A market stress event can result in fire sales from the fund managers in order to meet redemption requests, with an adverse effect on other market participants, leading to economic shocks and contagions. Open-ended funds are susceptible to the investors’ subscriptions and redemptions behaviour as it guides their decision-making framework at the fund’s design phase, but more importantly at the on-going portfolio and risk management activities.
For that reason, a high emphasis is given by regulators on the liquidity risk management by fund managers, resulting in many laws and regulations. In order to meet enhanced regulatory liquidity requirements, many industry guidelines have been issued giving more flexibility to funds in regard to their redemption terms and improving disclosures to investors. Moreover, various international bodies that set out global standards, such as the European Systemic Risk Board (ESRB) and International Organization of Securities Commissions (IOSCO) have recommended certain liquidity management tools (LMTs) to manage liquidity risk at an open-ended fund level.
Definition of liquidity risk
In the context of fund management, liquidity risk is defined as the liquidity mismatch between the fund’s investments and redemption terms. Thus, the correct design of the fund’s redemptions policy is of crucial importance for the proper implementation of the fund’s strategy and on-going monitoring.
Available Liquidity Management Tools in the Cyprus Jurisdiction
UCITS and AIF fund managers in Cyprus can better address liquidity risk by adequately assessing the fund’s intended strategy under normal and stress scenarios. This will allow managers to determine the most appropriate redemption policy for their funds, at the ultimate benefit of investors. LMTs can assist open-ended funds to effectively manage redemption requests at normal and stressed market conditions by enabling them to activate those tools in cases of market liquidity deterioration. These mechanisms include tools that effectively pass transaction costs to investors responsible for the fund’s capital activities, tools that restrict access to investors’ capital and other methods.
Tools that effectively pass transaction costs to investors responsible for the fund’s
1. Swing pricing/Anti-dilution levy: These two mechanisms aim to protect longer- term investors from the adverse price effect caused by net capital activities (subscriptions and redemptions) of other investors. The swing pricing can be used to adjust a single priced fund’s NAV, so that the transaction costs are borne by the investors responsible for the fund’s capital activities. Where the net capital activity is inflow (outflow), the fund’s NAV is adjusted upwards (downwards) by a swing factor. The swing factor is based on an estimation of transaction costs per unit so the Fund is able to pursue its contractual investment strategy, upon the net capital activities of investors. The swing pricing can be applied to all capital activities (full swinging) or where the capital activities of the Fund exceed a predetermine level (partial swinging). The anti-dilution levy is a similar tool with the swing pricing but instead of an adjustment to the fund’s NAV, investors pay an extra charge to the fund to cover transaction costs associated with their subscriptions/redemptions.
Tools that restrict access to investors’ capital
1. Redemption gate: A mechanism that restrict investors’ ability to redeem their capital, generally on a pro-rata basis. In the event of significant redemption requests, a fund is forced to sell its assets or distort its portfolio strategy by selling the most liquid assets, which is a detriment for the remaining investors of the fund as they end up with a less liquid portfolio. The ability of a fund manager to gate redemptions can prevent this situation as it allows both the redemptions and any asset sales to be spread over time.
2. Side pockets: When there is a high uncertainty to the valuation of assets due to temporary market disruptions or scarce liquidity, side pockets can be used to segregate specific assets from the fund’s overall portfolio. In practice, the liquid and non-liquid portions of the portfolio are segregated in to two investment vehicles, with different units representing them. The liquid portion of the portfolio continues in accordance with the redemption and valuation policies of the fund, while the illiquid portion of the portfolio freezes subscriptions and redemptions. This mechanism allows the fund manager to protect existing investors from the need to liquidate assets in the portfolio with low liquidity, at distressed market conditions. They are most often used in funds investing in less liquid assets, such as private equity, venture capital or hedge funds.
3. Notice period: This outlines the length of advance notice that an investor must give to a fund manager in order to redeem their investment from the fund. From a fund’s perspective, the use of notice periods gives more time to meet redemption requests in an orderly manner, without the need to sell assets at the worst possible time.
4. Suspension of redemptions: A mechanism to be used as a last resort during a liquidity crisis when no other option is available, due to its embedded risks. Suspension of redemptions may be decided by the senior management of the fund or by the regulator, to protect investors from the effects of dysfunctional market.
1. Redemptions in kind: A tool that gives the ability to the fund manager to meet redemption requests by transferring securities instead of cash. It is a significant tool at the hand of fund managers that frees them from the need to liquidate a significant portion of their assets in the event of large redemption requests. Due to the operational complexity embedded in this tool, it is solely used to meet large redemption request from non-retail investors.
2. Short term borrowings: Most fund structures are able to borrow on at least a temporary basis, which can be utilised as a source of short-term liquidity in limited circumstances.
3. Redemption fees: A tool with the aim to reduce the desire of investors for redemptions in normal and distressed market periods. It is a charge that a fund levies to investors when exiting the fund, especially before a pre-defined time horizon in the fund’s pre-contractual documents. Investors pay a redemption fee in accordance with the amount of shares held.
Author: Charalambos Christou, CFA, Executive Director – Head of Risk Management at MFO Asset Management Ltd