Managing fund liquidity - does COVID-19 change things?

by David Croker Partner

Email +44 (0)7718 097331

We have seen a sharp drop in global financial markets in recent weeks as economies face risks stemming from strict government-imposed social restrictions aimed at slowing the spread of COVID-19. The reduction in liquidity in markets, together with increased redemption requests from investors, is heightening liquidity risk in funds. But, even before the outbreak, asset managers were being asked by regulators to revisit their approaches to managing fund liquidity.

If firms haven’t been taking this agenda seriously, now is the time to engage. I’m expecting the regulators to sharpen scrutiny in this area as they begin to test how effective firms have been in handling the crisis. We’ve already seen more intense liquidity reporting requests from the FCA since the outbreak. To meet regulatory expectations more broadly, there are a number of areas firms need to be particularly alert to. 

How liquid are your assets?
Firms would be wise to look at the asset side of their funds’ balance sheets, not least because some recent high-profile suspensions were partly driven by investments in illiquid securities. Regulators want to see firms get themselves comfortable that investments in assets, including those listed on an exchange, are sufficiently liquid to satisfy redemption demands at short notice.  

Reading the FCA’s recent Dear AFM Chair letter, it seems clear that firms ought to be using ‘liquidity buckets’ to determine the liquidity of underlying assets and, therefore, the overall fund. I know that this is something the regulator is looking at in the context of COVID-19, so firms should take this opportunity to make sure that they are accurate. 

Plan for the unforeseen 
If there is one thing that the COVID-19 outbreak has underscored for me, it is the importance of planning for unexpected events. As part of the incoming rules for funds investing in inherently illiquid assets such as infrastructure and property, the FCA will be asking firms to have in place contingency plans in case of a liquidity crisis. This basic principle applies to other funds too, so firms should act quickly on this, particularly as we move to the next stage of the pandemic. 

Stress testing of funds will be critical for firms in the current environment. With ESMA’s guidelines on this due to kick in from September, UCITS and AIF managers should be adapting their scenario designs, ensuring these are sufficiently tailored to each fund and performed quarterly, up from the current annual requirement. Given that the guidelines do not address extreme pandemics like COVID-19, few firms have stress tested this type of extreme event. Regulators will look for evidence of how quickly and robustly firms have been able to incorporate various COVID-19-related scenarios into their stress testing in anticipation of further challenging conditions.

Be transparent with your clients
With my old regulator hat on, I’d also be looking for evidence that fund documentation contains clear and meaningful information on liquidity risks to aid investors. Now more than ever, firms will need to get this right if they want to provide clients with confidence to invest in today’s challenging market conditions. 

Getting your governance right
Overlaying all of this must be sound fund governance. The FCA’s 2020/21 Business Plan is clear that this remains a priority for the asset management sector. Have you reviewed your governance for escalating and managing liquidity risk? Are Board members, including iNEDs, sufficiently involved? Does your depositary have adequate oversight of the process? These are just a few examples of the questions firms are facing from the regulator. 

Liquidity, liquidity, liquidity
Firms are undoubtedly busy responding to the fallout from the pandemic, grappling with operational resilience issues and ensuring that vulnerable customers are protected. While these things are clearly vital, firms can’t afford to forget their wider regulatory work, which isn’t going away. Fund liquidity is integral here, and COVID-19 will only reinforce this. 

 

by David Croker Partner

Email +44 (0)7718 097331

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