. Where firms switch to a ‘pro rata’ approach, they may need to adjust the fund’s liquidity profile to meet the more stringent test.

The FCA found that in some firms few funds ever failed stress tests, suggesting that thresholds and triggers may not be challenging enough. In our view, it will be important for firms to keep thresholds and triggers up to date, especially given recent market turbulences and challenging market conditions. Equally important is for firms to take appropriate action where funds fail stress tests, which the FCA did not see consistently.

The FCA found that some firms had a limited understanding of the models and methodologies used, particularly when their construction is outsourced. The FCA wants to see more regular challenge and review of firms’ models, reflecting its broader feedback on governance and oversight.

The FCA found that firms factored single investor concentrations into their liquidity management process but did not fully consider investor type concentration in redemption stresses. ESMA notes in its guidelines (which the FCA expects firms to apply) that firms can build models based on factors such as investor type (e.g. wealth manager, pension fund), investor concentration, investor location and investor strategy (e.g. long-term, target risk level). As part of stress testing, we think firms should also consider the potential for foreseeable harm for different groups of customers under the Consumer Duty.

Redemption process

The FCA wants firms to conduct pre- and post-redemption testing to ascertain how liquidity has been affected by redemptions, and to consider carefully how they manage the trade-off between liquidity risk and customer fairness. In our view, under the Consumer Duty firms should also consider whether their target market understands the extent to which they may receive a worse price if they redeem in stressed market conditions, and whether the target market can bear this risk. This will be particularly important where firms are selling illiquid funds (e.g. long-term asset funds) to retail investors.

The FCA found that many firms only had a trigger for enhanced governance at a large redemption threshold, rather than monitoring the cumulative impact of small redemptions. In our view, it will be important for firms to set a clear risk appetite for when cumulative trends of small redemptions should trigger enhanced governance and actions. Firms also need to test operational processes thoroughly in conjunction with any third-party service providers. While this review did not focus on operational processes, they were a key element highlighted in the FCA's review of resilience in liability-driven investment.

Liquidity management tools

When using swing pricing and other anti-dilution tools, the FCA wants the calculation of thresholds, application of tools and pricing adjustments to be done on a fund-by-fund basis and reassessed with accelerated governance as conditions warrant. Firms will need to decide which thresholds and pricing should apply to which funds under different market conditions, and consider how to incorporate this into their liquidity risk management frameworks. In our view, it will be important for firms to have robust internal review and challenge on their models, including during design and ongoing performance monitoring.

The FCA also found a potential over-reliance on third-party administrators for swing pricing calculations, and an absence of back-testing using the firm’s own executed prices. Going forward, asset managers will need to scrutinise third-party administrators’ calculations more, and it is likely that third-party administrators will need to engage more with asset managers to explain their methodologies.

The FCA is considering issuing further rules or guidance on the factors that firms should consider when calculating dilution adjustments. In this review, the FCA makes it clear that it wants firms to incorporate the market impact cost into swing pricing. ‘Market impact’ is when a transaction moves the market price because it is large relative to available market liquidity. Including the market impact cost in swing pricing is a particular challenge because the information may not be readily available.

IOSCO’s proposed guidance notes that the fund’s daily net asset value (NAV) may be calculated before the portfolio has been adjusted as a result of the net fund flow on that day, so firms have to estimate the liquidity costs to be incorporated into swing pricing. IOSCO suggests that firms estimate the market impact based on analysing previous transactions under similar market conditions or using relevant market data/models. To do this, asset managers will have to apply judgement since no two sets of market conditions will be identical, and in previous transactions the difference between the price when the order was placed and the final executed price will be affected by random market movements as well as by the market cost. Calculating the market impact of trading has been a particular challenge under the PRIIPs Regulation. In our view, firms’ governance processes should pay particular attention to assessing the effectiveness of firms’ models of market impact, including through back-testing.

Valuation

The FCA found that valuation processes were reasonably robust, however, internal challenge was seldom evident. Good practices include committees challenging valuations, subjecting less liquid buckets to line-by-line interrogation and scrutinising the performance of third-party valuation services. Firms will need to ensure that their committees have the MI and skills to challenge valuations.

Most of the funds surveyed had very limited exposure to fundamentally illiquid positions. Where funds hold illiquid assets, valuation can be more challenging. For example, ESMA’s recent common supervisory action on valuation found that for real estate and private equity, issues can arise in the alignment between the NAV calculation, the asset valuation frequency and the availability of up-to-date data. In our view, it is important for firms to assess the quality of their data and valuation models, including through periodic back-testing, and to have strong oversight to mitigate the risk of any conflicts of interest.

Next steps

The FCA has made it clear that it expects the Board as a whole to focus on ensuring that their firm meets its expectations on liquidity risk management. This means carrying out an assessment of how the firm’s risk management practices measure up against the FCA’s findings, and acting quickly to close any gaps that emerge. In our view, firms should pay particular attention to:

• reviewing their governance structures and MI to ensure that there is sufficient escalation and challenge (including creating a specific liquidity risk management committee where needed);
• reviewing their liquidity risk management frameworks and ensuring they have a sufficiently granular risk appetite;
• enhancing their liquidity risk stress tests and associated scenarios to consider wider macro-economic influences and use appropriately conservative assumptions;
• model governance and model validation (including on models for swing pricing, stress testing and asset valuation); and
• creating a variety of playbooks to be activated should a liquidity stress occur – these should be tailored to each fund and consider the different escalation triggers and processes based on the different scenarios;
• considering how market impact cost can be built into swing-pricing and other anti-dilution tools; and
• engaging with third parties e.g. delegated investment managers and third-party administrators, to ensure that they have appropriate liquidity risk management tools and processes and that their liquidity triggers are in line with the firm’s own liquidity risk appetite.