FCA warn fund managers to get liquidity management right
On 6th July, FCA published the findings of its review of liquidity management in the asset management sector. The multi firm review looked at the liquidity management frameworks of 14 Authorised Fund Managers (AFMs) (e.g. UCITS Management Companies and ACDs) but noted that all asset managers and managers of Alternative Investment Funds (AIFs) are expected to consider the findings and apply them appropriately for their businesses.
This is not the first time the FCA have urged firms to review their liquidity management practices in recent years. This review follows a 'Dear CEO' style letter to the Boards of AFMs in 2019, months after the suspension of the Woodford fund, reminding them that effective liquidity management in the funds they manage is one of their central responsibilities.
While the FCA identified a range of both good and bad practice, the FCA found that “most firms fell short” in at least some aspects of their liquidity management. This will do little to dissuade the regulator from its belief that further work on liquidity management is needed to ensure investors receive appropriate protections. This is particularly topical given the renewed focussed on consumer protections under Consumer Duty, which begins to apply in just a few weeks.
What did the FCA find?
One of the most interesting points, in our view, was that the FCA repeatedly emphasise the need to treat all customers fairly when processing redemptions. This includes both from a price/NAV perspective, as well as from a liquidity perspective. In short, FCA assert that firms should in general dispose of a ‘vertical slice’ of the portfolio, including both more and less liquid assets, that accurately reflects what the redeeming investors actually owned. This is in contrast to the practice of simply using available cash and selling the most liquid assets, which results in the more illiquid assets being retained for the continuing investors and altering the composition and liquidity of the remaining portfolio.
The “pro-rata” approach to redemptions should then feed through and be reflected in firms’ modelling, monitoring and stress testing. So instead of using the less conservative approach of assuming the most liquid assets would be sold first, which FCA say creates “a false sense of security”, firms should instead contemplate what would be needed to sell a proportionate “slice” of every asset in the portfolio to meet the redemption request, and factor this into their monitoring and stress testing accordingly.
Other key takeaways include:
Liquidity risk management should be given more weight in firms’ governance arrangements and the Board and Committee packs should reflect this.
More detailed liquidity reporting, presented to the Board and Governance committees, is required on an ongoing basis, rather than only on an exceptions basis. This should include details of stress tests, test failures, commentary on larger investor behaviour and any observed trends in liquidity of the portfolio and redemptions which could impact the liquidity profile of the fund over time.
Liquidity stress testing should include a wide enough range of redemption scenarios to adequately represent the risks. For instance, covering the largest investors over a variety of time periods and circumstances, factoring in investor type concentrations where redemptions could be highly correlated e.g. if many pension funds or other similar investor types all wanted to redeem at the same time for similar reasons.
Firms should be willing – by which we assume FCA mean the Compliance Officer should be willing – to challenge portfolio managers and traders on the transactions they undertake to meet investor redemption requests and whether these are appropriate and in the best interests of all investors, including both remaining and departing investors. There is no single answer to what this ‘challenge’ should look like in practice, but we expect ongoing monitoring and testing of some sort will be required to fully meet FCA expectations.
The liquidity management approach (e.g. the setting of thresholds, application of anti-dilution tools and pricing adjustments) should be adapted per fund rather than the firm adopting “one-size-fits-all” approach to all funds it manages.
What do the FCA expect firms to do?
Alongside publishing its review, the FCA has issued a Dear CEO Letter summarising its findings. In the letter, the FCA make it clear that it expects firms to consider the findings and apply them to their businesses appropriately.
Specifically, firms are expected to:
Review the governance arrangements in place to oversee liquidity risk
Ensure regulatory requirements are met when meeting redemptions, and ensure that both redeeming and remaining investors are treated fairly
Work with service providers to ensure operational systems and processes are fit for purpose, can be executed swiftly and scaled to handle additional demand when needed
Perform liquidity stress testing diligently, and use liquidity management tools appropriately and in line with regulatory expectations
If you have any questions on the findings of this review or what it means for your firm, please get in touch.