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Dear Chair Letter: Good Practice for Authorised Fund Managers

Dear Chair Letter: AFMs

4 November 2019

The FCA has today written a Dear Chair letter to Authorised Fund Managers (AFMs) in relation to Effective Liquidity Management practices in the authorised funds that they operate.

The FCA writes that as an AFM:

• ensuring effective liquidity management in funds is central responsibility; and
• that it remains your responsibility even if investment management has been delegated to other person.

Good fund governance ensures the liquidity of an AFM funds’ underlying assets is appropriately considered.

However, open-ended funds are not always able to liquidate assets sufficiently quickly to meet increased redemption requests from investors. This issue can be more acute in daily dealing funds, which make up most of the retail market in the UK. Your firm can prevent this leading to harm through suitable portfolio composition, effective fund governance, including independent directors, understanding your investor base, as applicable, and investors’ redemption rights, and using liquidity tools appropriately, particularly in time of market volatility and stress.

What is the Regulator doing?

On the 30 September, the FCA published a policy statement (PS19/24) on illiquid assets and open-ended funds that outlined various measures to strengthen the regulatory framework in relation to this area.

These measures included:

• Mandating temporary suspension of dealing in certain circumstances;
• Improvements in liquidity management processes for impacted funds; and
• Increased disclosure to customers.

Whilst this policy statement focused on non-UCITS retails schemes (NURS), however all open-ended fund firms should recognise that effective liquidity management is an irreducible, core function.

The new rules do not come into effect until next September (2020), however fund managers and depositaries may wish to consider whether it would be in investors’ interests to adopt some of the measures ahead of the coming into force date where these do not conflict with the rules already in place, such as improved liquidity management.

FCA Focus points: Liquidity Management

In particular the FCA stresses that they wish for AFMs to consider their obligations on portfolio composition, asset eligibility and liquidity management, and they would also like AFMs to review liquidity management arrangements against the FCA good practice referred to below:

The Collective Investment Schemes (COLL) sourcebook details requirements for asset managers and authorised funds and in particular in relation to AFMs of UK authorised funds and their considerations of the appropriateness of assets they invest in.

• Section COLL 5.2.7AR for UCITS or COLL 5.6.5AR for NURS outline the criteria which transferable securities must fulfil to be an eligible asset for a scheme.
• COLL 5.2.3R for UCITS or COLL 5.6.3R for NURS requires that AFMs should ensure funds have a prudent spread of risk. This requirement to consider the spread of risk is in addition to the specific provisions on spread for UCITS in COLL 5.2.11R, such as the requirement that no more than 10 percent of scheme property should consist of transferable securities issued by any single body.
• Furthermore, the regulator advises that purely meeting the requirements in COLL 5.2.11R may not, in itself, ensure a prudent spread of risk in a fund.
• AFMs must at all times during a dealing day comply with their obligations to redeem units at the request of qualifying unitholders under COLL 6.2.16R(3).

Authorised Fund Managers should, in particular, consider the requirements under COLL 5.2.7AR, including that the liquidity of transferable security does not compromise their ability to redeem units in a fund.

When assessing the liquidity of an asset, AFMs may be required to consider several factors, which could include considering whether a security is, in practice, sufficiently liquid, even where it is admitted to trading on an eligible market.

In circumstances where asset are less liquid, the regulator informs that “robust valuation process are vital”

In the FCA’s earlier review of hard to value assets, carried out in 2017, they highlighted the need for firms to have expertise and independence in their valuation process, as well as firms needing to be able to demonstrate meaningful adherence to their valuation policies.

Good Practice: Liquidity Management for Investment Firms

The FCA’s letter advises that firms must have appropriate systems, controls and governance to oversee and manage liquidity risks.

To this end, the FCA have published a paper entitled “Liquidity management for investment firms: good practice” that outlines good practices for dealing, disclosing, overseeing and implementing liquidity tools.

Firms are reminded that they should review and assess their own liquidity management arrangements against this paper and make improvements where necessary to ensure compliance with the applicable requirement for liquidity management and valuation under FCA rules and directly applicable European regulation.

Liquidity Recommendations in IOSCO 2018

The FCA’s most recent letter points to IOSCO’s latest report on Recommendations for Liquidity Risk Management for Collective Investment Schemes. Published in February last year, the International Organization of Securities Commissions (IOSCO) report detail 17 recommendations that entities responsible for managing liquidity funds, such as Authorised Fund Managers, should undertake to ensure that liquidity is managed to safeguard and protect the interests of investors, including during stressed market conditions.

Of IOSCO’s recommendations, the FCA highlights the following key recommendations to AFMs that a responsible entity should undertake:

• Ensure that it has access to, or can effectively estimate relevant information for liquidity management
• Set appropriate liquidity thresholds which are proportionate to the redemption obligations and liabilities of the fund
• Regularly assess the liquidity of the assets held in the portfolio
• Have a liquidity risk management process so that it can identify an emerging liquidity shortage before it occurs
• Put in place and periodically test contingency plans to ensure that it can use any applicable liquidity management tools where necessary quickly and in an orderly way
• Incorporate relevant data and factors into its liquidity risk management process to create a robust and holistic view of the possible risks
• Conduct ongoing liquidity assessments in different scenarios, which could include fund level stress testing, in line with regulatory guidance

What should AFMs do now?

Fund managers should now look to review their firms’ practices as soon as possible against the recommendations and good practices advised by the regulator to ensure they are appropriate and implement any changes where required. If your firm should require any advice or assistance in reviewing the details for liquidity management, particularly during times of volatility or stress, please do not hesitate to contact our experience consultants who are able to offer practical support and assistance.

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