Managing fund liquidity through product governance
23 July 2020
Regulatory focus on fund liquidity shows no sign of easing, with the FCA’s Acting CEO Chris Woolard indicating in a recent speech that his team will soon be consulting on measures to address liquidity mismatch in funds. As asset managers await these new proposals, they are also having to hone their approaches to managing fund liquidity risk following the FCA’s Dear AFM Chair letter last year and market stress following the COVID-19 outbreak.
With the FCA’s supervisory review of product governance underway, firms may also face scrutiny on how effectively they are managing liquidity risk through their wider approach to product design and distribution. In this blog, I set out some of the ways that firms can do this and the importance of getting this right, both to satisfy the regulator and customers.
Embedding liquidity considerations into the target market assessment
So, how should asset managers be considering liquidity management when meeting their product governance obligations? A central consideration here is whether the liquidity profile of a fund is fit for purpose for the identified target market. For example, investors may have preferences over the duration of an investment and the ability to redeem at short notice.
Fund managers should also consider whether open-ended daily dealing funds invested in illiquid assets make sense for all types of investors and, if not, what that means for their target market assessments. Should investors who have indicated they want the option to exit the investment early be deemed unsuitable for those daily dealing funds invested in illiquid assets? Also, where customers have chosen the fund to provide a steady future income stream, fund managers should carefully assess whether this can be achieved in stressed conditions where investors may ramp up redemption demands.
Liquidity and product complexity
Another area that firms should be alert to is how changes to market conditions can impact the liquidity profile of their investments and, in turn, the complexity of the fund and whether it remains appropriate for the identified target market. This has been a particularly important consideration in recent months given the impact of COVID-19 on liquidity conditions in the capital markets.
Under MiFID II, an asset is deemed ‘non-complex’ where, for example, there are frequent opportunities to liquidate the asset at prices that are publicly available to market participants. It’s possible that changing market conditions could prevent an investment from being redeemed at market prices, rendering some products ‘complex’. Firms should have systems and controls in place to capture the impact of liquidity changes in their assessment of instrument complexity.
Communicating with distributors
An important feature of the MiFID II regime is for product manufacturers to oversee distribution activity to ensure that the target market is respected, which requires an effective communication flow through the investment chain. This has been a challenge for firms and something the regulator will be looking at during its product governance review.
Asset managers should ensure that liquidity management is central to their communication with distributors. They will need to communicate the liquidity profile of the fund and how it behaves in times of stress, so that distributors can sell the product to the appropriate target market.
Are you prepared?
Fund liquidity management was a key focus of the FCA prior to COVID-19. But I expect it to become an even greater priority for regulators in the months and years to come. This is partly because of the FCA’s planned consultation later this summer, but also in recognition that liquidity challenges during the pandemic are likely to have been tamed by central banking interventions that can’t necessarily be relied upon going forward - making robust liquidity management essential to withstand future market stress.
The FCA’s current work on product governance presents a clear opportunity for the regulator to scrutinise how firms are re-assessing their approaches to managing liquidity risks, including how they are incorporating any lessons learnt from recent experiences stemming from COVID-19. Dealing with such risks through product governance will be important to satisfy the regulator and, ultimately, customers - by ensuring they are able to buy the right products to meet their investment needs.