Fund liquidity scrutinized by global regulators
Why historical simulations offer the best approach
Published
May 2023
Senior Director, Regulatory Product Management, CFA
Senior Director, Pricing and Analytics Product Management
Global regulators in Europe, Asia and the United States are scrutinizing fund liquidity requirements in the wake of the pandemic and recent market volatility. The aim: to bolster sector resilience, maintain market integrity, and strengthen funds ability to meet redemption requests. Here, the protection of retail investors and reduction of systemic risk is in sharp focus, after the pandemic ‘dash for cash’ in March 2020 and the U.K. pensions crisis last year.
As regulators seek to boost market resilience, potentially misplaced assumptions about the adequacy of liquidity reporting – and what’s needed to satisfy redemptions – could place an onerous burden on the global fund industry and ultimately costs on investors. Among global policymakers, the proposal by the Securities and Exchange Commission (SEC) in the U.S. is the most far reaching to date. As we stated in our comment letter to the SEC, ICE believes there are alternative, simpler measures that can achieve the same goals, with far better outcomes for investors, funds and their regulators.
The trifecta: Three regulatory themes are common across jurisdictions
Liquidity stress testing and scenario analysis
- Central to the European Securities and Markets Authority’s (ESMA) guidelines for EU firms, are expectations that funds quantitatively assess the liquidity impact to their portfolios of historical simulations and hypothetical scenarios.
- In the U.K., the Financial Conduct Authority (FCA) is consulting with the industry to improve regulation of the country’s ~2,600 asset management firms, including a recommendation that would convert ESMA’s liquidity stress testing guidelines into FCA rules.
- In the U.S., the SEC’s proposal includes new minimum standards that incorporate stressed conditions and would require funds to have 10% of their net assets be highly liquid.
Liquidity classification of fund assets
- In the U.S., open-end funds (except for money market funds and most exchange traded funds) must classify the liquidity of their investments into one of four categories and the SEC is proposing that these categories be consolidated. The SEC is also proposing that these funds file portfolio information with the SEC each month, with the report becoming public after 30 days.
- In the EU and the U.K., liquidity categorization is only required by alternative investment funds.
- The FCA is considering extending the requirement for alternative investment funds to disclose certain liquidity categories to ‘UCITS’ funds. UCITS funds are similar to mutual funds in the U.S.
Liquidity management tools
Regulators demand that funds have liquidity management tools, often including swing pricing, to handle potential liquidity mismatches when dealing with large redemption and subscription requests, and the Financial Stability Board and the International Organization of Securities Commissions are each working on recommendations for increased use of liquidity management tools.
ICE’s paper last year – ‘Liquidity and Swing Pricing During Volatile Markets’ – looks at the tools available for the assessment and application of swing pricing adjustment factors (i.e. the amount by which to adjust the NAV given a particular amount of net redemptions or net subscriptions). In particular, this paper has led to numerous follow-up client conversations where two topics are commonly raised: the method of calculating swing pricing factors and the frequency of calculation of these factors. Some methodologies calculate implicit transaction costs based on observed bid-ask spreads of fund investments while others also incorporate market impact, taking into account the size of the orders. Clients tell us that quarterly recalibration is the most common, but some indicate they expect to move to more frequent recalibrations (up to daily in certain cases).
Recent regulatory action includes:
- The SEC proposal of mandatory swing pricing for open-end funds.
- ESMA’s application of swing pricing tools by money market funds.
- The FCA’s proposal to clarify rules around how swing pricing is applied, noting firms may not always use existing rules consistently, which could harm consumers.
SEC’s proposed approach to liquidity profiles: A misguided approach to market impact
In its recent proposal, the SEC expressed concern about funds’ liquidity management and their ability to adjust to changing market conditions during initial pandemic volatility. As support, the SEC noted that around two-thirds of funds did not appear to reclassify the liquidity profile of any investments between the February 2020 and March 2020, as reflected in N-PORT filings.
Yet ICE’s analysis of March and April 2020 data suggests this conclusion is overstated - particularly the assumption that funds were slow to adjust to market volatility. During that period, our clients were contacting us for real-time validation of our liquidity models, and we consulted with various market participants to assess market liquidity. Hence, what the regulator may see as unchanged classifications often may be the result of a validated re-assessment of a position’s liquidity. Samples of these results and our conclusions are posted in our comment letter to the SEC.
The SEC proposal also includes changes to the ‘significant market impact standard’. This refers to the requirement for funds to classify their holdings based on the sale or disposition that does not significantly change the market value of the investment. Changes to this rule, in our view, offer no discernable benefit to investors and would be unnecessarily burdensome. The SEC’s current liquidity rule provides funds flexibility in determining what constitutes a significant change in the market value of their holdings and how to assess the impact of a sale or disposition. The SEC proposal would remove that flexibility and apply a uniform definition of a significant change in the market value of an investment, with separate methodologies for determining significant market impact for-exchange-listed and non-exchange-listed instruments. Funds would be required to make daily volume calculations for exchange-listed instruments, with an emphasis on such securities’ volume impact instead of price impact. By emphasizing volume over price, liquidity calculations may be impaired. For example, ICE Liquidity IndicatorsTM factors non-linearity into its calculations, recognizing that volume in the market on one day impacts the ability to sell that same volume on subsequent days without moving the price. We believe that funds should have flexibility to design their liquidity programs with assumptions based on the specific characteristics of the instruments they hold.
Historical simulations are the best approach
Given the multitude of factors that impact the liquidity of financial instruments, we believe more accurate liquidity assessments can be made by using historical simulations/scenario analysis and stress testing. To achieve this goal, and consistent with the existing requirement set forth in SEC Rule 22e-4 (the Liquidity Rule) for funds to design liquidity risk management programs which consider the “liquidity of portfolio investments during both normal and reasonably foreseeable stressed conditions,” ICE believes that a better alternative to the SEC’s proposal would be to provide more specific requirements relating to liquidity stress testing - similar to ESMA requirements.
ICE offers analytics that allow clients to stress test portfolios through both historical simulations (such as the 2008 credit crisis, 2014-2015 Eurozone contagion, COVID-19) and hypothetical stresses (e.g., moderate stress, adverse and severely adverse scenarios). This functionality allows funds to visualize and measure the liquidity of their portfolios under baseline and stress scenarios and has been broadly adopted by our European and Asia-Pacific clients. Instead of trying to conflate a normal, current baseline scenario with stressed inputs, as proposed by the SEC, keeping these factors as separate outputs would give regulators the ability observe funds’ liquidity.
Our liquidity risk management service, ICE Liquidity IndicatorsTM, is designed to support firms’ risk management with solutions that assist in complying with various regulatory obligations regarding liquidity stress testing, liquidity classifications and swing pricing factor calculations. These liquidity indicators use ICE’s broad evaluated pricing content (such as price, yield, bid-ask spreads, duration, etc.) based on an extensive network of market data sources. Our evaluated pricing extends far back enough to allow us to quantitatively measure the impact on liquidity from the 2008 Global Financial Crisis (GFC). We are able to run today’s liquidity models with actual multiplier effects observed during the GFC to assess the impact a recurrence of that event would have on a portfolio.
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Resources
Liquidity rule violations enforced by U.S. regulator
In May 2023 the U.S. SEC took its first-ever action in enforcing the Liquidity Rule. This rule prohibits mutual funds from investing more than 15% of their net assets in illiquid investments, requires prompt remedial steps if they breach this limit, and requires funds to adopt a liquidity risk management program.
The SEC’s complaint alleges that the fund in question previously held ~21-26 percent of its net assets in illiquid investments, classified its largest illiquid investment as “less liquid”, ignored restrictions, transfer limitations, the absence of a market for the shares, and disregarded advice of fund counsel and auditors. The SEC’s complaint seeks permanent injunctions and civil money penalties against the fund’s advisor as well as certain officers and trustees of the fund.