With market liquidity under pressure since the financial crisis, the U.K.’s Financial Conduct Authority (FCA) published guidance on Monday on good practices for investment firms to ensure they can meet redemptions, particularly when markets are under stress.
“Managing liquidity has become more challenging for fund managers since the financial crisis,” the FCA notes. “The low interest rate environment has given rise to a widespread search for yield in fixed-income securities. This has led to a greater proportion of lower-rated securities, which trade predominantly in over-the-counter (OTC) markets, and tend to offer only limited liquidity, being held in funds that offer frequent, often daily, dealing.”
The FCA has examined how large investment-management firms manage liquidity in their funds and the guidance aims to share the good practices that the regulator observed during the project with the rest of the investment fund industry.
The FCA recommends that firms that are in the process of evaluating their liquidity management practice should focus on: whether their tools, processes and underlying assumptions are suitable for market conditions; ensuring operational preparedness; and that fund investors have full disclosure on liquidity risks and the tools available to manage those risks, such as swing pricing, deferred redemption and suspension.
The FCA reports that its work uncovered some good practices among fund managers, including: processes to ensure that a fund’s dealing arrangements are appropriate for its investment strategy; regular assessments of both liquidity demands and the liquidity of portfolio positions; the use of liquidity buckets; stress testing; and independent monitoring of portfolio exposures.
The FCA also stresses the importance of adequate disclosure to investors about firms’ liquidity management practices: “Investors who have a good understanding of these risks are better prepared to make sound decisions during market stresses and are less likely to heighten redemption pressures by selling their fund investments when liquidity risks are accentuated by market conditions.”