On July 6, 2023, the FCA published a Dear CEO letter, following its multi-firm review of liquidity management by Authorised Fund Managers (AFMs), calling on all asset managers and managers of Alternative Investment Funds (AIFs) to consider the implications of the review’s findings for their businesses.

Following high-profile failures in liquidity management such as the Woodford scandal, and after the market stress tests resulting from the Covid-19 pandemic and rapidly rising interest rates, regulators have been more or less aligned in their focus on liquidity and the determination of the appropriate levels of illiquid assets in daily priced funds. It is a topic that is unlikely to escape their attention or fall off the regulatory agenda in the near future.

This latest review builds on the FCA’s earlier work, in 2019, when it wrote to UK AFM Boards asking firms to review their liquidity management arrangements against FCA good practice. At this time, the FCA also made enhancements to rules which require funds to suspend dealing in certain circumstances.

The 2023 multi-firm review was carried out by the FCA to identify what (if any) improvements have been made since 2019, and what weaknesses remain in firms’ ability to implement effective liquidity management framework.

What did the FCA find?

The FCA found “a wide disparity” among firms reviewed in how they comply with regulatory standards and in the depth of their liquidity risk management expertise. Further, in the view of the FCA’s review, most fell short in some aspects of their liquidity management framework, requiring additional attention in order to ensure that investors are treated fairly in both normal and stressed market conditions.

• Governance: The FCA found that many firms did not attach sufficient weight to managing liquidity in their frameworks and governance structures, with liquidity risks often flagged only on an exceptional basis.

• Liquidity Stress-Testing: With regard to stress-testing, the regulator found that firms’ approaches to stress-testing varied significantly, ranging from sophisticated scenario modelling to unsatisfactory box-ticking exercises. Of particular concern, the FCA found that at some firms, few funds ever failed stress tests, suggesting that thresholds may not be challenging or stringent enough, especially given increased market volatility in recent times. Many firms operated models on the assumption that the most liquid assets would be sold first, creating a false sense of security, and affecting portfolio composition – and negative outcomes for remaining investors – if executed. The FCA instead recommends a pro-rata approach where a proportionate ‘slice’ of every asset in the portfolio is sold to accommodate the redemption.

• Redemptions: The FCA found that many firms only had a trigger for enhanced governance at a large redemption threshold, rather than monitoring the cumulative impact of multiple small redemptions. With particular respect to the upcoming Consumer Duty changes, firms should also consider whether their investors understand the impact of redemption in stressed market conditions on price, and whether this is meeting their risk appetite. This will be particularly important in cases where firms are offering illiquid funds (eg long-term asset funds) to retail investors.

What does this mean for managers?

The FCA’s letter has made it clear that it expects fund Boards to take proactive steps to ensure that their firm meets its expectations on liquidity risk management.

The FCA’s key suggestions include:

• With regard to governance, the introduction of a separate liquidity management committee to ensure that there is sufficient escalation and challenge;
• With respect to stress-testing, reviewing their currently liquidity risk management frameworks and ensuring they have a sufficiently granular risk appetite;
• Managers are encouraged to create a range of liquidity playbooks to be activated should various liquidity stress events occur – these should be tailored to each fund and consider the different escalation triggers and processes based on the different redemption scenarios; and
• Consider engagement of third parties such as delegated investment managers and third-party administrators, to support the design and implementation of appropriate liquidity risk management protocols and processes.

In part as a result of the regulator’s enhanced scrutiny and recommendations on liquidity management, we have seen a significant increase in the number of AFMs looking to outsource their liquidity management activities to a trusted third party. A provider – either as part of management company and risk management remit, or as a standalone service – is able to provide independent day-to-day liquidity management oversight, as well as running appropriate stress test and redemption scenarios and advising on suitable liquidity management tools and strategies.

If regulators begin to request more regular liquidity management reports from managers, unbundled liquidity management services will be required to ensure that portfolio data can be easily integrated into any new regulatory reporting templates.

The FCA findings suggest that when choosing a delegated investment manager or third-party administrator, it is important to select a partner with sufficient resources and expertize to ensure that appropriate systems and controls are implemented to manage liquidity effectively, especially in times of stress. The expectations of the FCA in regard to liquidity management practices are clear, and by choosing the right service provider, AFMs can be confident that they are meeting these expectations in a timely and diligent manner.

What happens next?

We expect regulators across several European jurisdictions to remain focused on this issue. The FCA’s multi-firm review findings have fed into the FSB and IOSCO’s work on liquidity with regard to open-ended funds. On July 5, 2023 the FSB consulted on its recommendations to address structural vulnerabilities from liquidity mismatch in open-ended funds, and IOSCO consulted on guidance on anti-dilution liquidity management tools. While the FSB and IOSCO recommendations are not yet applicable to firms, they indicate a clear direction of travel for global regulatory priorities in this regard.

The key takeaway of the FCA’s letter is that many firms will have to undertake significant additional work to demonstrate they are managing fund liquidity effectively to protect the best interests of investors. The FCA is likely to scrutinize fund liquidity management arrangements just as closely going forward and demonstrating the development, testing and implementation of robust liquidity management arrangements will also be essential for firms to show commitment to ensuring good customer outcomes under the forthcoming Consumer Duty standards.