Dec 19, 2019
Fund Managers have a job to do for the Regulator
In mid-November the Financial Markets Authority (FMA) held its MIS Lab #5 series of seminars in Auckland and Wellington. At these seminars the regulator introduced its programme for managed fund LRST, announcing that the first of a regular annual LRST survey would be sent out in February 2020 for all licensed MIS managers to complete.
Liquidity risk for a managed fund is the possibility of mismatches arising between incoming withdrawal requests and the ability of the investment manager to respond by liquidating assets at prices and over time periods that are not disadvantageous to unitholders. The stress testing involves running hypothetical scenarios to discover where the relationship between unitholder withdrawals and asset sales breaks down to the detriment of investors in a managed fund. The FMA wants New Zealand fund managers to analyse and report back on LRST for their products.
Origins of Managed Fund LRST Programmes
LRST has become a major contemporary focus of financial markets regulators since the global financial crisis (2007-10) exposed managed fund liquidity problems under contagion withdrawal conditions. These “liquidity crunches” prompted worldwide coordinated actions by regulators. A key point arrived when the International Organisation of Securities Commissions (IOSCO), of which the FMA is a member, published “Principles of Liquidity Risk Management for Collective Investment Schemes” in April 2012. IOSCO then followed up with “Recommendations for Liquidity Risk Management for Collective Investment Schemes – Final Report” in February 2018. In publicly launching its own LRST project in 2019 with a target for rolling it out to New Zealand fund managers in 2020, the FMA is following on from the general trend established for this type of regulatory work by IOSCO.
Whose Liquidity Risk are we talking about?
If mismatches occur between unitholder withdrawals and achievable asset sale prices and times for completion, then issues can arise for investor equity. Some unitholders could be treated better or worse than others depending on whether or not they got their money out of the fund before mismatches blew up into crises. Confronted with problems of this sort, dilemmas can arise for fund managers and their supervisors when striving to act in the best interests of investors. For example, when deciding on how to react to a fund liquidity crisis, should fund unit transactions be suspended for a time, keeping the fund itself as a going concern, or should the fund be shut down, assets liquidated, and investors all paid out together?
However, it is not just the best interests of fund investors affected that may need to be taken into consideration. Managed fund liquidity risk stresses hit individual investors but on a large enough scale can become cumulatively systemic across the economy. There is the bigger picture to consider: is the wider economic interest more important than the interests of managed fund investors? In weighing up these matters, regulators must decide what to focus on, and whether the most appropriate resolution should be investor-centric or system-centric.
There can be tensions between regulators in these fraught circumstances. Central banks tend to be concerned with systemic threats applying widely across the economy as a whole, whereas financial markets regulators may see the problem as one of avoiding unnecessary losses for retail consumers of financial products. It may not always be possible to reconcile individual investor needs with systemic economic requirements, or for regulators to agree on a solution that suits everyone’s interests. That leads to the question: who gets thrown under the bus first?
The FMA’s LRST Plans
The FMA has publicly committed to an LRST work project. In its Annual Corporate Plan 2019/20 the regulator states:
“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).
“MIS stress testing – work with supervisors to test the readiness of MIS managers to respond to a liquidity crisis event” (p. 13).
At the MIS Lab #5 seminars, the FMA announced that its LRST working method will be a survey of all licensed MIS managers. Category 2 fund managers will be excluded unless they are also licensed MIS managers. The regulator has employed a team to conduct the survey and hired consultants to write the questions. February 2020 is the proposed target time for the survey to go out to retail fund managers to complete, but the FMA will send out prior communications on the matter, including exact timing, in January.
From what the FMA has said thus far, the LRST survey could potentially be a substantial piece of work for fund managers to complete. The survey is proposed to be in two parts:
Part 1: Fund managers’ current understanding of and approach to LRST
Part 2: Fund managers’ response to a specific LRST scenario
The survey will combine tick-box and long-form questions, with recipients given a four-week completion period. The purpose of the survey is to gather sufficient information to publish an initial report on the status of LRST issues for managed funds in New Zealand. The report will treat the survey findings in aggregate, but the FMA is open to including additional material such as a guide, information sheet, good and bad practice examples, and individualised feedback.
The FMA has further announced that the fund manager LRST survey and report are planned to become regular annual events. If so, they will attract ongoing investor attention and news media commentary.
Are there any clues for what the FMA’s LRST survey might ask?
Wholesale fund managers will be excluded from the survey because the FMA does not presently regulate them. However, there are likely to be questions for MIS managers concerning their knowledge and oversight of wholesale managers and the redemption terms of their investments in wholesale funds.
As luck would have it, the Bank of England’s Financial Policy Committee (FPC) has just issued its latest Financial Stability Report, which contains a section on its most recent conclusions concerning how assessment of fund liquidity risks should be addressed (See Appendix 1 for the section verbatim). These conclusions have been reached in agreement with Britain’s Financial Conduct Authority (FCA) and concur with those of the US Securities and Exchange Commission (SEC). A spot of cribbing over the hols might be in order for those expecting to be surveyed next February.
Quirks and Wrinkles
Matching fund liquidity and withdrawal rules is not without complications. Some kinds of funds (mortgage, real estate, hedge funds, private equity) are traditionally low liquidity and do not permit unitholder withdrawals upon demand anyway. In an era of chronically low interest rates, investor search for yield has driven some active fund managers into less liquid assets to try and boost returns at higher risk. Implications for returns if managers pull funds away from less liquid assets in order to ease withdrawal constraints may not be palatable to investors.
Passive funds have been widely used as cash liquidity substitutes by fund managers, but could get caught up in liquidity crunches themselves or even contribute to them, as research by financial markets regulators has shown. Locked-in funds (KiwiSaver, workplace superannuation, QROPS) limit or obstruct investor withdrawals deliberately, typically due to legislative constraints, and so are not dysfunctional just because they do not offer withdrawal on demand. Muddying matters further, “parallel portfolios” have become common whereby managers offer identical funds under both retail and KiwiSaver formats, but these funds differ in respect of withdrawal rules. On the disclosure front, PDS, SIPO and OMI clarity and accuracy could be called into question concerning consistency with actual fund design around liquidity and withdrawal requirements. In future years, LRST surveys might also be sent to wholesale funds, which the FMA has announced it wants to start researching with a view to greater oversight and potential regulation.
Practical Issues for MIS Licensees
Licensees need to establish and maintain routines for managing fund liquidity risk stress events (LRSE):
Source: Bank of England 16 December 2019
Vulnerabilities in Open-ended Funds
The FPC judges that the mismatch between redemption terms and the liquidity of some funds’ assets means there is an advantage to investors who redeem ahead of others, particularly in a stress. This has the potential to become a systemic risk.
As part of the ongoing review by the Bank and FCA of open-ended funds, the FPC has established that there should be greater consistency between the liquidity of a fund’s assets and its redemption terms. In that regard:
In addition to enhancing financial stability, these changes should also promote funds’ ability to invest in illiquid investments, helping to increase the supply of productive finance to the economy through business and financial cycles, in line with the Committee’s secondary objective.