Edwin Schooling Latter, the FCA's Director of Markets and Wholesale Policy, recently delivered a speech to the Investment Association on open-ended funds investing in less liquid assets. He analysed some of the main issues which are relevant in addressing the liquidity mismatch between the assets and liabilities and how this affects redemptions. This issue has become a significant one for regulators here and in Europe.
He cited the most common examples of open ended funds where this issue has been a problem, namely real estate funds and the much discussed LF Woodford Equity Income Fund. However, the issue has the potential to cause difficulties with different fund types. In the cases cited, the funds have had to suspend dealing as redemption requests have exceeded available liquidity and the ability to realise assets at a fair price. He noted that suspension is not necessarily a bad option. It helps protect investors from the sale of assets at poor prices and helps to ensure that all investors are treated equitably.
In his speech Mr Schooling Latter reviews again some of the risks with daily redemptions and illiquid assets.
The most obvious issue is that of price. If assets need to be sold quickly to meet redemption requests, this can have an impact on values achieved. A slower and managed process can achieve better pricing. This is referred to as the asset liability mismatch. He also noted that having some cash and liquidity does not solve the problem. If some investors anticipate issues and sell early, they will utilise the cash reserves and leave remaining investors effectively experiencing reduced valuations as assets begin to be sold to meet further redemption requests.
He also notes how such behaviour triggers further systemic risks. If a fire sale of assets occurs to meet redemption requests, these lower prices are reflected throughout the industry as valuations reflect market prices. This in turn can create further selling pressures.
How does one address these risks?
Mr Schooling Latter notes that these risks can be addressed in two ways. On the asset side by increasing liquid assets or on the liability side, by ensuring redemption requests more properly reflect the nature of the underlying assets.
On the former, he notes that this would mean placing restrictions on the type of assets that may be held within a fund. At present, UCITs funds may only hold 10% of assets in illiquid securities. However, he also notes that more liquid assets embody a price premium. Less liquid assets often produce better long term returns and many investors do not need frequent redemptions, as they invest for the longer term. Therefore, it does not seem sensible to introduce asset restrictions which would impact the ability to maximise returns over the longer term. There is also the economic benefit to the country of investors investing for longer term returns.
Overall, he believes that placing restrictions on the type of investments used by retail funds is not the route to take. He suggests though that further thought needs to be given as to how funds that are marketed as liquid to investors, can achieve that objective.
Matching liabilities to assets- swing pricing
Mr Schooling Latter notes that an alternative to restrictions on the asset side, is to align redemption arrangements better with the liquidity of assets. One tool which very directly addresses first mover advantage is swing pricing. The redemption price swings lower at times of stress to reflect the issues arising from the sale of investments thus causing less detriment to remaining investors. He notes that the extent of swing pricing would vary with market conditions and overall redemption pressure, and so may be difficult to calibrate in practice.
It may avoid remaining investors bearing "an unfair proportion of costs, risks, or loss of value, as the fund's most liquid assets are sold to meet redemptions by exiting investors". At the same time, it needs to be used fairly and swing pricing should not unfairly penalise redemptions and in itself, act as a deterrent to sales and as a de facto suspension of the fund.
His conclusion is that there is merit is using this as a tool. It may protect investors particularly against loss from first mover advantage but may need stronger regulatory guidance surrounding its use.
Matching liabilities to assets- notice periods
The other remedy which Mr Schooling Latter discuses is longer notice periods prior to redemption. He notes three main benefits. Firstly, a straightforward notice period is arguably easier to understand for consumers and may in itself, demonstrate the illiquid nature of the assets.
Secondly, he argues that the fact that the NAV would change between the notice of redemption and the valuation of the assets at some future redemption date, would cause investors to pause before redeeming at times of market stress.
Thirdly, it should hopefully allow a fund a longer period to sell out of less liquid assets. This might mitigate against the fire sale of assets and poorer prices.
Finally, one would need to determine how long a notice period should be. Should it relate to the period needed to sell least liquid assets or would that be unnecessarily restrictive. Alternatively, should it apply only in times of market stress.
If there are to be new requirements to cater for funds holding illiquid assets, the FCA is also exploring and engaging on how one judges liquidity.
Other topics covered include how any changes in approach would be introduced for existing funds. Additionally bearing in mind the change of landscape for EU based funds following Brexit, how would a tighter regime in the UK interact with other jurisdictions?.
Mr Schooling Latter makes clear that he FCA are keen to engage with stakeholders as to how to address this issue for the benefit of the industry as a whole.