By Patric Foley-Brickley, Managing Director, Apex FundRock UK.
While there are signs emerging that inflation may have peaked, central banks nevertheless remain cautious and interest rates continue to rise. Market volatility and these rising interest rates continue to spook investors, leading to greater redemptions being sought.
With an eye on avoiding a repeat of the Woodford scandal of several years ago, in which many investors lost money, the FCA earlier in the summer published a ‘Dear CEO’ letter reminding funds to implement sufficient liquidity oversight, management and procedures to respond to any increase redemption scenarios.
This is a growing concern, with the cost of living making crisis many people rebalance their portfolios, seeking greater liquidity in their investments by moving money into lower-risk, interest rate pegged savings vehicles that have suddenly become more attractive.
So, what new detail did the FCA letter contain, and what are the implications for fund managers?
With ongoing inflation and the fallout of the pandemic still working its way through the economy, the FCA recently undertook a multi-firm review of liquidity management by Authorised Fund Managers (AFMs). The FCA’s letter called on asset managers and managers of Alternative Investment Funds to consider the implications of the review’s findings for their businesses.
For some, the review will make for uncomfortable reading. It found “a wide disparity” in how firms comply with regulatory standards with regards to liquidity and in the depth of their liquidity risk management expertise. It was also discovered that most funds fell short in some aspects of their liquidity management framework. And despite the risks and the high-profile reputational fall-out of the Woodford case, many firms were found not to be giving liquidity management the priority it deserves in governance structures.
Feeling the stress
The review also discovered wide variance when it came to stress testing with some firms carrying out detailed and sophisticated modelling, while others treated stress testing as little more than a box ticking exercise. Of particular concern, the FCA found that at some firms, few funds ever failed stress tests. This might suggest that stress thresholds may not be challenging or stringent enough, especially given increased market volatility and macroeconomic uncertainty.
Many firms operated models on the assumption that the most liquid assets would be sold first, creating a false sense of security. If enacted, this strategy would also lead to negative outcomes for remaining investors in the funds. The FCA instead recommends a pro-rata approach where a proportionate ‘slice’ of every asset in the portfolio is sold to accommodate the redemption.
The FCA also found that, when it comes to redemptions, many firms only triggered enhanced governance at a large redemption threshold. This might mean that multiple smaller redemptions – and their cumulative impact – could go relatively unnoticed. In light of the forthcoming Consumer Duty changes, the FCA is calling on firms to ensure investors understand the impact of redemption in stressed market conditions. This will be particularly important in cases where firms are offering more illiquid funds (e.g. long-term asset funds) to retail investors.
So, what are the implications of this review for fund managers and how can they meet the FCA’s expectations on liquidity management?
The FCA outlines a number of suggestions for actions fund managers can take. These include the following; the introduction of a liquidity management committee; reviewing current liquidity risk management frameworks; creating a range of liquidity playbooks to be activated should various liquidity stress events occur; consider engagement of third parties such as delegated investment managers and third-party administrators, to support the design and implementation of appropriate liquidity risk management protocols and processes.
On the last point, many managers are seeking third independent partners – like FundRock and Apex Group – which can help firms stay ahead of FCA regulation and ensure stress testing and liquidity management is robust, and leaves firms prepared for any and all scenarios. The broader view of a third party, and the ability to see a business objectively and from the outside, gives a much clearer picture of current risk management strategies which will keep both investors, and regulators, reassured.
Following the FCA letter, it is likely that other regulators across Europe will also be looking more closely at liquidity management. The FCA’s multi-firm review findings have fed into the FSB and IOSCO’s work on liquidity with regard to open-ended funds. On July 5, 2023 the FSB consulted on its recommendations to address structural vulnerabilities from liquidity mismatch in open-ended funds, and IOSCO consulted on guidance on anti-dilution liquidity management tools. While the FSB and IOSCO recommendations are not yet applicable to firms, they indicate a clear direction of travel for global regulatory priorities in this regard.
In conclusion, it’s clear that managers will have significant work to do over coming months, to ensure their liquidity management approach is on a firm footing and ready to withstand any potential economic shocks. Regulators are focused on proactively managing any fall-out from macroeconomic uncertainty, and crucially, avoiding a repeat of what was seen with Woodford. Fund managers should act now to ensure they can withstand whatever the wider economy might throw at them and give investors and the FCA confidence in the prudence of their liquidity operations.
The FCA is likely to scrutinise fund liquidity management arrangements just as closely going forward and demonstrating the development, testing and implementation of robust liquidity management arrangements will also be essential for firms to show commitment to ensuring good investor outcomes under the forthcoming Consumer Duty standards.