We set out detailed findings and good practice from our multi firm review of liquidity management frameworks. We have also written to the sector in a companion Dear CEO Letter.
Who this applies to
This multi-firm review will be of interest to:
- Asset Managers
- Authorised Fund Managers
- Investment and Portfolio Managers
What firms need to do
Each firm included in this review has received individual feedback about the areas they need to improve.
You should consider the application of these findings to your own firm and make any enhancements to your liquidity management processes that may be necessary, with appropriate proportionality to the size of your firm and the funds you manage.
Why we did this work
In November 2019 we issued a letter to the Boards of Authorised Fund Managers (AFMs), detailing good practice in liquidity management. This review assesses firms’ progress in implementing effective liquidity management frameworks.
The FSB and International Organization of Securities Commissions (IOSCO), have recently published proposals for further guidance on liquidity management tools. Our supervisory findings from this multi-firm review have informed our contributions to this work.
We wanted to see what improvements have been made since 2019 and what weaknesses remained.
We chose a sample of 14 firms of different sizes for this review. We asked them to provide us with information on their liquidity management frameworks and followed up with in-depth discussions on their methodologies.
Although this review focuses on AFMs, we expect all asset managers and managers of Alternative Investment Funds to consider the findings for their businesses. Property funds were not subject to this review.
Scope of this review
We tested the effectiveness of a range of controls. We considered both the arrangements at the AFM (See SYSC 4.2.1B: Responsibility of senior personnel of AIFM in SYSC 4.2, and Principle 3: Management and control in PRIN 2.1) and, importantly, interactions with the MiFID manager, including where firms delegate portfolio management to a third-party investment manager (see COLL 6.6.15: Committees and Delegation within COLL 6.6).
We considered the prominence of liquidity risk management in the governance framework (see SYSC 4.1.1(1): General Requirements within SYSC 4.1).
We looked at stress testing methodologies (see COLL 6.12.11 (1) and COLL 6.12.11(2): Measurement and management of risk in COLL 6.12), and how firms balance the needs of both redeeming and remaining investors in the redemption/subscription process.
For example, through appropriate dilution adjustments. Our review focused on outcomes for end investors. We considered these controls primarily on whether investors were being treated fairly (SYSC 4.2.1B). We did not test operational processes on this occasion.
However, we know from other work that operational effectiveness and the ability to execute liquidity management can have a significant impact on the overall effectiveness of a liquidity management framework.
While our review primarily focused on authorised funds, the good practices we observed can be applied to a wide variety of fund types.
What we found
With few exceptions, we observed that many firms under our review did not attach sufficient weight to managing liquidity in their frameworks and governance structures. Their board and committee-level discussions on liquidity risk and associated reporting packs fell short of our expectations.
In many cases, liquidity risks were flagged only on an exceptions basis, resulting in Committees discussing liquidity issues in isolation, where a wider context would be of benefit.
Likewise, we saw very little evidence of focus on the composition and evolution of less liquid ‘buckets’ within funds. Some firms did not have processes in place to accelerate governance in times of stress.
Good Practice - Governance
- A focus on liquidity management from the top of the organisation. Those firms with a separate liquidity risk management committee charged with either managing liquidity specifically or having a customer protection focus, generally do a far better job at managing liquidity risk. This, along with a liquidity risk appetite statement demonstrates commitment from the top of the organisation and permeates all other aspects of managing liquidity.
- Established and documented protocols for escalating issues and increasing governance frequency during volatile market conditions.
- Creation of a liquidity ‘playbook’ outlining governance actions and escalations to be followed when liquidity stress testing triggers are activated, and in preparation for various market scenarios.
- Detailed liquidity reporting, presented to the Board and Governance Committees, including trends of redemptions and ‘change flags’ on the evolution of liquidity buckets within funds and strategies, particularly when redemptions and deteriorating liquidity coincide.
- An internal governance framework that has appropriate representation from all areas of the organisation, including risk and distribution, while having robust internal conflicts management in place.
- Thorough scrutiny of the least liquid ‘buckets’ for liquidity, portfolio turnover, valuation, and use of dilution adjustments.
- The willingness to challenge investment managers about their funds’ liquidity and the composition of portfolio transactions undertaken to meet investor redemptions.
- Building consideration of longer notice periods or redemption tenors for funds with a high proportion of less liquid assets into product governance.
Liquidity Stress-Testing (LST)
We found that firms’ approaches to stress testing methodologies varied from highly sophisticated in-depth models to basic tick-box exercises. Many firms in their models used the less conservative approach of assuming the most liquid assets would be sold first, creating a false sense of security, and affecting portfolio composition if executed.
This approach provides a distorted view of real portfolio liquidity and makes stress tests less effective in comparison to a more conservative pro-rata approach to modelling, where a proportionate ‘slice’ of every asset comprising the portfolio is contemplated to accommodate the redemption.
Stress test results also varied widely across the portfolio of firms under our review. Where the results suggest that no or few funds ever fail tests, it should be considered whether thresholds and triggers set by the firm are not challenging enough to reflect volatile and stressed market conditions. Where the funds repeatedly trigger in stress tests, we did not see sufficient follow-up actions within firms’ governance. Stress test results were often the only measure of liquidity reported to committees and presented on an exceptions basis.
Some firms had a limited understanding of the models and methodologies used, particularly when their construction is outsourced and there is insufficient internal evaluation of the stress tests results.
We found that firms were aware of single investor concentrations and factored these into their liquidity management processes. However, we observed that investor type concentration analysis was not fully considered in redemption stresses, where redemptions could be highly correlated to such concentration, as was seen in the LDI crisis.
Many firms had not followed all of the guidelines referenced in the ESMA stress testing guidelines in UCITS and AIFs. These guidelines were published in 2019 and applied from 30 September 2020. We have said publicly that we expect firms to continue to apply these ESMA guidelines (which includes the stress testing guidelines) to the extent they are relevant, and we will also continue to apply the guidelines in respect of our functions.
Good Practice – Liquidity Stress-Testing
- Full application of the ESMA guidelines through the firm’s LST policies, processes, and procedures.
- Use of a ‘pro-rata’ methodology and not ‘most liquid first’ in calculating both liquidity bucketing and stress testing, in which volume and participation rates have real stresses applied. The effectiveness of stress testing methodologies benefits from the incorporation of market impact costs.
- There is regular challenge, review and updating of the firm’s models (whether internal or external), supported by qualitative and quantitative assessments of liquidity conditions, and analysis of their drawbacks and weaknesses.
- Results are presented to appropriate committees and boards, including information on stress tests, test failures, and commentary on larger investor behaviour, for discussion and appropriate escalation.
- Firms undertake testing of multiple scenarios for redemptions, covering the largest investors over a variety of time periods and circumstances, factoring in investor type concentrations where redemptions could be highly correlated.
- There is increased scrutiny of liquidity assumptions of least liquid buckets.
- Appropriate use of tools to ascertain and observe trends in liquidity of the portfolio, and redemptions which could impact the liquidity profile of the fund over time.
Most of the firms in our review had processes in place for smaller and larger redemptions, but these processes did not go far enough to ensure investors were treated fairly, particularly in a stressed scenario. There was very little oversight from the AFM/AIFM over whether customers are treated fairly.
Only one firm conducted rigorous pre- and post-redemption testing of the portfolio, to assess whether investors were disadvantaged from a liquidity standpoint by redemptions and used that information to hold managers accountable. They required investment managers to be transparent in the way they manage the trade-off between liquidity risk and customer fairness when assessing liquidity changes in funds.
Many firms only had a trigger for enhanced governance at a large redemption threshold. Few firms presented any system or tools to observe and monitor cumulative trends of small redemptions, and their effect on portfolio composition and thus liquidity. Most firms had a defined large redemption threshold trigger, but some relied only on notifications from outsourced agents, without their own trigger and escalation process.
Firms with appropriate liquidity management frameworks had robust large redemption plans and escalation processes which triggered at an appropriate threshold.
Good Practice – Redemption Process
- An appropriate internal trigger in place to generate enhanced governance process capturing both large redemptions and cumulative smaller redemptions, with appropriate thresholds without reliance on third party administrators.
- Consideration of interests of the remaining investors in the fund as part of the redemption process to assess fairness of outcome for their position, especially where the fund holds less liquid assets.
- Pre and post redemption testing is applied to ascertain how liquidity has been impacted by redemptions, including appropriate scrutiny of changes to the least liquid buckets, together with challenge provided to the investment manager when warranted.
- A process for consideration of alternative solutions to meet sudden large redemptions in funds with a concentrated portfolio or investor base or both.
- A thorough end to end process test or ‘war gaming’ is used to simulate large redemptions followed by implementation of a ‘lessons learned’ exercise.
Liquidity Management Tools
We observed a variety of approaches in the use of swing pricing across the industry.
Thresholds for volumes of redemption orders to trigger the use of swing pricing in fund ranges were often the same across all funds, notwithstanding their different underlying asset classes.
Likewise, thresholds for applying swing pricing for very similar funds were often very different between one firm and another.
Thresholds and pricing were adjusted dynamically by some firms, with increased frequency when conditions warranted, and in other firms were never changed.
Our review also indicated a potential over-reliance on the third-party administrators for swing price calculations, and an absence of any back testing with respect to the firm’s own executed prices.
These weaknesses echo findings of the Joint Bank of England and FCA review of open-ended investment funds from 2021 implying need for further improvement of swing pricing processes.
Good Practice – Liquidity Management Tools
- Calculation of thresholds, application of anti-dilution tools and pricing adjustments is done on a fund-by-fund basis, rather than via a one-size-fits-all approach, which is reassessed with accelerated governance as conditions warrant.
- Market impact cost is incorporated into the methodology for calculating the swing factor.
- Back testing is performed using the firm’s own executed prices to inform, enhance and demonstrate swing pricing effectiveness, without overreliance on the third-party administrator.
- Information about swing pricing changes is provided in management reporting to the Board and governance committees.
We found that valuation processes [for mainstream open-ended funds] were reasonably robust, with most firms having separate valuation committees and defined processes for valuing less-liquid positions.
However, internal challenge to valuations was seldom evident.
Most of the funds surveyed had very limited exposure to fundamentally illiquid positions (as opposed to less liquid) and had processes to stop these types of illiquid assets entering portfolios.
Firms’ experience of the Russia / Ukraine conflict in early 2022 had informed their processes and generally led to improvements, with most firms dealing with challenges appropriately through testing escalation procedures and acceleration of the governance processes, ad-hoc committees, special working groups, and correct pricing.
Good Practice – Valuation
- Having an independent dedicated Valuation Committee within the firm’s Governance framework.
- Analysis and challenge of valuations is provided at the Committee level.
- Management information from the Valuation Committee is provided to boards oversighting liquidity practices.
- Less liquid buckets are subjected to line-by-line interrogation at the relevant committee.
- The performance of third-party valuation services is tracked and challenged.
- Processes are in place to ensure that fundamentally illiquid assets are unable to enter open ended funds with short redemption periods.
What we expect from firms
As emphasised in our recent Asset Management Portfolio Letter, good governance is particularly important during this period of heightened uncertainty.
We expect governing bodies to be composed of members with sufficient expertise, who receive timely an appropriate management information about risk, and who actively oversee issues, such as liquidity risk, within your firm.
We expect asset managers to have robust governance arrangements to effectively oversee liquidity risks. This should include established lines of responsibility and escalation procedures to enable the firm to respond adequately to volatile market conditions with effective liquidity risk management processes.
Firms have tools available to improve the quality of their liquidity management, but we have concerns that they may not always oversee them correctly or have consistent processes for deciding when and how to use them. When asset managers set a liquidity strategy to meet redemptions, they must meet regulatory requirements.
Asset managers should ensure exiting and remaining investors are treated fairly when considering the costs of redemption and consider the mix of assets that may be employed to meet redemption requests.
Asset managers should work with service providers to ensure that operational systems and processes are fit for purpose, can be executed at pace, and can be scaled to handle additional demand when needed.
We expect firms to consistently use liquidity stress testing and employ liquidity management tools appropriately.
The review was carried out prior to the implementation of the new Consumer Duty Principle requiring firms to act to deliver good outcomes for retail customers. While this did not apply at the time of the review many of the examples of good practice highlighted already work towards improved outcomes, and firms should view their liquidity management practices with this in mind.
We expect you to review your firm’s liquidity management arrangements, consider the application of the above findings together with the accompanying Dear CEO letter, and make any enhancements that may be necessary.
Though this review mainly focussed on AFMs, we expect all asset managers/managers of AIFs to consider the findings for their business too.