With the spotlight falling increasingly on fund liquidity risks, not least from central banks concerned about emerging systemic risks, the Financial Conduct Authority (FCA) has published its final rules on liquidity risk management for non-UCITS retail schemes (NURS). The FCA started reviewing these rules after several property funds were suspended in the wake of the 2016 EU referendum. The FCA has stated that it has also taken into account lessons from the Woodford Equity Income Fund suspension in June 2019. Importantly, however, the new rules will not apply to UCITS funds such as the Woodford fund. We therefore expect further rule changes for such mainstream retail funds in the near term.
The new rules require:
- open-ended funds to suspend redemptions as soon as there is material uncertainty regarding the value of immovable assets that account for at least 20% of the fund’s assets;
- funds investing mainly in illiquid assets to include a risk warning in their financial promotions, and to disclose more details on liquidity risks in the prospectus;
- funds investing mainly in illiquid assets to have robust contingency plans for a liquidity event; and
- depositaries of funds investing mainly in illiquid assets to oversee fund liquidity management practices.
Compared to its consultation (on which we wrote a blog), the FCA has softened its stance through:
- not taking forward its proposed requirement to include the phrase “a fund investing in inherently illiquid assets” in a fund’s name, where this is what the fund does;
- dropping its proposed guidance limiting the amount of cash that funds can hold in order to satisfy redemptions; and
- allowing a fund manager to continue dealing where there is material uncertainty in the value of the fund’s assets, if the fund manager has a reasonable basis for determining that this is in the clients’ best interests and the depositary agrees.
Implications for firms
The new rules will give fund managers additional clarity on the FCA’s expectations in relation to fund suspensions, and could lead to more frequent suspensions in some cases.
The FCA has not taken forward its proposal to add the phrase “a fund investing in inherently illiquid assets” to a fund’s name, which would have been the most prominent investor risk warning. However, risk warnings in financial promotions may still reduce the attractiveness of open-ended funds investing in illiquid assets to certain types of retail investor. Nevertheless, if retail investors are more aware of the risks up-front, they may respond less negatively to fund suspensions.
The measures on depositary oversight and contingency planning will mean more scrutiny of fund managers’ liquidity risk management processes – something that we are already seeing from regulators, both in the UK and internationally.
What the new rules are intended to achieve
Overall, the new rules are designed to reduce the risk that a fund will be suspended when investors were not aware that their investment was illiquid - but will not eliminate this risk. Some have argued that only closed-ended funds are suitable for illiquid retail investment, since they can be traded without selling the fund’s underlying assets. However, the FCA has said that it does not want to prohibit open-ended funds from investing in illiquid assets provided investors understand and are willing to accept the liquidity risk this can involve. Nevertheless, the FCA wants fund managers to have clear arrangements and disclosures on how mismatches between the dealing frequency of open-ended funds and the liquidity of the underlying assets will be managed.
The FCA’s rules come into force on 30 September 2020.
The FCA is considering additional liquidity rules for listed securities that do not have a liquid market in practice – an issue that garnered some further attention due to the Woodford fund suspension.
Meanwhile, fund liquidity issues are rising rapidly up the central banking priority list. In particular, the Bank of England’s Financial Policy Committee has concluded that fund liquidity risk poses systemic risks that could affect the broader financial system and the real economy. The Bank of England and the FCA are conducting a joint review to examine the costs and benefits of aligning redemption terms, including pricing and notice periods, with the typical time it takes to realise market prices for funds’ assets in normal and stressed market conditions. They will report on their progress in the December 2019 Financial Stability Report.
These issues are also attracting a lot of attention at international level. ESMA has published its final guidance on liquidity stress tests for investment funds. Following the European Systemic Risk Board’s 2018 recommendation on liquidity and leverage risks in investment funds, the European Commission is expected to publish legislation on fund liquidity management in 2020. We expect this to cover the availability and use of liquidity management tools, the role of national regulators in suspending redemptions, the prevention of excessive liquidity mismatches, and liquidity reporting for UCITS funds. These issues may be considered as part of the upcoming reviews of UCITS V and AIFMD.
The new rules in detail
A NURS must suspend dealing when its Standing Independent Valuer (SIV) expresses “material uncertainty” regarding the value of immovable assets that account for at least 20% of its assets. However, following responses to the consultation, the FCA has decided to allow the fund manager to continue dealing if it has a reasonable basis for determining that this is in the clients’ best interests and the depositary agrees – although the FCA considers such circumstances to be limited.
The FCA has not provided a definition of “material uncertainty”, nor guidance on what “clients’ best interests” may look like. This may result in different interpretations of the rules. It will therefore be important for firms to document the rationale for all decisions made.
New Category “FIIA”
The rules have introduced a new category called “funds investing in inherently illiquid assets” (FIIA). A NURS is considered an FIIA if it has disclosed to investors that it is aiming to invest at least 50% of its scheme property in inherently illiquid assets or, it has done so for at least three continuous months in the past 12 months. However if a fund can show that its redemption arrangements match the liquidity of its assets, it will not fall under this category.
“Inherently Illiquid” has been defined as an investment in an immovable asset or infrastructure project, a transferable security that is not readily realisable, a security that is not listed/traded on an eligible market and for which the trading process is difficult, or a unit in an FIIA. The FCA acknowledges that certain listed securities which are illiquid in practice will not be caught by this, and is considering further rules for such securities.
FIIAs will be subject to additional requirements as follows:
- Standard Risk Warnings: FIIAs must include the following wording in financial promotions to retail clients: “[Name of fund] invests in assets that may at times be hard to sell. This means that there may be occasions when you experience a delay or receive less than you might otherwise expect when selling your investment. For more information on risks see the prospectus and key investor information document”.
- Liquidity Disclosures in Prospectus: FIIAs will be required to disclose contingency plans for liquidity management in exceptional circumstances in the prospectus.This must include:
- an explanation of the fund’s liquidity risks and how these may crystallise;
- the tools and arrangements the fund manager would use to mitigate these risks; and
- the circumstances in which such measures would typically be deployed and the likely consequences for investors.
- Enhanced Depositary Oversight: The fund’s depositary will be required to assess regularly the liquidity risk of the fund’s underlying assets. Depositaries will also be required to oversee fund managers’ liquidity management.
- Liquidity Management: FIIAs will be required to create and maintain contingency plans which set out:
- how the fund manager will respond to a liquidity risk crystallising;
- the liquidity tools and arrangements that may be deployed, including any operational challenges and the consequences for investors; and
- communication arrangements for relevant parties, including how the fund manager will work with all concerned parties to implement the plan.
If a NURS receives a significant number of redemption requests in a short timeframe, and the fund manager decides that it would rather sell assets quickly than suspend the fund, the FCA has introduced:
- a requirement that the intention to do so must be disclosed in the prospectus; and
- guidance that if a fund manager wishes to sell an immovable asset quickly, a fair and reasonable price must be agreed with its SIV for the immovable.