Liquidity Risk Management a Key Focus in the Central Bank's Letter to FMCs

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Liquidity Risk Management a Key Focus in the Central Bank's Letter to FMCsOn 12 March 2021, the Central Bank published a copy of a letter dated 10 March 2021 which has been sent to the chair of the board of certain fund management companies ("FMCs").

The FMCs to which this letter was issued are those that were surveyed last year as part of the supervisory exercise involving investment funds that have significant exposures to corporate debt and real estate assets. While the letter is specifically addressed to these specific FMCs and relates to a sub-set of the funds managed by those FMCs, the Central Bank notes that the findings from the exercise which were published in a report by ESMA in November 2020 more broadly are important and should be noted by all FMCs.

Specific action is required by FMCs that received this letter. The contents of the letter need to be brought to the attention of all members of the board of the FMCs, the relevant designated persons and to the relevant responsible person(s) within delegate fund service providers. Consideration of the contents of the letter is required to be concluded and the results presented to and approved by the board of the FMC no later than the end of June 2021, with an action plan to take any necessary steps promptly and in any event no later than the end of December 2021.

The Central Bank requires firms that received the letter to consider how their liquidity risk management frameworks and fund structures should be adapted to take into account the experience and lessons learned from the market and redemption activity in 2020 and the findings of ESMA's report. The Central Bank expects consideration to be given to the steps that are needed to increase funds’ resilience to future shocks and states that the following are important in considering what changes may be required:

  • the alignment between the liquidity profile of funds’ investments, the risk profile of investors, redemption policies and settlement periods and the development of new policies to correct misalignments in a timely manner. The Central Bank notes that this is of particular importance for funds investing in less liquid assets or assets that have demonstrated variable levels of liquidity in 2020;
     
  • ensuring that the full suite of liquidity management tools ("LMTs") are in place and used appropriately. The Central Bank notes that this should include consideration of the circumstances where LMTs are appropriate outside of stress scenarios. The Central Bank expects fund management companies to consider the extent to which the use of swing pricing or anti-dilution levies are required to ensure that transaction costs, including liquidity premia, associated with redemptions are borne by those exercising their redemption rights, limiting the effect of large redemption flows on remaining investors, particularly in times of stress and market volatility;
     
  • the policies and procedures in place relating to the use of LMTs should include appropriate disclosure in fund documentation and communication with investors to ensure clarity and transparency around the regular use of LMTs and conditions for their implementation;
     
  • there should be an assessment of all other factors that could impact fund liquidity or trigger unplanned sale of assets;
     
  • a realistic and conservative estimate of the percentage of a fund’s assets that can be liquidated over certain time periods should be prepared and fund management companies should ensure that redemption policies are aligned with this. The Central Bank states that any misalignment in this regard should be corrected in a timely manner;
     
  • information should be available on the profile of the investor base to better understand any potential risks associated with redemption patterns, particularly in stressed market conditions; and
     
  • designing and testing funds’ liquidity risk management frameworks and planning for future market disruption events should not assume government or central bank intervention of the nature or scale seen in 2020.

ESMA's report identified five priority areas for action which would enhance the preparedness of these fund categories for potential future adverse liquidity and valuation shocks:

  1. ongoing supervision of the alignment of the funds’ investment strategy, liquidity profile and redemption policy;
  2. ongoing supervision of liquidity risk assessment;
  3. fund liquidity profile reporting;
  4. increase of the availability and use of LMTs; and
  5. supervision of valuation processes in a context of valuation uncertainty.

In this report, ESMA notes that some funds presented potential liquidity mismatches due to their liquidity set up, which should be addressed, and that this is especially the case for funds investing in asset classes illiquid by nature while offering a combination of high redemption frequency and short notice periods. In addition, ESMA states that concerns around the valuation of portfolio assets have clearly emerged, especially for real estate funds for which the crisis could have a more significant impact over the longer term and notes that real estate funds do not frequently adopt LMTs in their liquidity set-up. Against this background, ESMA notes that fund managers authorised under the UCITS and AIFM Directives should enhance their preparedness to potential future adverse shocks that could lead to a deterioration in financial market liquidity and valuation uncertainty.

By Nicholas Blake-Knox, Jennifer Fox, Eimear Keane, Sarah Maguire & Jill Shaw of Walkers.