Liquidity risks in investment funds: a look at the regulatory environment

On 18 July 2019, the International Organization of Securities Commissions (IOSCO) published a statement in response to commentary on whether its Recommendations for Liquidity Risk Management for Collective Investment Schemes dated February 2018 (LRM Recommendations) are adequate in light of recent liquidity problems which have been covered extensively in the press.  Specifically, the Bank of England’s Financial Policy Committee’s Financial Stability Report dated July 2019 states “funds’ assets and investments strategies should be consistent with their redemption terms” and that IOSCO’s LRM Recommendations “did not prescribed how this should be achieved”.

IOSCO’s statement explains why the LRM Recommendations “provide a comprehensive framework for regulators to deal with liquidity risks in investment funds” and that they:  

1. 

stress a proper alignment of fund assets and redemption terms throughout the entire lifecycle of the fund (design, pre-launch, launch and subsequent operations);

2. 

prevent liquidity and redemption mismatches from arising in the first place, rather than just mitigating problems as they crystallise;

3. 

deal with attendant benefits and risks when open-ended funds may exceptionally look to use other liquidity management tools (such as suspensions) when faced with redemption pressures; and

4. 

allow domestic regulators to apply the practical recommendations in a prescriptive manner to manage liquidity risks.

In Hong Kong, the Securities and Futures Commission (SFC) has for some time emphasised the need for fund managers to strengthen liquidity risk management and fund resilience. In its 4 July 2016 circular, the SFC provided guidance on liquidity risk management requirements for managers of SFC-authorised funds: see our 2016 article. On 15 September 2017, the SFC issued a circular on Common Instances of Non-Compliance in Managing Funds and Discretionary Accounts which listed “failure to put in place a proper liquidity risk management process” as one of nine key non-compliance areas.

More recently, the SFC has enhanced its regulation of liquidity risk management for investment funds:

1. 

The revamped Fund Manager Code of Conduct, requires fund managers of both open-ended and closed-ended funds to conduct stress testing for regular monitoring of the liquidity risk of a fund. An explanation of liquidity management tools and material terms regarding redemptions and preferential treatment must also be disclosed to investors.

2. 

Following its circular of 29 June 2018, the SFC requires authorised funds to provide quarterly reports of its liquidity profiles with reference to specific liquidity categories and details of the fund’s subscription and redemption amounts.

3. 

The revised Code on Unit Trusts and Mutual Funds (Code), which came into effect on 1 January 2019, includes further requirements on liquidity management. The Code:

a. 

includes a general principal that investments held by a scheme must be liquid;

b. 

reinforces the maximum overall limit of 15% of a fund’s net asset value in securities or other financial products or instruments that are neither listed, quoted nor dealt in on an organised market;

c. 

codifies the SFC guidelines in its circular of 4 July 2016 requiring management companies to maintain and implement effective liquidity risk management policies to monitor the liquidity risk of a scheme; and

d. 

requires disclosure of liquidity risks in the scheme’s offering documents, including a summary of the scheme’s liquidity risk management policy and process and an explanation of the liquidity management tools that may be employed.

In its statement, IOSCO said that it “intends to conduct a robust assessment exercise beginning in 2020 which will review how the 2018 LRM Recommendations have been implemented in practice”. Ashley Alder, the SFC’s CEO, is the Chair of the IOSCO Board.