The onset of Covid-19 has led to re-evaluations of best practice in many aspects of asset management. From a European regulator perspective, one concern that has emerged is liquidity management. Fund managers are under renewed scrutiny over their management of liquidity.
In recent months, the European Systemic Risk Board (ESRB) has released recommendations for increased scrutiny of UCITS (undertakings for collective investment in transferable securities) and AIFs (alternative investment funds); national regulators requesting further information; and the Financial Conduct Authority (FCA) directing its focus on long-term investor interests.
The ESRB released its recommendations on the 6 May 2020. The European financial supervisor called for increased scrutiny of two types of funds in particular (both UCITS and AIFs), namely: open-ended corporate debt funds with short redemption periods, and funds with significant exposure to real estate. It has recommended national regulators carry out a supervisory exercise, which will be coordinated by ESMA, to consider the following issues:
- the level of redemption requests from the onset of Covid-19;
- how the fund managers responded (for example, did corporate debt funds sell any assets, and if so, how) and what liquidity management tools (LMTs) they used (for example, redemption gates and anti-dilution levies);
- what LMTs are available to the funds now, and the level of current liquid assets held by the funds;
- the number and nature of their investors; and
- in respect of real estate funds, the impact on valuations.
The ESRB has requested a report on the conclusions of this supervisory exercise by 31 October 2020.
The ESRB followed with a further statement on 13 May 2020, with more detail of the concerns underlying its recommendation. This statement notes that the period since the start of the pandemic has seen significant drops in some asset prices, large redemptions in respect of certain funds, and a notable deterioration of liquidity in some markets.
Where a tension exists within corporate debt or real estate funds of short redemption periods versus non-liquid assets, emergencies such as Covid-19 may increase the risk of quick sales of assets, which can cause further consequences such as falls in valuations and reductions in transactions that can have an impact on the entire financial system. From the ESRB’s perspective, when markets are stressed, “the timely use of LMTs is a key element of prudent liquidity risk management by investment funds“. However, the ESRB is concerned that the availability and diversity of LMTs is not sufficiently harmonised across EU member states.
According to market press, regulators across Europe have mainly taken two different approaches to requesting information: either when a serious event occurs, or they are requiring regular and broader reporting.
The Financial Conduct Authority (FCA) is among the regulators that have requested information following a serious event. The UK regulator has requested that asset managers provide clear warnings if they are considering suspensions, and to notify it if their funds drop 10% or more in a day for any reason (including investor withdrawals). The Central Bank of Ireland has asked for prompt notifications from any asset manager facing a liquidity crunch requiring significant action.
Other regulators are requiring more regular, broader reporting. Both the German and French regulators have asked for updates on investor subscriptions and withdrawals from open-ended funds. Luxembourg’s financial regulator is doing the same but on a weekly basis. France is also requesting daily information on any breaches of investment restrictions and the use of liquidity management tools such as swing pricing.
The UK’s financial regulator has also turned its attention to long-term investor interests. On 8 July 2020, Christopher Woolard, interim chief executive of the FCA, delivered a speech in which he noted that there has been “considerable discussion about how to ensure redemption arrangements offer a fair deal to those remaining in the fund as well as those who wish to exit“.
The regulator has promised a new consultation later this summer, focusing on long-term investor interests in light of the liquidity issues created by the pandemic. Woolard in his speech said that the FCA is looking at whether these interests would be better served by exploring whether these funds could move to a structure, such as a tail fund, in which promises to investors regarding liquidity are more closely aligned with the liquidity of fund assets.
Fund managers, especially those managing open-ended real estate and bond funds, are facing increased levels of scrutiny concerning liquidity management, which is unlikely to disappear soon. The UK has already seen property fund suspensions after the Brexit referendum, further suspensions as a result of Covid-19 and commentary on best practice for open-ended real estate funds by industry bodies such as AREF.
The FCA is facing calls to do more to protect investors caught up in fund suspensions. Across Europe, fund managers should be prepared to deal with increased levels of reporting requirements and would be advised to ensure that suitable liquidity management policies and procedures are in place to meet the changing regulatory climate. In particular, fund managers should consider using a broader range of LMTs, such as anti-dilution levies, redemption fees, swing pricing, side pockets, redemption gates and tail funds, before turning to the nuclear option of suspending a fund.