Top Down, Bottom Up: The Topsy-Turvy World of Fund Liquidity

Regulators on both sides of the Atlantic are tightening liquidity rules for investment funds with the primary focus on whether or not fund portfolios can keep their promise of daily liquidity to their fund investors at all times. We have recently discussed the liquidity scrutiny evident at European regulators, particularly in the wake of the high profile Woodford failure, but here we’ll take a look at two concurrent rules aimed at providing a similar outcome.

It is interesting in this debate that US and EU regulators are addressing an identical issue, that is whether the funds’ portfolio composition allows the fund to meet redemption requests each day. However, the manner and means by which they wish asset managers and funds to assess fund liquidity is materially different. It is interesting to do a brief comparison exercise of the similarities and differences of the two regimes. The irony is that the vast majority of those impacted, particularly mid- to large-sized asset managers, have fund families in both the EU and the US and would much prefer a harmonized ruleset. That remains elusive, for now.

Top Down Approach – European Requirements

AIFs and UCITS have had long standing requirements to evaluate liquidity and to stress test their funds as part of their Risk Management Process (RMP). The European Securities and Markets Authority (ESMA) requirements are more philosophical in nature, mandating that funds should be evaluating liquidity using stress testing and back testing, but not spelling out exactly how this should be done or specific considerations for testing. On the heels of both the Woodford liquidity crisis and the roll out of the US Securities and Exchange Commission (SEC) Liquidity Risk Management Program requirements, ESMA released liquidity stress testing guidelines in an effort to be more transparent on their expectations for assessments and evaluations. 

Under ESMA requirements, managers must take their existing funds and replicate:

  • historical market crises – i.e. In a black Monday scenario, how would my asset classes be impacted? This would determine how liquid the fund would have to be to meet redemptions.
  • large redemption requests – i.e. a large investor has a significant redemption or market events drive wide spread redemptions across the investor base.
  • credit and interest rate changes and the impact on holdings, lending, borrowing, etc.

Bottoms Up Approach – US Requirements

The US rules essentially demand the building of liquidity pillars of the fund from the bottom up. Driven by a written liquidity risk management program, a fund must classify each portfolio holding into a four-category ranking of liquidity based on time to convert to cash and specific to parameters of the position and the fund. This detailed analysis is costly both in terms of market data solutions and significant time investments by oversight teams.

Further, the liquidity risk manager must plan for the impacts of redemptions, tightened credit, or more extensive market illiquidity in times of both normal and stressed conditions. For example, funds may rely on lines of credit or interfund lending to increase liquidity, however in a period of extreme volatility, shared funds in a line of credit or within a lending contract may also experience illiquidity and would look to draw against the same resources. These rules also introduced the ability to swing price as a liquidity tool, similar to what exists in European rules today. However, that allowance has proven to be a non-event as operationally US funds cannot put swing pricing into work.

The Global Approach

Global asset managers are finding themselves stuck in the middle of top down and bottoms up liquidity assessments. Though UCITS and AIF managers had the original groundwork laid, managers with US mutual funds may find themselves with a liquidity program more easily replicated in a global fund structure due to the prescriptive nature of the requirements. Instead of operating two programs, a singular, albeit complex, liquidity program could meet both requirements. As managers try to streamline global processes, they will have to weigh cost considerations with bespoke processes.

As the US rules are fairly new and the ESMA guidelines go into effect in September 2020, it will be some time before we see lessons learned or best practices from either. What is certain is that liquidity regulation is here to stay and those managers caught in the middle have big decisions to make on the future of the liquidity programs in a short amount of time.