The investment funds sector has more than doubled over the past decade and now stands at well over USD 50 trillion, according to a November Financial Stability Board report. Also, asset managers are playing a greater role in financing the real economy, as well as in managing the savings of households and corporates. It is therefore unsurprising that the sector’s role in financial markets is firmly in the sights of global policymakers. As we highlighted in April, market volatility due to the pandemic has re-ignited the debate about liquidity management of open-ended investment funds and of asset management activity more widely.

Recent releases by the FSB, the European Central Bank (ECB) and ESMA, coupled with reviews by national regulators, point clearly to this topic being a major focus of policymakers throughout 2021 and beyond. All firms, including those which have recently reviewed their processes, need to be prepared for closer supervisory scrutiny of their liquidity management frameworks and for fund structures to be subject to more prescriptive rules around redemption frequency.

Questions for CEOs

  • Are the redemption terms in our funds aligned to the liquidity of the underlying assets?

  • Can we evidence that our investment process is subject to internal discipline and external challenge, and that we are not swayed by so-called “herd behaviour”?

  • Can we evidence how we monitor investor behaviour in times of stress and what we do to mitigate potential issues?

  • Are we reviewing all aspects of our liquidity management framework, in the light of lessons learned during the period of high market volatility this year?

  • What liquidity management tools are available to us?

  • Are we enhancing our stress testing scenarios, including for exchange-traded funds (ETFs)?

  • Do we have daily dealing funds in less liquid or illiquid assets? What extra measures can we take to minimise the risk of fund suspensions?

  • Are we reviewing the way in which the money market funds (MMFs) we manage, or are invested in, operated before and after the “dash to cash”?

FSB review of non-bank financial intermediaries (NBFIs)

The FSB's November 2020 report to the G20 reviews the causes of the high market volatility in March 2020. Its findings closely reflect the areas highlighted in KPMG's new reality publication, Ensuring stable capital markets (PDF 1.83 MB). The FSB says that the interconnectedness within the NBFI sector and with banks, as well as greater reliance on market and funding liquidity to support market-based intermediation, reinforce the need to analyse the overall system. It notes that, “Absent central bank intervention, it is highly likely that the stress in the financial system would have worsened significantly” and that “The financial system remains vulnerable to another liquidity strain, as the underlying structures and mechanisms that gave rise to the turmoil are still in place”.

The report highlights liquidity mismatches, the build-up of leverage in certain types of investment funds, and that large differences arose between certain fixed income ETF share prices and the estimated value of their assets. As regards MMFs, which at end-2019 accounted for approximately USD 7 trillion of assets under management, the FSB recognises that:

  • The sector plays an important role in supporting the real economy, both as a liquid and diversified cash management tool for investors, and as a key source of funding for governments and corporates (both financial and non-financial)
  • Post-2008, international standards on MMF regulation were strengthened, notably through valuation, maturity and liquidity risk management requirements
  • The MMF sector is heterogeneous - with differing characteristics depending on fund type, structure and investor type across jurisdictions - and such differences are important in assessing the effect of pandemic-related market dislocations

The FSB also observes that open-ended funds invested in illiquid assets could amplify liquidity stress, while recognising the variety of fund structures (including interactions between mutual funds and ETFs), underlying assets (including their role in facilitating investment for the real economy) and the availability and use of liquidity management tools across different jurisdictions.

The FSB has set out a schedule of work relating to NBFIs in general and to open-ended investment funds in particular:

  • 2021: proposals to enhance MMF resilience, including with respect to the underlying short-term funding markets 
  • 2021 & 2022: examination of the availability and effectiveness of liquidity risk management tools for open-ended funds, including the experience of redemption pressures and use of tools in the March turmoil and their aggregate impact on the market
  • 2021 & 2022: consideration of how to improve the structure of core funding markets, including by looking at the role played by hedge funds and other leveraged investors, as well as at the limitations on big dealers' ability to facilitate trades
  • By 2022: an analysis of whether existing policy tools are sufficient for dealing with the systemic risks posed by non-banks and the desired level of resilience of NBFIs

As we noted in September, in any analysis of 2020 there is the “test tube” problem. We can observe what happened given the current levels of asset management activity in capital markets and the volume and types of investment funds, but we cannot know for certain what would have happened if more investors had held sovereign debt and other securities directly and not via investment funds. Would there have been greater or lesser redemption activity? Might the regulatory disciplines around open-ended funds - in particular, diversity requirements and liquidity risk management tools, including deferred redemptions or “gates” - have helped to minimise or smooth redemptions rather than have exacerbated volatility?

The ECB's view

Luis de Guindos, ECB Vice President said in November that investment funds should hold more cash and liquid assets to ensure they can meet redemption requests in times of financial stress. He called for new rules to beef up fund's liquidity buffers and to ensure that redemption terms are closely aligned to the liquidity of the underlying assets.

The ECB's long-held view that there should be a macroprudential framework for investment funds has been reinforced by the need for it to intervene in the Euro money markets earlier in the year. The Vice President said that existing safeguards, such as fund suspensions or “gating”, were not enough to stem outflows.

ESMA warns managers

ESMA has warned investment funds with less liquid assets to prepare better for market shocks. Its November report found shortcomings in the liquidity management of real estate and corporate debt funds during the period of high market volatility. Only 0.4 percent of the funds under review suspended during that period, but this figure was double the percentage for all EU funds.

In comparison, many UCITS in ESMA's sample used swing pricing to control or smooth redemption activity, where allowed by national rules, and only four suspended for up to 13 days due to valuation uncertainty and large outflows. Pages 36 and 37 of ESMA's report contain interesting tabular analyses of which types of liquidity management tools (LMTs) are made available in each member state, with suspensions being the only commonly-available tool for both UCITS and AIFs.

ESMA has set out five priority areas for fund managers and national regulators authorities:

  1. Ongoing supervision of the alignment of the funds' investment strategy, liquidity profile and redemption policy.
  2. Ongoing supervision of liquidity risk assessment, including consideration of the impact of margin calls and loan covenants in real estate funds. 
  3. Fund liquidity profile reporting.
  4. Increase of the availability and use of LMTs.
  5. Supervision of valuation processes in a context of valuation uncertainty.

More widely, the common supervisory action (CSA) on liquidity management by UCITS will continue in 2021.

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