Global policymakers have raised investor protection and financial stability concerns in response to liquidity issues that manifested in parts of the investment fund industry during the Covid-19 pandemic.
The Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) warned of the harm that may arise when investors flee for the exits in the face of market stress.
When sellers don’t have to “bear the costs of liquidity” when redeeming units, the remaining investors are disadvantaged, a report from IOSCO stated.
Furthermore, this distortion can encourage shrewd investors to redeem their fund units early, which could pose a risk to financial stability.
“Investors in these [funds] may be incentivized to redeem shares/units ahead of others if they anticipate that other fund investors will redeem shares and that remaining investors will bear the associated transaction costs,” the IOSCO report stated.
IOSCO was particularly concerned about funds prone to liquidity mismatches, such as open-ended funds with short-term redemption obligations but relatively illiquid portfolio holdings.
“Although it is difficult to quantify and determine the materiality, a first-mover advantage may give rise to excess redemptions, and [funds’] sales of portfolio assets to meet excess redemptions may contribute to greater market volatility and additional pressure on asset prices,” IOSCO warned.
As a result, IOSCO called for funds to adopt tools designed to ensure investors who seek to redeem their units also bear the full costs of those transactions.
Existing methods for fund managers to manage liquidity issues include suspending or limiting redemptions in certain circumstances. Specific anti-dilution tools would require fund managers to impose a transaction levy to account for the costs of trading during market stress or to adjust the fund’s net asset value to reflect these costs, IOSCO said.
The proposed guidance covers the design of these tools, including how fund managers should estimate liquidity costs, how these tools would be triggered, and how their use would be governed and disclosed to investors.
The global fund industry is pushing back.
The Alternative Investment Management Association (AIMA) said in its submission to IOSCO’s consultation that while it supports the use of anti-dilution and liquidity management tools, it’s not convinced the proposed reforms are warranted. Specifically, AIMA stated that policymakers are seeking to impose uniform solutions on a diverse industry, which “risks creating counterproductive behaviour and undermining asset managers’ fiduciary duty to treat all investors in funds fairly.”
AIMA’s submission to the FSB argued that the proposed approach ignores the diversity of the fund industry, most notably the fact that the landscape includes institutionally focused funds that don’t necessarily trade on a daily basis like retail funds do, and that these funds hold assets that range from highly liquid to illiquid.
Imposing uniform liquidity requirements on a diverse industry could increasingly drive institutional investors to manage their assets directly, AIMA warned. Managing assets directly would leave institutions free to add to the selling pressure when market stress arises.
AIMA also suggested that a more rigidly defined set of rules for managing liquidity could actually exacerbate the problem.
“More sophisticated investors will be aware of when the ability to redeem may be limited and so act first,” the AIMA submission stated. “It will also create herd behaviour within funds and their investors as funds are forced to act in concert by unnecessarily rigid and deterministic rules.”
Other industry trade groups questioned the premise underlying the regulators’ proposals.
The U.S. Securities Industry and Financial Markets Association (SIFMA) argued in its submission that investors aren’t always driven to sell their fund units to avoid dilution and liquidity costs.
Further work is needed to “confirm that transaction cost avoidance actually drives investor behaviour,” SIFMA stated. “If more widespread use and acceptance of [liquidity management] tools is based on solving a ‘first mover’ advantage, more data-driven validation work should be conducted to give that rationale additional credibility.”
SIFMA also questioned the benefits of building and maintaining a framework to guard against dilution that doesn’t occur during normal market conditions.
“If there is reason for additional regulatory measures to address liquidity and the risk of material dilution, we encourage data-driven and incremental measures that balance actual costs and potential benefits, preserve the role of the fund manager as the party best positioned to know their specific facts and circumstances, and avoid prescriptive frameworks built on estimates and data limited by artificial precision,” SIFMA said.
The European Fund and Asset Management Association (EFAMA) pushed back on the premise that fund liquidity issues represent a significant financial stability risk.
“Although liquidity risk management can support the resilience of a fund and, thus, the robustness of the broader sector, it would be unsubstantiated and disproportionate to derive the conclusion that fund liquidity risks would inevitably lead to financial stability ones,” EFAMA’s submission to IOSCO stated.
EFAMA also argued that the fund industry held up well during the pandemic-driven market stress. While certain funds faced large redemptions, the fund industry didn’t suffer any major breakdowns as a result.
“[W]e note that while financial risks have recently materialized with multiple bank failures in March 2023, preceded by the U.K. liability-driven investment crisis in September 2022, as well as the by earlier Archegos [Capital Management] debacle in March 2021, there have been no failures of similar magnitude in the European investment fund industry,” EFAMA stated.
IOSCO aims to finalize its guidance by the end of the year.