Asset managers should prepare for a tightening of the rules around liquidity management amid mounting concern among regulators about risks in the asset-management industry. These were heightened by the collapse of Silicon Valley Bank (SVB) in March. Regulators are seeking to avoid a repeat of the stresses exposed by the March 2021 pandemic, which prompted considerable volatility in financial markets and liquidity injections by central banks.
Why asset managers should focus on improving liquidity management
FCA review highlights shortcomings in liquidity management
The UK’s Financial Conduct Authority (FCA) sparked alarm bells in July when it urged asset managers to increase their focus on liquidity risk. The statement followed a review of asset managers which found gaps in liquidity management that could potentially harm investors. 1
The UK financial regulator said that while some firms demonstrated very high standards, a wide disparity existed in the quality of compliance with regulatory standards and the depth of expertise in liquidity risk management. The FCA found that a minority of firms had inadequate frameworks to manage liquidity risk.
It warned that the effective management of liquidity was vital to ensure that ‘investors are able to withdraw their investment in line with their expectations and at an accurate price that reflects its value’. The FCA added that poor liquidity management presents serious risks to investors and to wider market stability.
Global concerns
The FCA is not alone in having doubts over the ability of asset managers to maintain liquidity. Also in July, the US Securities and Exchange Commission (SEC) adopted rules aimed at helping control systemic risk in the money market and large liquidity funds, which together comprise trillions in investor dollars. The rules increase minimum liquidity requirements, remove provisions allowing for the temporary suspension of redemptions, and require certain funds to implement a liquidity fee framework and enhance fund reporting.
Meanwhile, the Financial Stability Board (FSB), which coordinates financial rules for G20 countries, has proposed reforms for investment funds designed to address liquidity issues and increase their resilience to market shocks. The FSB said stresses were revealed during the turbulence in markets that accompanied the onset of the Covid-19 pandemic. Central banks had to inject liquidity into markets during the pandemic when some funds struggled to meet redemption calls. 2,3
In September, however, asset managers rejected the proposals in their responses to a public consultation on the matter. The European industry body EFAMA argued that the proposals would add unnecessary complexity to liquidity risk management and ultimately result in higher costs for end investors, with little benefit.
The FSB and the International Organization of Securities Commissions (IOSCO), an association of organisations that regulate the world’s securities and futures markets, will publish final reports at the end of this year. Given that worries over liquidity are far from new and reflect various concerns, it seems that asset managers should indeed prepare for tighter liquidity rules, whatever the position of bodies such as EFAMA.
Long-term worries
The London-based law firm Macfarlanes, for example, argues that the focus on liquidity risks has been growing since the gating of UK property funds in 2016, following the Brexit vote and the collapse of the Woodford Equity Income fund. Market turbulence during the March 2021 pandemic and other stress events simply compounded these concerns. Macfarlanes adds that ‘changing market conditions, such [as] shifts in macro-economic fundamentals and policy, are provoking a wider attempt to shore up the rules’. 4
The trend of open-ended funds investing in less liquid assets and increasingly in vehicles that permit retail investors is also a cause for concern.
Finally, the higher-for-longer interest-rate outlook has prompted warnings of possible liquidity crises. A blog post published by the International Monetary Fund (IMF) in August argued that rapid monetary policy tightening potentially causes significant volatility in bond and interest-rate derivatives markets. It noted that ‘even the value of safe US Treasury securities drop[s] by as much as 30% when yields go up by 400 basis points— – the actual shock to 10-year Treasury note yields since 2020”.
The IMF added that investment funds in particular could face rapid redemptions ‘as their customers can quickly exit unprofitable funds’.
The article pointed to the collapse of SVB in the US in March. The value of the bank’s bond holdings slumped amid rapid monetary tightening, hitting earnings, capital, and cash buffers. The IMF added that ‘depositors saw these strains and withdrew funds’ – and since the bank was not prepared to access central-bank liquidity in time, it failed, as did other US lenders. 5
Tighter rules on the way
In conclusion, it seems likely that policymakers will continue to adjust the rules in relation to fund liquidity despite pushback from the industry – and that supervisory bodies will increasingly focus on managers that appear to be at risk of breaching liquidity rules.
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