Feb 29, 2024
In late December 2023, the Financial Standards Board (FSB) and the International Organisation of Securities Commissions (IOSCO) co-ordinated the issue of two position papers concerned with liquidity risk management (LRM) for open-ended funds (OEFs), equivalently described as collective investment schemes (CISs). The FSB paper is entitled Revised Policy Recommendations to Address Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds (FSB Paper), whereas the IOSCO paper is a final report named Anti-dilution Liquidity Management Tools – Guidance for Effective Implementation of the Recommendations for Liquidity Risk Management for Collective Investment Schemes (IOSCO Paper).
In the IOSCO Paper, OEFs are defined as follows:
An OEF is a registered / authorized / public collective investment scheme (CIS) which provides redemption rights to its investors from its assets, based on the net asset value of the CIS, on a regular periodic basis during its lifetime - in many cases on a daily basis, although this can be less frequently.
(IOSCO Paper, p. 1)
Both the FSB Paper and the IOSCO Paper are written to address a potential problem for OEFs variously described as “market liquidity risk” or “liquidity mismatch”, which refers to a situation wherein a fund receives a sudden large influx of redemption requests to be settled in cash that:
This sort of situation typically can arise when there is a run on an OEF, either because of a loss of investor confidence in the fund or its manager or because of a crisis in the markets in which the fund invests. In either case, panicked investors may “dash for cash” by demanding their money back from the fund forthwith, with may the Devil take the hindmost applying to those further down in the queue, trapped therein, while the fund’s asset prices fall under intense selling pressure, perhaps precipitously. To address this problem, OEF managers need to devise appropriate LRM policies and procedures and develop effective liquidity management tools (LMTs) to help prevent undue losses to their remaining investors and contribute to maintaining stability in financial markets.
The scope of the LRM problem is set out in the FSB Paper as follows:
The Revised FSB Recommendations are addressed to financial regulatory and supervisory authorities and set out the key objectives that an effective regulatory and supervisory framework should achieve to address the vulnerabilities arising from liquidity mismatch in OEFs, to the extent jurisdictions’ liquidity regulations are not yet consistent with the Revised FSB Recommendations. The goal of the Revised FSB Recommendations, combined with the new IOSCO Guidance on Anti-Dilution LMTs, is a significant strengthening of liquidity management by OEF managers compared to current practices. A substantial improvement in addressing the liquidity mismatch in OEFs, greater use of - and greater consistency in the use of - anti-dilution LMTs, and a step change of the status quo are expected.
(FSB Paper, p. 1)
The IOSCO Paper words the problem’s scope somewhat differently but with the same objective:
To the extent that proper asset valuation and use of liquidity management tools (LMTs) do not remove the liquidity mismatch vulnerability, redeeming investors may benefit at the expense of remaining investors …
Investor protection and financial stability concerns could arise when transacting investors in OEFs do not bear the costs of liquidity associated with fund subscriptions/redemptions, which disadvantages existing/remaining investors. Anti-dilution LMTs can address these concerns by passing on the costs of liquidity to transacting investors by adjusting the price at which they transact. These tools form an important part of an overall liquidity risk management framework for OEFs.
In particular, the greater inclusion of anti-dilution LMTs in OEF constitutional documents, and their greater and more consistent use in both normal and stressed market conditions were specifically highlighted in the FSB assessment as having relevance and benefits to ongoing efforts to support global financial stability.
(IOSCO Paper, p. 1)
In both papers, there is emphasis on introducing more “anti-dilutionary” LMTs that will sheet home the costs of exiting OEFs to departing investors so that these same costs do not fall inequitably on those who remain invested in the funds or else create wider financial instability risks.
The two December 2023 papers build upon and culminate a substantial background of prior multiple publications by FSB and IOSCO concerned with LRM and LMTs. The latest papers provide updated standards that financial market regulators will require and OEF managers are expected to adhere to. For the purpose of this article, it will be the principal changes that are focused upon and what they imply for managed investment scheme (MIS) managers in New Zealand rather than an examination of the full range of standards that FSB and IOSCO have together propounded.
The FSB Paper states that it is intended to supersede Section 2 of the 2017 FSB publication Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities. Section 2 is linked in the 2017 document with Annex 1, which contains a list of 14 policy recommendations concerned with financial stability risks, of which the first nine are directly related in some way to market liquidity risk, whilst the other five address leverage, operational risk, and securities lending. The FSB Paper includes the nine market liquidity risk recommendations revised with new amendments incorporated as its own Annex 1 (see Appendix 1). It also has a marked-up version showing all changes made and the reasonings for them as Annex 2. A lot of text is evidently changed in the FSB Paper’s Annex 1 compared with the 2017 version’s Annex 1. Probably of most significance are the amendments made to the FSB’s Revised Recommendations 3 and 5.
Revised Recommendation 3 reveals far-reaching applications for OEFs and their managers in that its background discussion in the FSB Paper formally introduces four fund categories defined by the relative market liquidity risk of fund assets. Each category is to be governed by sets of rules concerning its most appropriate LRM and LMTs, the essentials of which are stated as follows:
When determining asset and portfolio liquidity, managers should consider the extent to which (i) the liquidity characteristics of asset holdings are more difficult to assess, contingent on market conditions, or asset holdings are difficult to value in stressed market conditions; and (ii) the liquidity characteristics of the portfolio can create a potential incentive for investors to redeem early to the disadvantage of other investors.
(FSB Paper, p. 15)
The FSB Paper’s four OEF categories are:
(Ibid., pp. 15-6)
LRM policies and procedures and LMTs to be applied will differ depending on which category an OEF falls under. The FSB Paper sets out the standards that financial markets regulators should require of LRM and LMTs in this regard:
For funds that invest mainly in “liquid” assets (Category 1), daily dealing would remain appropriate. The managers of those funds should continue to enhance their liquidity management practices where appropriate. For funds that invest mainly in “less liquid” assets (Category 2), offering daily dealing to fund investors (without notice or settlement periods) may remain appropriate, subject to OEF managers being able to demonstrate to the authorities (in line with the authorities’ supervisory approaches) that they implement anti-dilution LMTs, as described in Revised Recommendation 5. Funds that allocate a significant proportion of their assets under management to “illiquid” assets should create and redeem shares at lower frequency than daily and/or require long notice or settlement periods. The relevant authorities could also consider requiring that such funds be structured as closed-ended funds.
As indicative guidelines, investing more than 50% of assets under management in either liquid assets or less liquid assets is likely to constitute “mainly investing” in that category of assets; investing more than 30% of assets under management in illiquid assets is likely to constitute “allocating a significant proportion” to that category of assets. Authorities will be responsible for establishing the processes and specific criteria within which OEF managers will allocate funds to the respective categories in line with the indicative guidelines, as well as relevant specificities of the domestic liquidity framework in each jurisdiction.
(Ibid., p. 7)
Revised Recommendation 3 (see Appendix 1) masks behind its rather generalised wording a very detailed and intrusive regulatory regime that is designed to force fund managers into matching up the liquidity of their assets under management with prescriptive approaches to deploying LRM and LMTs.
Revised Recommendation 5 (see Appendix 1), referred to in Revised Recommendation 3, is novel in its heavy emphasis on anti-dilutionary LMTs, which are designed to ensure that there are no “first mover” advantages available to investors who try to cash out early from OEFs to their own financial benefit ahead of their fellow investors, including ensuring that the investors cashing out bear all the related transaction costs. Unlike Revised Recommendation 3, Revised Recommendation 5 spells out very clearly what regulators are expected to demand of fund managers in relation to having in place suitable anti-dilutionary LMTs.
The FSB’s Revised Recommendations repeatedly urge IOSCO to review and update its own 2018 LRM recommendations, which followed on from FSB’s 2017 recommendations, as set out in IOSCO’s final report entitled, Recommendations for Liquidity Risk Management for Collective Investment Schemes. The FSB Paper is more high-level than the IOSCO Paper, which is quite granular in its approach to how OEF managers should devise and apply LRM and LMTs, particularly anti-dilutionary LMTs.
Responding to the FSB Paper, the IOSCO Paper introduces many new revisions to its prior recommendations in respect of LRM. The core of the IOSCO Paper is a list of six new prescriptive rules for anti-dilutionary LMTs, which rules are described as “guidance to responsible entities” (IOSCO Paper, p. 2). These rules for OEF managers to follow are found in Appendix 2. The IOSCO Paper contains five “Elements” as follows (Ibid., p. iii):
The Elements will be required reading for OEF managers who need to get to grips with introducing appropriate and effective anti-dilutionary LMTs. In respect of these LMTs, the IOSCO Paper lists and describes five types (Ibid., p 10):
OEF managers will need to consider which of these types of anti-dilutionary LMTs are most appropriate and effective for the kinds of funds they offer, including taking into account the market liquidity risk characteristics of the assets that their funds invest in and any triggers that might be applied to imposing transaction costs as appropriate upon their investors.
Element (IV)’s Guidance 5 is concerned with governance, runs to four pages in length (see IOSCO Paper, pp. 18–21), and should serve as a wake-up call to directors and senior managers of OEFs. Highly detailed and prescriptive, Element (IV) requires in part, under the heading, “Reporting to Senior Management or Board”, that:
The oversight process should result in adequate and timely management information being produced and reported to the senior management / board of the responsible entity. The board should consider this information and appropriately address any weaknesses that have been identified.
The content and amount of management information to be produced and the arrangements for who considers it should be decided in a proportionate way, taking account of the size of the responsible entity, the characteristics of the OEFs it manages (e.g., their size and complexity) and the levels of management within its corporate structure. Such arrangements should however ensure that the most senior level of management explicitly considers liquidity risk management processes on a periodic basis, making use of relevant management information when doing so, in order to satisfy itself that the processes are adequate and are operating in the best interests of the funds and their investors. This might also be done with review reports from the internal audit function.
(Ibid., pp. 20-1)
Element (V)’s Guidance 6 concerning disclosure to investors highlights that it is not enough for OEF managers to have in place suitable anti-dilutionary LMTs and appropriate governance oversight thereof, but in addition investors must receive adequate disclosures that they can understand. To this end, Guidance 6 states, for example, that:
Transparency of anti-dilution LMTs is important to investors and careful consideration is needed on the extent and timing of information to be provided to them, to strike an appropriate balance between transparency and the efficacy of the tool. It is important that the level of transparency is appropriate (i) to help investors better incorporate the liquidity cost into their investment decisions and (ii) to avoid any unintentional counter-productive effect (e.g., any trigger effects which may lead to pre-emptive redemptions by investors or any actions taken by investors to game the mechanism and thereby reduce the effectiveness of the anti-dilution LMTs). This is relevant both in terms of investor protection and financial stability.
(Ibid., p. 22)
It is evident from the tenor of the IOSCO Paper that IOSCO, of which New Zealand’s Financial Markets Authority (FMA) is a member, takes anti-dilutionary LMTs with the utmost seriousness and expects the same of its member regulators and the OEF managers that they oversee and regulate.
At the end of September 2023, FMA announced that it was consulting on a proposed LRM guidance, having previously published guidance on the matter in April 2020. The consultation closed on 10 November 2023, just over a month before the publication of the FSB Paper and the IOSCO Paper. Accordingly, the consultation paper (Consultation) makes now dated references to FSB and IOSCO recommendations on LRM from 2017 and 2018 respectively. However, the Consultation does state FMA’s desire to, “Reflect changes in market conditions since 2020 and recommendations by the International Organization of Securities Commissions (IOSCO) and the Financial Stability Board (FSB)” (Consultation p. 2).
It is reasonable to expect that FMA will consider the Revised Recommendations and Guidances respective to the FSB Paper and the IOSCO Paper when finalising its new guidance on LRM. Accordingly, it would be prudent for MIS managers to undertake their own research into the implications of the FSB Paper and the IOSCO Paper, especially for the application of anti-dilutionary LMTs to the funds that they manage, including selection and application of appropriate LMTs, and any knock-on effects for MIS trust deeds, governance arrangements, and investor disclosure obligations such as amendments to PDSs, OMIs, and website pages.
“The FSB and IOSCO papers are well-timed in their publication, given the proximity to the consultation that FMA undertook in late 2023 in respect of its proposed new guidance on LRM,” said Matthew Band, General Manager of Trustees Corporate Supervision at Trustees Executors.
“These papers are calling for a much more fine-grained LRM regime than some MIS managers will perhaps be used to working under.”
“Logically, FMA will be taking these two papers into account when finalising its new guidance.”
“There is a lot for MIS managers to chew over in the FSB Paper and the IOSCO Paper concerning how they will implement updated LRM requirements and adopt appropriate and possibly new LMTs for their funds, not to mention the governance and investor disclosure consequences entailed.”
“Anti-dilution LMTs are evidently very much top of mind with financial markets regulators given the stance taken on them by FSB and IOSCO.”
“There is potential for anti-dilution LMTs to alter the way in which managed funds are offered to the public in New Zealand.”
“Obviously we will have to await the release of FMA’s new guidance on LRM to find out what the requirements arising for MIS managers and their Supervisors will be.”
“We expect to be discussing the new guidance with our supervised MIS clients once it becomes available.”
For comment or more information, or to be added to the free email subscriber list of “The Supervisor”, please contact Matt Band at [email protected].
FSB Paper’s Annex 1 list of revised policy recommendations to address vulnerabilities from liquidity mismatch in OEFs:
Recommendation 1: Authorities should collect information on the liquidity profile of open-ended funds in their jurisdiction proportionate to the risks they may pose from a financial stability perspective. They should review existing reporting requirements and enhance them as appropriate to ensure that they are adequate, and that required reporting is sufficiently granular and frequent.
Recommendation 2: Authorities should review existing investor disclosure requirements and determine the degree to which additional disclosures should be provided by open-ended funds to investors regarding fund liquidity risk and the availability and use of liquidity management tools, proportionate to the liquidity risks funds may pose from a financial stability perspective. Authorities should enhance existing investor disclosure requirements as appropriate to ensure that the required disclosures are of sufficient quality and frequency. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them.
Recommendation 3: In order to reduce material structural liquidity mismatches in open-ended funds, authorities should have requirements or guidance on funds’ liquidity risk management. Such requirements or guidance should state that funds’ investment strategies and the liquidity of their assets should be consistent with the terms and conditions governing fund unit redemptions both at the time of designing a fund and on an ongoing basis. The redemption terms that open-ended funds offer to investors should be based on the liquidity of their asset holdings in normal and stressed market conditions. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them.
Recommendation 4: Authorities should ensure that a broad set of liquidity management tools and measures is available for use by managers of open-ended funds in normal and stressed market conditions as part of robust liquidity management practices. Authorities should also reduce operational and other barriers that prevent the use of such tools and measures. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them.
Recommendation 5: Authorities should ensure that anti-dilution liquidity management tools are available to managers of open-ended funds. Authorities should also ensure that managers of open-ended funds consider and use such tools to mitigate potential first-mover advantage arising from structural liquidity mismatch in open-ended funds they manage, to ensure that investors bear the costs of liquidity associated with fund redemptions, and to arrive at a more consistent approach to the use of liquidity management tools. Such tools should impose on redeeming investors the explicit and implicit costs of redemptions, including any significant market impact of asset sales to meet those redemptions. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them as well as to prepare guidance on the design of anti-dilution liquidity management tools.
Recommendation 6: Authorities should require and/or provide guidance on stress testing at the level of individual open-ended funds to support liquidity risk management to mitigate financial stability risk. The requirements and/or guidance should address the need for stress testing and how it could be done.
Recommendation 7: Authorities should promote (through regulatory requirements or guidance) clear decision-making processes for open-ended funds’ use of quantity-based liquidity management tools and other liquidity management measures, particularly in stressed market conditions. The processes should be made transparent to investors and the relevant authorities. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them.
Recommendation 8: While asset managers have the primary responsibility to consider and use quantity-based liquidity management tools and other liquidity management measures, authorities should provide guidance on their use particularly in stressed market conditions. In this regard, IOSCO should review its 2018 recommendations and, as appropriate, enhance them. Where jurisdictions consider it appropriate, authorities should also provide direction in stressed market conditions regarding open-ended funds’ use of such tools and measures, taking into account the costs and benefits of such action from a financial stability perspective.
Recommendation 9: Where relevant, authorities should give consideration to system-wide stress testing that could potentially capture effects of collective selling by funds and other investors on the resilience of financial markets and the financial system more generally.
(FSB Paper, pp. 23-4)
IOSCO Paper’s new guidance for OEF managers on anti-dilutionary LMTs
(IOSCO Paper, p. 2)