When it comes to Illiquidity, Prevention is Better than Cure

The crisis has passed, but we need to prepare for a second wave: fund managers can’t afford to be complacent about liquidity concerns.

The early weeks of the COVID-19 pandemic saw liquidity come to the fore. More than 80 mutual fund strategies in Europe implemented measures such as gating in March, according to Fitch Ratings, Inc. By April, the sum trapped in UK property funds had hit £20 billion, and German regulator BaFin was holding daily calls with retail fund managers deemed at risk. And it wasn’t just Europe. In the U.S., the Federal Reserve rolled out three emergency credit programs in two days in March.

That sense of panic, though, has since subsided. Strong performance in markets in April and May has done much to alleviate concerns, and, while volatile, most asset managers seem to have ridden out the storm. But issues around liquidity are nothing new, and they aren’t going away. In fact, funds, both public and private, may find they rise up the agenda once again sooner than they expect. That’s for two related reasons. 

The first is that we’re never too far from the next liquidity crisis. Before COVID-19, there were the funds that ran into trouble in the financial crisis and more recently, in the UK following the EU referendum. Given the massive economic uncertainty and huge government spending the pandemic has prompted, it would be brave to bet that there will be a long period of respite now. 

The second reason funds cannot ignore liquidity, though, is that regulators won’t let them. It’s an irony of the pandemic that it was behind the Bank of England’s decision in March to postpone its planned investigation into the potential mismatch between the daily dealing offered by most open-ended funds and the underlying liquidity of their holdings. That’s now likely to be back on the agenda.

And there is, of course, already regulation in place. In September 2019, the FCA announced new rules on managing liquidity risk for non-UCITS retail schemes investing in inherently illiquid assets and in November, wrote to authorized fund managers more widely, reminding them of this “central responsibility”. The U.S. SEC’s Liquidity 2018 Disclosure rule, meanwhile, came into effect last year, requiring open-end funds to discuss the operation and effectiveness of their liquidity risk management in shareholder reports. 

With the immediate crisis past, regulators are likely to be revisiting these requirements, and ensuring funds are meeting their obligations. One way or another, liquidity is likely to be back up on the agenda. 

Public and Private

How funds tackle that will vary widely. Much depends on whether we discuss public investments, such as mutual funds and open-ended vehicles, or private funds, such as hedge funds and PE. The latter usually have little need for daily liquidity. Gates, lock-up periods, notice periods and other restrictions around redemptions are far from uncommon for hedge funds. For instance, while the typical lifespan for a PE fund is 10 years; not all funds need to offer daily trading. 

Regardless, though, fund sponsors and managers must have orderly processes for withdrawals, and these must be clearly disclosed and followed. We’ve seen in the past that the SEC, among others, is prepared to take robust action against deviations such as preferential redemption strategies to benefit large investors: a breach of the fiduciary duty, apart from anything else.

Disclosure is not simply a regulatory requirement, either; it contributes to the liquidity management strategy. Clearly outlining the steps and potential restrictions on redemptions at the outset in the fund documents during onboarding can prevent panic if they have to be implemented. 

Liquidity management goes beyond this, though, and will include proper risk management, and investment strategies and policies tailored to meet obligations—whether that’s for daily, monthly, annual or less frequent liquidity. As the FCA’s November letter put it, (addressing open-ended funds) effective liquidity management is an “irreducible, core function” for managers. It also outlined some of the key features of a robust liquidity management regime: 

  • Processes to ensure subscription and redemption arrangements are appropriate for the fund’s investment strategy
  • Regular assessment of liquidity demands
  • Ongoing assessment of portfolio positions’ liquidity
  • Using liquidity buckets for liquidity risk management
  • An independent risk function, monitoring portfolio bucket exposures and reporting breaches
  • Stress testing to assess the impact on their funds of “extreme but plausible scenarios”

 

Start to Finish

In truth, many problems with liquidity are there right at conception. They are often the result of a mismatch between the assets and the fund vehicle.

This can be the result of trying to appeal to a particular investor base. We saw this in the aftermath of the financial crisis, for example, when many institutional investors suddenly craved the protections offered by UCITS funds. That resulted in some merger arbitrage managers switching to the vehicle, despite the fact that the strategy doesn’t really lend itself to the diversification ratios required.

At the outset, then, managers have a responsibility to choose a fund structure appropriate to the strategy and the liquidity of underlying assets. That, in turn, will require looking at the portfolio construction and working to ensure adequate liquidity to meet redemption for the trading terms.  

Managers can also, at the outset, ensure they make use of the tools available to mitigate liquidity risks and manage redemptions when required. That may be notice periods on redemption requests, or anti-dilution levies and swing pricing. These can, of themselves, help avoid the need for more extreme measures such as gating. Since they apply throughout the investment lifecycle, when investors buy-in to the fund, as well as redeem, they do not carry the same connotations as gating and are less likely to panic the remaining investors.

Preparing for Failure 

However, the appropriate tools can properly be determined only in the context of the likely strains on liquidity. Liquidity risk management frameworks are therefore a key tool in determining. In addition to matching underlying asset liquidity to redemption requests, managers can address market liquidity risk within the framework to ensure positions can be unwound at a reasonable cost over target time horizons.

Having identified risks and modelled liquidity in different scenarios, managers should finally prepare a liquidity contingency plan, documenting the different actions to be taken to respond to liquidity events of varying severity—and to black swan events. In short, all liquidity management plans must allow for failure. 

In periods of extreme volatility, gating may well be the only answer, and funds should prepare for the worst. This will ensure restrictions on redemptions are in line with their fiduciary duty to ensure equal treatment of investors (avoiding later regulatory action). It can also ensure managers have a clear communication plan in place. In a time of panic, a clear communication strategy may not be enough to reassure investors and stem redemption requests, but it can avoid exacerbating the situation. Likewise, the relationship with regulators is critical at such times. Proactive communication and an ongoing dialogue about liquidity are essential.

In truth, that communication—particularly with regulators—should be ongoing. Beginning it during a crisis is unlikely to deliver the best outcomes. It should also cut both ways; and regulators must also engage with fund managers. There is a tension between what some regulators seem to want in terms of ensuring liquidity in times of stress and requirements of generating returns, particularly for long-term savings and retirement schemes. 

Managing that tension is likely to be an ongoing challenge, and managers must be clear with investors and regulators about the trade-offs and how they will be managed. To do that, though, they must have a clear understanding of these themselves.

This article is part of Duff & Phelps’ Global Regulatory Outlook 2020 series.

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