FSB and IOSCO propose reforms for investment funds aimed at addressing liquidity issues

On 5 July 2023, the Financial Stability Board (FSB) launched a consultation on policy proposals that target the risks posed by liquidity mismatches.  The FSB’s proposals are designed to be adopted alongside the International Organization of Securities Commissions’ (IOSCO) new guidance on the use of anti-dilution liquidity management tools, which was also issued for consultation on the same day.

The FSB’s consultation report builds on a report published in December 2022 and proposes changes 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), setting out the key objectives for financial regulatory and supervisory authorities to address the vulnerabilities arising from liquidity mismatch in OEFs, to the extent jurisdictions’ liquidity regulations are not already consistent with the revised FSB Recommendations.

The goal of the revised FSB Recommendations, combined with the new IOSCO guidance on anti-dilution LMTs, is a significant strengthening of liquidity management by OEF managers compared to current practices.

Revised FSB Recommendations

While the view is that the 2017 FSB Recommendations remain broadly appropriate, the FSB has noted that enhancing clarity and specificity on the policy outcomes the Recommendations seek to achieve, would make them more effective from a financial stability perspective. There is also a  material variation in how LMTs are used as well as room for greater use of LMTs, in particular anti-dilution tools that are intended to pass on the cost of liquidity to redeeming shareholders in both normal and stressed market conditions. 

Key proposals include the following.

Redemption

The Revised FSB Recommendations seek to provide greater clarity on the redemption terms that funds could offer to investors, based on the liquidity of their asset holdings. The FSB propose achieving this by introducing a bucketing approach, where funds would be grouped into different categories depending on the liquidity (e.g. liquid, less liquid, illiquid or comparable categories) of their assets. Funds in each category would then be subject to specific expectations in terms of their redemption terms and conditions.

The FSB considers that for funds that invest primarily in liquid assets, daily redemption policies would still be appropriate.  For funds that invest mainly in less liquid assets, offering daily dealing to fund investors (without notice or settlement periods) may remain appropriate, subject to fund managers being able to demonstrate that they implement anti-dilution LMTs in line with the revised FSB Recommendations - whereas funds that invest more than 30% of assets in illiquid vehicles would be expected to offer less frequent redemptions, or require longer notice periods from investors.

First mover advantage

The proposals aim to mitigate the “first-mover” advantage that may arise due to liquidity mismatches -  requiring funds to impose on investors the cost of liquidity associated with fund redemptions and subscriptions through the use of (in particular anti-dilution) liquidity management tools.

Investor awareness

Proposals requiring clearer public disclosures from fund managers on the availability and use of LMTs in normal and stressed market conditions. This change aims to enhance investor awareness on the objectives and operation of anti-dilution LMTs.

New IOSCO Guidance

In its 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 recent IOSCO and FSB consultation papers, should be read in conjunction with one another. 

To support the greater use of anti-dilution LMTs by funds to mitigate investor dilution and potential first-mover advantage arising from structural liquidity mismatch in OEFs, IOSCO is proposing the following:

• Responsible entities should have appropriate internal systems, procedures and controls in place at all times in compliance with applicable regulatory requirements for the design and use of anti-dilution LMTs as part of the everyday liquidity risk management of their OEFs to mitigate investor dilution and potential first-mover advantage arising from structural liquidity mismatch in OEFs.
• As part of their liquidity risk management framework, responsible entities should consider and use at least one appropriate anti-dilution LMT for each OEF under management to mitigate investor dilution and potential first-mover advantage arising from structural liquidity mismatch in OEFs.
• Anti-dilution LMTs used by responsible entities should impose on subscribing and redeeming investors the estimated cost of liquidity, i.e., explicit and implicit transaction costs of subscriptions or redemptions, including any significant market impact of asset purchases or sales to meet those subscriptions or redemptions. Independently of the anti-dilution LMT used, responsible entities should be able to demonstrate to authorities (in line with the authorities’ supervisory approaches) that the calibration of the tool is appropriate and prudent for both normal and stressed market conditions.
• If responsible entities set thresholds for the activation of anti-dilution LMTs, those thresholds should be appropriate and sufficiently prudent so as not to result in any material dilution impact in the fund.
• Responsible entities should have adequate and appropriate governance arrangements in place for their liquidity risk management processes, including clear decision-making processes for the use of anti-dilution LMTs.
• Responsible entities should publish clear disclosures of the objectives and operation (including design and use) of anti-dilution LMTs to improve awareness among investors and enable them to better incorporate the cost of liquidity into their investment decisions and mitigate potential adverse trigger effects.

Next steps

Both consultations close on 4 September 2023, and the FSB and IOSCO plan to publish their respective final reports in late 2023.

An FSB and IOSCO public outreach event to launch their respective consultations is scheduled to take place on Wednesday 12 July.  The intention is that the FSB and IOSCO will provide an overview of the main proposals in their consultations - and the opportunity is provided for participants to provide their early feedback on those consultations.

FCA work on Liquidity Management

On 6 July, the FCA published findings and examples of good practice from its recent multi-firm review of liquidity management, together with a companion Dear CEO Letter.  It has directed firms to review their liquidity management arrangements, consider the application of the FCA’s findings and make any necessary enhancements

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 UK 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. (see our blog post on the FCA’s review and Dear CEO Letter here).