Asset managers globally can no longer ignore fund liquidity risk management. Fund liquidity regulation is arriving in all jurisdictions. Despite all challenges to define, observe, model, measure and therefore regulate liquidity risk, it has long been clear this day would come, given the crucial role of liquidity risk in the investment process of open-ended funds.1
Now, liquidity risk regulation has moved to center stage. On Feb. 1, the International Organization of Security Commissions (IOSCO), the global standard-setter for securities regulators, released its final report on “Recommendations for Liquidity Risk Management for Collective Investment Schemes,” which summarizes the results of a public consultation opened between July and September 2017.
The message is loud and clear: “IOSCO expects that securities regulators will actively promote the implementation by responsible entities of the 2018 Liquidity Recommendations.”
While the U.S. Securities and Exchange Commission (SEC) had released in 2016 the 22e-4 Rule on liquidity risk management programs, regulators in other jurisdictions appear to have been waiting for IOSCO’s decision in the hope for guidance and cross-border harmonization on this complex subject.
Their patience may have been repaid. On top of the report’s recommendations, IOSCO simultaneously released “Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration,” a comprehensive survey of existing liquidity risk management practices and tools.
The IOSCO report is already beginning to have an impact. On Feb. 14, the European Systemic Risk Board (ESRB) referred to the IOSCO report when it released “Recommendations on Leverage and Liquidity in Investment Funds.” The goal of the ESRB’s report is to establish a harmonized reporting framework across the European Union for Alternative Investment Funds (AIFs) and Undertakings for Collective Investment in Transferable Securities (UCITS). Similar initiatives from other regulators are likely to come soon.
The IOSCO report reaffirms and enhances its 2013 report: “Principles of Liquidity Risk Management for Collective Investment Schemes.” It also responds to a number of issues that the Financial Stability Board (FSB) targeted at IOSCO in its 2017 report: “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities.”
While the FSB looks at liquidity from a systemic risk angle only, the IOSCO also incorporates investor protection considerations.2 Systemic risk can derive from a liquidity mismatch between a fund’s assets and its redemption policy which may trigger redemption spirals and fire sales. However, the presence of such a mismatch may also be the cause of unfair investor treatment: For example, transaction costs from redemptions and subscriptions are subsidized by all other shareholders at all times, generally penalizing longer term shareholders over shorter term ones.
Importantly, IOSCO promotes a principles-based rather than a one-size-fits-all approach to liquidity risk management. With this flexibility, IOSCO may be able to meet existing jurisdiction-specific constraints, but also affirm that alternative practices are available or may be more appropriate for different fund strategies.
Individual countries will decide how to implement IOSCO’s recommendations. Possibilities include imposing the adoption of specific liquidity risk measures and limits similar to what the SEC did in prescribing time-to-liquidation buckets. Alternatively, local regulators may simply defer to funds the choice of specific metrics and limits as well as the definition of liquidity governance policies, in line with the IOSCO principles. Regardless, funds globally will likely need to equip themselves with liquidity risk solutions and policy management programs. Doing nothing may no longer be a viable option.
1 MSCI started engaging in fund liquidity risk research nearly a decade ago. For example, see Finger, C. and C. Acerbi. (2010). “The Value of Liquidity: Can It Be Measured?” MSCI Working Paper
2 The three IOSCO founding objectives of securities regulation are: 1) the protection of investors; 2) ensuring that markets are fair, efficient and transparent; and 3) the reduction of systemic risk.
Getting ready for liquidity risk management rules
Liquidity risk management: What’s next? (recorded webinar; client access only)
The SEC’s new liquidity risk rules: Now comes the challenge
LiquidityMetrics overview (client access only)
LiquidityMetrics methodology (client access only)