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In the wake of the unprecedented market stress prompted by the Covid-19 outbreak, regulators have been on guard for funds unable to meet investor redemption demands. And now, the Canadian Securities Administrators (CSA) are issuing new guidance for fund managers on dealing with critical liquidity risk.

When it comes to fund liquidity, the central concern for policymakers is a surge in redemption requests leading to panic-selling that could drive down asset prices at the expense of investors who don’t rush for the exit.

To prevent this sort of liquidity crunch, regulators expect fund managers to ensure their funds’ assets can meet redemption demands in a timely manner, even when markets are under stress.

One of the emergency measures that the CSA took in response to the Covid-19 crisis was to provide funds with more room to maneuver by temporarily raising short-term borrowing limits, thereby increasing funds’ access to liquidity.

Now, in the wake of concerns being raised about fund liquidity as a potential systemic risk by the Bank of Canada, at the domestic level, and the Financial Stability Board (FSB), at the global level, the CSA has released new guidance to fund managers on liquidity risk management.

That guidance stresses the need for fund managers to ensure they’re prepared to address concerns before they arise.

“If a fund does not manage its liquidity risk properly, there could be adverse outcomes for the fund and its investors,” the guidance noted. “For this reason, taking a proactive and preventative approach […] is critical to ensuring that this risk is appropriately managed and dealt with in a timely manner, as it is very challenging to address material liquidity problems after they occur.”

Among other things, the CSA’s guidance covers the creation and ongoing maintenance of firms’ liquidity risk management policies, governance, stress testing, and liquidity risk disclosure.

In terms of governance, the guidance suggested that fund managers should determine whether a new or existing committee that’s independent of the portfolio management function should be tasked with overseeing liquidity risk management.

Also, while stress testing is not specifically mandated under securities legislation, the CSA’s guidance sets out key factors for firms to consider when carrying out stress testing to assess a fund’s ability to meet redemption requests.

The regulators note that the guidance doesn’t create any new regulatory obligations for fund managers, nor is it one-size-fits-all.

Instead, it aims to provide a framework for fund managers to ensure that they’re adequately addressing liquidity risk in their particular funds for both normal and stressed market conditions — such as the current pandemic or the 2008 global financial crisis.

The guidance also outlines the global liquidity risk management recommendations from the umbrella group of global regulators, the International Organization of Securities Commissions (IOSCO). Those also focus on ensuring fund managers can respond to stressed market conditions.

“Taking a preventative and proactive approach to liquidity risk management is critical to ensuring such risks are appropriately managed,” said Louis Morisset, chair of the CSA and president and CEO of the Autorité des marchés financiers (AMF).

“We are publishing this guidance to support investment fund managers in their ongoing development and maintenance of robust, effective liquidity risk management frameworks,” he said.

Additionally, the CSA noted that it will continue to monitor funds’ liquidity risk management as part of its ongoing continuous disclosure reviews.