Measure for measure: the new liquidity framework for open-ended funds

The Bank of England (BoE) and the Financial Conduct Authority (FCA) have concluded their study into potential vulnerabilities because of liquidity mismatches in open-ended funds. The authorities became concerned about market disruption after a series of funds were closed to investors, including UK property funds after the Brexit vote and the high-profile suspension of Woodford’s Equity Income Fund.

The problem

As part of the study, the BoE and FCA conducted a survey of 272 UK authorised open-ended funds, primarily to collect data on the use of liquidity risk management tools. The survey included the period spanning the pandemic-related market disruption in March 2020. Among other findings, the survey found that:

• managers might be over-estimating the liquidity of their funds’ holdings; and
• swing pricing is predominantly used to manage fund liquidity but there was inconsistency in the way that different managers applied the tool.

The proposed solutions

The authorities have now detailed two solutions to enable managers to manage the liquidity of their funds more effectively.

The first is the creation of a liquidity classification framework with four guiding principles.

1. An effective liquidity classification framework would capture the full spectrum of liquid and illiquid assets and consider both normal and stressed market conditions. Classifying and measuring liquidity should better enable managers to fulfil their obligations to manage liquidity risks.
2. An effective liquidity classification framework should play a role in the design of a fund and in determining appropriate redemption terms. The framework should help managers identify whether the liquidity risk management tools that are available to them are appropriate for the type of assets that the fund holds and the profile of its investors.
3. A consistent and realistic classification of the liquidity of funds’ assets could be used to enhance funds’ internal risk management, including stress testing. 
4. The classification should be sufficiently granular and should be available for regulatory reporting. The framework should be at least as granular as the five categories of the indicative liquidity classification that formed part of the BoE and FCA survey.

In addition, the authorities propose a more consistent approach to swing pricing, with the aims of better reflecting the dilution effect of investors exiting a fund, removing the first-mover advantage of exiting a fund, and improving financial stability. The study proposed that managers’ swing pricing adjustments should:

• as far as possible, account for the full cost of meeting investor flows. Managers should consider a range of factors, including the liquidity classification and explicit and implicit transaction costs;
• reflect market conditions and the associated costs of net flows. Greater swing should be typically be applied in stressed market conditions with higher transaction costs;
• be subject to periodic review to ensure their continued validity. There is an expectation that managers’ ability to manage the liquidity risks of a fund should improve over time; and
• be subject to an adequate level of transparency regarding the approach to and effects of swing pricing. Managers should be transparent about their use of swing pricing both before and after the tool has been used (i.e. in the fund prospectus and in their communications with investors in the fund).

What does this mean for asset managers?

Further information and engagement with the industry is likely, particularly in respect of the liquidity classification framework. For instance, more consideration will be given to whether a "top-down", "bottom-up", or mixed approach to liquidity classification should be pursued.

It is evident that the UK authorities have considered the US SEC’s implementation of a liquidity classification framework. The report’s stated intention that the UK’s framework should be an integral part of managers’ approach to managing risks, as well as suggesting that the results should be reported to regulators, seeks to avoid the contention that US approach does more of the latter than the former.

The BoE and FCA will also apply the principles in relation to their ongoing work. This includes the UK’s engagement in international work on liquidity in open-ended funds (which see our earlier blog).

The principles are also relevant to the UK’s ambition to launch a new Long Term Asset Fund by the end of 2021, and the FCA’s delayed work on notice periods for UK property funds. In both instances, the principle of granular and ongoing measurement of the liquidity of a fund’s holdings is likely to feed into regulatory fund wrappers. Assets such as corporate bonds might become a point of contention with policymakers.

There is still more to follow from the regulators. But for now, managers will wish to compare their current and potential new funds against the report’s principles for liquidity risk management.