The Central Bank of Ireland (the Central Bank) recently issued a letter to Fund Management Companies (FMCs) that were surveyed as part of a European Securities and Markets Authority (ESMA) co-ordinated exercise. The review sought to analyse the preparedness of funds with significant exposures to real estate and corporate debt to potential future shocks, including any resumption of significant redemptions and/or an increase in valuation uncertainty. While the letter was specific to this set of FMCs and a sub-set of funds they manage, the findings from the ESMA review more broadly are important and should be noted by all FMCs.
In August 2019 and April 2020, the Central Bank wrote to FMCs reminding them of the importance of effective liquidity risk management and compliance with relevant legislative and regulatory obligations for UCITS and Alternative Investment Funds (AIFs). In particular, these letters clarify that FMCs are required to:
Calibrate their liquidity risk management frameworks to take account of dealing frequency, investment strategy, portfolio composition and investor profile
Conduct regular liquidity stress testing of investment funds
Appropriately identify and deploy liquidity management tools (LMTs), and
Ensure that the Board accepts responsibility for the ongoing assessment of liquidity risk within funds under management
These Central Bank letters were written in the context of Brexit preparedness and more recently the market uncertainty due to COVID-19. The Central Bank has noted that a key observation from the period of market stress is that investment funds with exposure to less liquid assets were particularly susceptible to increased redemption requests.
Following supervisory engagement with European National Competent Authorities (NCAs) that assessed the preparedness of real estate funds and corporate debt funds to potential future shocks, ESMA published a report in November 2020 (the ESMA Report). The ESMA Report made some key observations concerning the requirement for FMCs to enhance their liquidity management procedures.
The ESMA Report indicated that only a few investment funds had adjusted their liquidity set-up according to their investment strategies in response to the liquidity issues encountered, for example the use of LMTs, dealing frequency, portfolio construction and notice/settlement periods. According to the ESMA Report, this indicates that many investment funds remain no better prepared for future liquidity shocks, periods of market volatility or increased redemptions than they were prior to the COVID-19 outbreak.
Requirement for an action plan
Taking into account the findings of the ESMA Report, the Central Bank has clarified that it requires FMCs to consider how liquidity risk management frameworks and fund structures should be adapted to take into account the experience and lessons learned from the market illiquidity and investor redemption activity in 2020 and the findings of the ESMA Report. FMCs should also consider the steps needed to increase funds’ resilience to future shocks. The following elements are important in considering what changes may be required:
The alignment between the liquidity profile of funds’ investments, the risk profile of investors, redemption policies and settlement periods and the development of new policies to correct misalignments in a timely manner. This is of particular importance for funds investing in less liquid assets or assets that have demonstrated variable levels of liquidity in 2020
Ensuring the full suite of LMTs are in place and used appropriately. This should include consideration of the circumstances where LMTs are appropriate outside of stress scenarios, given their potential to enhance investor protection and dampen the effect of large increases in redemption requests on market conditions. FMCs should consider the extent to which the use of swing pricing or anti-dilution levies are required to ensure that transaction costs, including liquidity premia, associated with redemptions are borne by those exercising their redemption rights, limiting the effect of large redemption flows on remaining investors, particularly in times of stress and market volatility
FMCs' policies and procedures around the use of LMTs should include appropriate disclosure in fund documentation and communication with investors to ensure clarity and transparency around the regular use of LMTs and conditions for their implementation
The assessment of all other factors that could impact fund liquidity or trigger unplanned sale of assets. For example, the possibility of increased margin calls that may increase cash needs
A realistic and conservative estimate of which percentage of a fund’s assets can be liquidated over certain time periods and ensure redemption policies are aligned with this assessment. Any mis-alignment in this regard should be corrected in a timely manner
Information on the profile of the investor base to better understand any potential risks associated with redemption patterns, particularly in stressed market conditions
The design and testing of liquidity risk management frameworks and the planning for future market disruption events should not assume government or Central Bank intervention of the nature or scale seen in 2020
The Central Bank requires FMCs that were surveyed to conclude an assessment of their liquidity management frameworks and where relevant, for a remediation plan that addresses the results of such assessment to be presented and approved by the Board of FMCs no later than the end of June 2021. FMCs that adopt remediation plan are required to take any necessary steps to implement such plan promptly and in any event no later than the end of December 2021. A copy of the report presented to the Board should be available to the Central Bank on request.
The Central Banks letter should be brought to the attention of all members of the Board of FMCs, relevant designated persons and to the relevant responsible person(s) within delegate fund service providers.
For assistance in preparations for compliance or if you have any related queries, please contact a member of our Investment Funds team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.