Ensuring the liquidity of fund assets reflects the needs of investors | Wolters Kluwer Financial Services
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  • Ensuring the liquidity of fund assets and strategies suitably reflects the needs, expectations and proper treatment of market consumers and investors

    By Steve Blackbourn

    Published April 05, 2017

    The UK business conduct regulator (FCA) has for some time been analysing and contemplating the risks arising from various perspectives when looking at how consumers and investors interact and participate with financial-services industry sectors, systems and how they can access and use investment options and solutions. Accordingly, recent publications have looked to further open the process of industry debate to promote feedback and gather available evidence as to the means and methods by which organisations ensure that their investment products and services properly reflect regulatory requirements and expectations, and deliver the appropriate outcomes for all consumers.

    The FCA has concluded that recent and past events, such as fund reactions to the UK EU Referendum vote during last year, provide a timely opportunity to review its own approach towards funds that invest in illiquid assets. During February (see DP17/1) the FCA has therefore sought to focus the debate on asset allocation and liquidity risks involving various investment vehicles, funds and markets. In doing so, the FCA wants to directly encourage and engage feedback ahead of potential new rules and guidance proposals (later in the year) concerning the operation of certain investment funds by fund managers.

    Understanding the liquidity triggers and exposures for assets, allocations and strategies 

    In particular, this discussion paper considers the risks concerning open-ended investment funds and the potential or inherent illiquidity of certain asset-types and/or underpinning certain investment allocation structures and strategies. As such, a number of factors are highlighted as of relevance or meriting due consideration across all levels of the product and/or service lifecycle:

    1.    Such investment funds and assets can typically involve assets of a financial and/or non-financial nature such as buildings, land or unlisted securities where the implications and exposures for investors may give rise to issues around ‘ suitability and resilience’ of certain fund vehicles and their underlying investment strategies in terms of those investors’ actual and changing interests, needs and expectations. But in addition, they might equally involve assets that might present some difficulty for a fund manager to buy/sell or value quickly.    

    2.    Concerns around the access, ease and nature of fund redemption might require fund management firms to properly and adequately account for wider implications to protect and secure necessary ‘ market integrity and sustainability’.       

    3.    There is also the important dimension of organisations delivering ‘ fair treatment’ to both fund investors and its customers, in order to adequately and transparently meet and fulfil the associated regulatory standards and expected practices when conducting investment-related business.      

    The FCA is seeking to encourage industry debate and obtain feedback on a number of possible future policy approaches as it looks to protect and support both overall market integrity, and deliver good outcomes and experiences for specific consumers deemed to be at risk in certain circumstances or scenarios.

    In other separate but contemporaneous publications, the UK conduct regulator has also sought to advance its ideas and thoughts around both the effectiveness of the UK primary markets in serving the needs of issuers and investors (see DP17/2 & CP17/4), and also to update its evidential research on the prevailing liquidity conditions and its latest measures concerning the UK corporate bond market too.

    The wider scope of industry relevance and impact 

    The potential considerations and ramifications behind this paper (FCA DP17/1) can reach across many aspects of the UK investment industry, from specific fund operators and managers, investment advisers as well as intermediaries and ancillary service and platform providers, as well as other relevant specialist market users and fund investors e.g. institutions, and pensions and life assurance firms who make some use of open-ended investment funds which could be holding or be comprised of inherently illiquid assets.

    The paper looks at and comments on the prevailing range of measures and approaches to managing liquidity, and the tools fund managers have to handle and control the associated risk profile of their products and consumer demands for liquidity and exercising redemption rights. The available tools can be either ‘preventative’ or ‘post-event’ in nature and application, with matters such as portfolio investment limits and restrictions also enabling a level of both overall risk-diversification and specific liquidity risk oversight and control. The paper then goes on to outline some of the potential aspects and elements in which future rule and/or guidance developments might proceed, concerning areas such as fund structures and strategy, asset valuation processes as well as more prescriptive and interventionist issues from investor information and disclosures to formal and direct regulatory powers and action.

    The current regulation of open-ended funds and connected fund managers is already considered to be relatively complex, with the authorised funds regime e.g. collective investment schemes (CIS) and also the pertaining rules relating to certain funds such as the UCITS and AIFM Directives, protecting investors and controlling matters such as the promotion and (in certain respects) the composition of related funds etc.

    The tools and approaches for managing fund and asset liquidity

    The bulk of the 48-page publication concentrates on an outline of how and why liquidity is managed, though illiquid assets can still provide a necessary and important element of risk diversity and investment return. Therefore investor exposures and access to investment assets and fund vehicles which might involve illiquid assets can still play an essential and appropriate role and investment strategy for certain investors and consumers.

    The paper intentionally does fall short of any general review of fund liquidity measures in the UK, and also falls short at this point of any specific definitions as to what asset types/classes could constitute being inherently regarded as ‘illiquid’ in nature and treatment. Though it does highlight a number of scenarios and characteristics which might be unrelated but nevertheless can be indicative of the illiquid nature of an asset or fund product. This includes assets that are not traded on any organised market or indeed through any established market maker, but also trading circumstances and factors that can result in some significant imbalance between supply and demand or involve time and complexity to calculate or negotiate any related transaction price(s). In essence, the nature of the assets, the mechanisms for trading, or issues of legal title and transfer might amount to a difficult, complex and or prolonged transaction-based or free-trade process.

    However, it is apparent that open-ended funds which constitute illiquid assets which are targeted, offered or used by consumers who require or expect timely redemption or access to the underlying funds/cash can experience difficulties. So where fund managers can’t provide or determine valuations on which redemptions can be achieved when required or expected, then consumers might be vulnerable or even disadvantaged in the event of any sudden, dramatic or unforeseen change in market or pricing conditions.

    In the event of pressures on the demands for redemption and other stressed market situations, then fund managers can be faced with conflicts in properly balancing and serving the interests of both exiting and retained investors. In such circumstances, fund managers are expected and required to use various liquidity management processes and tools, including (but not limited to) clear fund contractual terms and conditions, to fairly protect and balance the sometimes competing interests of all fund investors/consumers.

    Keeping a light on future changes

    As usual, the prevailing industry discussion period, which closes in early May 2017, provides the opportunity for participant stakeholders to help inform the regulator on specific and practical industry views and considerations which might then contribute to the eventual shape, detail and extent of any future change proposals.

    The FCA has indicated it intends to issue detailed consultation proposals concerning new rules and guidance in this area later during 2017.

    It seems probable any future proposals could yet see the boundaries being pushed and extended on the nature and eligibility of investment assets used and held in related funds and products. This could also strengthen the obligations on firms to implement effective policies and more consistent and predictive mechanisms e.g. stress-testing and risk-profiling, showing how they better understand and reflect investor needs and behaviours, and overall consolidating the duty and expectations on fund managers to consider and actively manage and control the liquidity risk(s) of relevant stakeholders.

    About the author: Over a 25-year career Steve Blackbourn has undertaken various operational and regulatory roles at senior-management level in a range of international financial services organisations before becoming established as a U.K.-based compliance and financial crime consultant in 2008. Steve has held key positions within a global bank assurance group, an Advanced Risk-Responsive Operating FrameWork (ARROW) supervisory inspection team at the UK FSA and an international life/pensions and investment organisation. Steve has worked and continues to work alongside Wolters Kluwer in delivering project-specific as well as rolling consultancy support services with mutual clients. He is also a regular monthly contributor to Wolters Kluwer Financial Services’ Compliance Resource Network. In addition, he also works with a range of direct clients applying his broad scope regulatory-compliance and financial-crime background and skills to deliver a reliable and quality service with an emphasis on practical approach and commercial orientated solutions.



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