Liquidity risk: FCA warns of ‘regulatory intervention’ if funds do not get it right – Investment
The FCA said a review of asset managers’ liquidity management had found that firms needed to increase their focus on liquidity risk.
It added that doing so was vital so investors were able to withdraw their investment in line with their expectations and at an accurate price that reflects its value.
Poor liquidity management can bring with it serious risks for investors and to wider market stability.
In December The Financial Conduct Authority urged managers of liability-driven investment (LDI) funds to learn the lessons of the autumn liquidity crisis, claiming that liquidity buffers represent only part of the solution to future volatility.
What is liquidity risk?
The regulator said its review had highlighted some good practices but there was a wide disparity in the quality of compliance and liquidity risk management expertise among funds. A minority of firms in the review had inadequate frameworks to manage liquidity risk.
Camille Blackburn, director of wholesale buy-side at the FCA, said the regulator had seen examples in the market where liquidity risk had crystallised and the impact it had on investors.
She added: “This review should serve as a warning to all asset managers that they need to get this right. We expect boards to discuss our findings and assure themselves that their firms are not amongst the minority with serious gaps in managing liquidity risk.
“It’s vital the outliers take quick action. They risk regulatory intervention if they don’t take this opportunity to address weaknesses.”
FCA liquidity findings
The FCA’s review found the building blocks and tools for effective liquidity management were usually in place at firms, but these lacked coherence when viewed as a full process and were not always embedded into daily activities.
Many firms attached insufficient weight to liquidity risk management in their governance oversight arrangements, as well as insufficient challenge and escalation, particularly in volatile environments.
There were a wide range of approaches to liquidity stress testing with some methodologies insufficient to assess actual liquidity of the portfolio, using assumptions that were not appropriately conservative. The review explained: “Some firms’ models assumed that they would always sell the most liquid assets, without ever giving regard to the liquidity of selling a ‘vertical slice’ of the portfolio.
Firms “typically” had governance and organisational arrangements in place to meet large one-off redemptions but did not have sufficient arrangements in place to oversee cumulative or market-wide redemptions that could have a significant impact on a fund.
There were wide variations in the application of anti-dilution tools such as swing pricing, which could affect the price investors receive when redeeming.
Asset managers should take account of the findings, as many of the examples of good practice highlighted in the review and letter contribute to improved consumer outcomes and are consistent with the Consumer Duty, which comes into force on 31 July.
Liquidity risk practices
The FCA said enhancing liquidity risk practices would strengthen the UK’s wholesale markets and helps encourage growth in the UK economy.
Laith Khalaf, head of investment analysis at AJ Bell, said managing the liquidity of the underlying portfolio was crucial for open-ended funds. “They can face large withdrawals at the drop of a hat, and need to sell assets in an orderly fashion in order to meet redemptions. While the FCA acknowledges that some firms have achieved high standards in this regard, it broadly thinks there is plenty of scope for improvement, particularly within a minority of asset managers with serious weaknesses in their approach.”
Khalaf pointed out that the regulator was also in the process of opening up long term asset funds (LTAFs) investing in highly illiquid assets to retail investors.
“The initial impetus for Long Term Asset funds came from none other than Rishi Sunak, in his former role as Chancellor. The not-so-subtle goal is to tap up the large amount of money sat in pension funds for investment in UK infrastructure and start-ups, to help boost economic growth and fund the transition to greener energy.
“The government is also reportedly considering requiring pension funds to invest a certain proportion of their money in the UK, including into some illiquid assets. We will perhaps find out more when Jeremy Hunt gives his Mansion House speech next week. The government does seem to be focused on getting that pension money flowing into UK start-ups and infrastructure, despite the illiquid nature of these assets.”
