Pandemic risks loom large over financial markets

The COVID-19 global pandemic has disrupted virtually every aspect of life since the first quarter of 2020, not least financial markets.  Its advent has imparted renewed international impetus to financial markets regulator research into liquidity risk management (LRM) as it affects managed funds (in New Zealand, managed investment schemes/MIS).  For managed funds, liquidity risk is the financial risk arising from uncertainty about market liquidity of fund assets.  In practical terms, it is the risk that fund managers will be frustrated when trying to trade investments under abnormal market conditions.  When liquidity risk afflicts a managed fund, the manager encounters unusual difficulty in buying or selling assets on market at acceptable prices.  In extreme conditions, there may be no ability to transact at any price.  Other symptoms can include inability to transact assets within required timeframes, and loss of asset value caused by selling pressure, such as occurs when panic fire selling leads to price crash.  If an entire financial market becomes engulfed by this sort of liquidity risk, then it is said to be undergoing a “liquidity crisis event”.

The classic case of liquidity risk dominating financial markets prior to the COVID-19 liquidity crisis event of 2020 is the global financial crisis (GFC) of 2007-8.  During the GFC many financial markets suffered liquidity crisis events due to chaotic fire selling as frightened investors dumped risky assets willy-nilly in their stampede to the perceived safety of cash.  Managed funds were at the time affected by impairment of the ability to transact normally, asset pricing disruptions, significant asset value losses, and being caught up in the rush for the exits.  Fund managers found themselves unable to honour investor withdrawal requests under stated terms and conditions without incurring firesale prices to raise the cash required, supposing they could transact at all.  Some responded by suspending fund withdrawals, locking investors into falling markets.  Recent market-disruptive turbulence induced by COVID-19 during the second quarter of 2020 has apparently revived bad GFC memories among regulators.

Background to ongoing regulator interest in LRM

Concerned with the plight of retail investors during the GFC, many of whom used managed funds to accumulate and disburse retirement savings, and wanting to rebuild confidence in financial markets, regulators worldwide became keenly interested in LRM.  The seminal text concerning regulator response to GFC-exposed managed fund liquidity risk was published by the International Organisation of Securities Commissions (IOSCO) in February 2018.  Entitled Recommendations for Liquidity Risk Management for Collective Investment Schemes, this report encapsulated received wisdom of market regulators on LRM lessons learned from the GFC by late last decade.  The 2018 report was based on an earlier IOSCO report of March 2013 entitled Principles of Liquidity Risk Management for Collective Investment Schemes, and drew also upon a Financial Stability Board (FSB) report of January 2017 entitled Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities. It is evident from this significant body of work that the multi-national organisations concerned with financial markets stability agree that LRM is of serious importance. 

The 2018 IOSCO report picks up on one particular form of liquidity risk identified by the FSB, namely “liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units” (p. 1), which it restates as “the importance of ensuring the quality of day-to-day liquidity management where [collective investment schemes] are designed to have frequent dealing arrangements” (p. 2).  Of the various types of liquidity risk that can impede normal operations of managed funds, it is the liquidity mismatch occurring when the rate of investor withdrawal requests exceeds the rate of offsetting disposal of fund assets at acceptable prices that most exercises the wits of financial regulators.  At the extreme, managed funds seized up by liquidity mismatch find themselves boxed into a “can’t pay, won’t pay” impasse with their investors. 

One tool for managing liquidity risk is the ability for a fund to hold or borrow some proportion of cash, but typically cash detracts from returns of riskier assets, affecting fund performance, and in a run-on-a-fund situation may not be enough to stave off liquidity mismatch.  Fund managers may need to keep more in their box of liquidity management tools (LMTs) than just the ability to hand out a limited quantity of ready cash.  Exactly what else they might have in mind to use when confronted with liquidity mismatch is what piques the curiosity of financial markets regulatory authorities worldwide. 

Liquidity risk back in the limelight

In March 2021, IOSCO announced two new international initiatives concerned with LRM.  The first is that it will conduct a thematic review of the 2018 report and the second is that, in conjunction with the FSB, it will undertake an analysis of LRM as presently practised by fund managers.  In a press release, IOSCO stated:

The Thematic Review – conducted by the IOSCO Assessment Committee (AC) – aims to assess the extent to which the Recommendations [of the 2018 report] have been implemented through member regulatory frameworks. It also aims to gather information about how the responsible entities – to whom the recommendations are directed – have implemented them in practice. The Thematic Review report is expected for Autumn 2022.

Alongside the Thematic Review, IOSCO and the Financial Stability Board (FSB) are currently conducting a joint analysis of the availability, use and impact of liquidity risk management tools for open-ended funds (OEFs). The Joint Analysis is examining the experience of OEFs that faced redemption pressures during the COVID-19 induced market stresses of March and April 2020; the availability, use and impact on the broader market of liquidity risk management tools and how these were linked to the liquidity of underlying assets. (IOSCO Non-Media Official Posting 6 March 2021)

Supporting these two work streams, IOSCO announced that it would be conducting a voluntary survey of responsible entities, meaning MIS managers in the New Zealand context.  In respect of the survey, IOSCO said: 

To inform both the Thematic Review and the Joint Analysis, IOSCO is issuing today a Market Participants’ Survey. The Market Participants’ Survey is specifically designed to collect information from responsible entities both (i) on their adoption and practical implementation of the Recommendations as well as (ii) specific targeted information on their liquidity risk management practices and experiences during the March 2020 market turmoil. The latter information is being gathered through a schedule of supplemental questions within the Market Participants’ Survey.

Participation by responsible entities to the Markets Participants’ Survey is being undertaken on a voluntary basis. Individual responses will remain confidential and will be used only in anonymized and/or aggregated format. The submission deadline is 16 April 2021. Respondents are asked to send completed questionnaires to a dedicated mailbox ([email protected]).  (ibid.)

In theory there is nothing to stop New Zealand-based MIS managers from completing and submitting IOSCO’s 24 page survey by the due date.  However, even if New Zealand-based MIS managers do not have time for that, they should perhaps prudently make time to read through the survey anyway as it contains substantial information about what IOSCO thinks is best practice for LRM.  As the Financial Markets Authority (FMA) is a member of IOSCO, it is likely that it shares IOSCO’s mind on the subject.

LRM in Godzone

The FMA was quick to pick up on IOSCO’s 2018 LRM report as early as 2019.  In its Annual Corporate Plan 2019/20, the FMA stated in the chapter “Investment Management”, under the heading “Sector risks and harms we want to address”, that it was concerned about:

“Stability of funds – Managed Investment Scheme (MIS) managers have insufficient processes and controls to respond to a liquidity crisis event, which could lead to investor losses.” (p. 12)

This statement (also repeated twice verbatim in the FMA’s Strategic Risk Outlook 2019 pp. 7, 20) points under “Activities for 2019/20” to the work objective:

“MIS stress testing – work with supervisors to test the readiness of MIS managers to respond to a liquidity crisis event.” (p. 13)

The FMA’s interest in LRM was prescient, as just around the corner lay a catastrophe comparatively few foresaw as possible, but which had the capacity to deliver liquidity crisis events in spades, namely the COVID-19 global pandemic.  The FMA announced it was intending to survey MIS managers on LRM early in 2020, but like a lot of things, the scheduling was interrupted by the pandemic.

At the beginning of September 2020, after COVID-19 had inflicted a bout of havoc on financial markets, the long-awaited FMA survey on LRM, entitled FMA liquidity risk stress testing 2020 Questionnaire, finally arrived in the email inboxes of MIS managers.  The covering note from contracted survey conductor Buzz Channel stated that:

“The objective of this survey is for the FMA to gain a better general understanding of liquidity risk management practices and infrastructure currently in use by MIS Managers, including the use of liquidity stress testing. The FMA is particularly interested in the preparedness of MIS Managers to manage a liquidity crisis event, including their understanding of the relevant issues, their policies and processes, and the tools available to manage the event. Findings from this survey may help inform future policy decisions in this area.”  (Buzz Channel email 8 September 2020)

The note went on to say:

“The FMA understands that this survey is longer than our typical thematic survey’s [sic], and it will most likely require multiple individuals from across the organisation to collect and collate the information for the questions, we have ensured to give you adequate time to complete the survey (4 weeks).”  (ibid.)

MIS managers were probably grateful for the completion time extension as the FMA’s survey ran to 100 pages in PDF format and included 88 questions, not counting sub-questions.  Currency of the survey with the COVID-19 pandemic, which the IOSCO/FSB survey is still trying to catch up on, was ensured by the FMA’s questions 86 and 87.  Question 86 asked survey respondents to identify changes made (short term or permanent) to their practices because of the COVID-19 liquidity crisis event.  Specific potential changes the FMA was interested in included asset valuation, defining illiquid assets, cash flow forecasts, process of stress testing, metrics or data used, and policy changes.  Question 87 asked more broadly, “If anything, what was an interesting or important learning from the recent COVID-19 liquidity event, that you think the market would need to know?”

According to the FMA, a report on its analysis of the survey is aimed to be published by May 2021.  It will be interesting to see what the analysis reveals concerning, for example, LRM as applied within the context of the New Zealand share market, which is small by international standards and has potential problems in thinness of market liquidity for many listings. 

Conclusion

“Liquidity risk management (LRM) has become a focal point for financial markets regulators worldwide due to the deleterious effects of recent extreme market disruptions,” said Matthew Band, General Manager of Corporate Trustee Services at Trustees Executors.

“Respected multi-national organisations like the FSB and IOSCO have put a lot of resources into studying how liquidity risk has affected managed funds both before and after the advent of COVID-19 and what should be done to counter this risk.”

“New Zealand’s regulator, the FMA, has followed suit in a timely manner.”

“MIS managers will need to pay heed to regulator concerns around LRM, as will their Supervisors”

“Whilst most MIS funds could be described as pretty much plain vanilla, nonetheless there could be important lessons to be learned about how to avoid liquidity mismatches between investor withdrawal requests and market disposability of fund assets.”

“More guidance will be available from the FMA once it publishes its report on the LRM survey of MIS managers conducted in September 2020, which will no doubt trigger close scrutiny by the funds management industry.”

“In the interim, it is worthwhile for MIS managers to read through the IOSCO/FSB survey to get an idea of what international best practice LRM should look like, even if they don’t complete and return the survey themselves”.

“As a licensed Supervisor, we at Corporate Trustee Services anticipate that we will be having discussions with our MIS manager clients about their LRM practices once the FMA’s views are fully known.”

For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt at [email protected].