FCA directs asset management firms to increase their focus on liquidity risk

Quick action by outliers is vital to avoid regulatory intervention, according to the FCA as it publishes findings and examples of good practice from its recent multi-firm review of liquidity management, and a companion Dear CEO Letter.

The FCA’s review sought to assess what improvements have been made since 2019 (when the FCA issued a letter to the Boards of AFMs, detailing good practice in liquidity management) and what weaknesses remained. 

As things stand, the gaps in liquidity management observed by the FCA “could lead to the risk of investor harm” and firms are directed to take account of the FCA’s findings and make any enhancements that may be necessary.

Whilst the review focused on AFMs, the FCA expects all asset managers and managers of Alternative Investment Funds to consider the findings for their businesses.

Key findings and examples of good practice

Governance

The FCA has observed that many firms under review did not attach sufficient weight to managing liquidity in their frameworks and governance structures, with board and committee-level discussions on liquidity risk and associated reporting packs falling short of FCA expectations.  Those firms with a separate liquidity risk management committee charged with either managing liquidity specifically or having a customer protection focus, were generally observed to do a far better job at managing liquidity risk. 

Established and documented protocols for escalating issues/increasing governance frequency during volatile market conditions, and the creation of a liquidity ‘playbook’ outlining governance actions and escalations to be followed when liquidity stress testing triggers are activated, are highlighted as examples of good practice observed by the FCA.

Flagging liquidity risks on an exceptions-only basis carries with it the risk of Committees discussing liquidity issues in isolation where a wider context would be of benefit.  As such, detailed liquidity reporting is highlighted as good practice, along with a willingness to challenge investment managers about their funds’ liquidity and the composition of portfolio transactions undertaken to meet investor redemptions.

Likewise the FCA noted the importance of focus on the composition and evolution of less liquid ‘buckets’ within funds (e.g. for liquidity, portfolio turnover, valuation, and use of dilution adjustments).

More generally the FCA has reiterated its expectation that asset managers 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.

Liquidity Stress Testing

The FCA expects firms to consistently use liquidity stress testing. 

The FCA’s review highlights the use of pro-rata methodology in calculating both liquidity bucketing and stress testing as a good practice, highlighting the risk that a “most liquid first” methodology creates a false sense of security and provides a distorted view of real portfolio liquidity. 

The regular challenge, review and updating of the firm’s models (whether internal or external) is supported (not least to ensure that triggers set by the firm are challenging enough to reflect volatile and stressed market condition), as is the appropriate presentation of results to relevant committees and boards for discussion and appropriate escalation. 

Noting that many firms had not followed all of the guidelines referenced in the ESMA stress testing guidelines in UCITS and AIFs, the FCA reiterated is expectation that firms continue to apply these guidelines to the extent they are relevant (with the FCA also continuing to apply the guidelines in respect of its functions).

Redemption Process

The FCA directs asset managers to ensure exiting and remaining investors are treated fairly (particularly in a stressed scenario) when considering the costs of redemption, and to consider the mix of assets that may be employed to meet redemption requests. Good practices identified include:

• 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 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); and
  
  
• a thorough end to end process test or ‘war gaming’ used to simulate large redemptions followed by implementation of a ‘lessons learned’ exercise.

Liquidity Management Tools

The FCA expects firms to employ liquidity management tools appropriately, but has concerns that firms may not always oversee them correctly or have consistent processes for deciding when and how to use them.

Identified good practices include the calculation of thresholds, application of anti-dilution tools and pricing adjustments on a fund-by-fund basis, rather than via a one-size-fits-all approach – together with reassessment via accelerated governance as conditions warrant.

On swing pricing processes, the FCA identified inconsistent practices and a potential over-reliance on the third-party administrators for swing price calculations, and an absence of any back testing (to inform, enhance and demonstrate swing pricing effectiveness) with respect to the firm’s own executed prices. 

Valuation

The FCA’s review found that valuation processes were reasonably robust (however internal challenge to valuations was seldom evident), and firm’s experiences of the Russian/Ukraine in early 2022 having informed their processes and generally led to improvements.  Good practices identified include:

• having a dedicated Valuation Committee within the governance framework and appropriate information from that committee provided to boards oversighting liquidity practices;
  
  
• the analysis and challenge of valuations provided at Committee level, and less liquid buckets are subjected to line-by-line interrogation;
  
  
• tracking and challenging the performance of third-party valuation services; and
  
  
• processes in place to ensure that fundamentally illiquid assets are unable to enter open ended funds with short redemption periods.

Next Steps

Asset managers are directed to take account of the findings and examples of good practice, together with the accompanying Dear CEO letter, and make any enhancements that may be necessary. 

Whilst the review was carried out prior to the implementation of the new Consumer Duty (which comes into force on 31 July 2023), many of the examples of good practice highlighted in the review and Dear CEO letter contribute to improved consumer outcomes and are consistent with the Consumer Duty, and firms are directed to view their liquidity management practices with this in mind. 

International Backdrop

There is also a significant body of work under way internationally on liquidity practices.

Against the backdrop of a December 2022 Financial Stability Board (FSB) report setting out progress on liquidity management standards globally, the FSB has recently published a consultation paper proposing revisions to the FSB’s 2017 Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (the 2017 FSB Recommendations) in relation to liquidity mismatch in open-ended funds (OEFs). The revised draft Recommendations incorporate lessons learnt since 2017 and aim to enhance clarity and specificity on the intended policy outcomes to make the Recommendations more effective from a financial stability perspective.

In conjunction, the International Organization of Securities Commissions (IOSCO) has also published a consultation report on anti-dilution liquidity management tools. In the consultation report, IOSCO sets out proposed guidance for effective implementation of its 2018 recommendations for liquidity risk management for collective investment schemes (the 2018 IOSCO Recommendations). The aim of the guidance is to support greater and more consistent use of anti-dilution LMTs by responsible entities for open-ended funds (OEFs), in both normal and stressed market conditions.

IOSCO operationalised most of the 2017 FSB Recommendations through these 2018 IOSCO Recommendations and a set of related good practices, as such the two recent consultation papers should be read in conjunction with one another.  The consultations both close on 4^th September 2023, and the FSB and IOSCO plan to publish their respective final reports in late 2023. (see our blog post on the consultations here)

The FCA is an active member of IOSCO and the findings from the FCA’s multi-firm review and previous supervisory work have informed its contributions to IOSCO.

Given the international work on this topic, at this stage the FCA is not proposing changes to the requirements for asset managers. However, as international standards evolve and as indicated in DP 23/2, the FCA may consult on adjusting liquidity management rules and guidance, to be consistent with updated global standards.