The board of the International Organization of Securities Commissions has released its final report on the principles of liquidity risk management for collective investment schemes.
It begins with the observation that it is banks, not CIS’ that are in the “maturity transformation” business. Banks borrow money on short time frames (for example, from depositors who are entitled to withdrawal on demand) and lend money out on longer time frames. Indeed, this is precisely why (in the views of many theorists) there is a pressing need for central banks with the power to control the money supply. Those central banks can step in when the process of maturity transformation goes poorly.
But CIS’ aren’t in the maturity transformation business, and in the normal flow of events – TBTF crises notwithstanding -- central banks don’t step in when CIS’ get in trouble. Thus, liquidity risk management is an integral part of the business model of any CIS – of anyone who doesn’t want to get into maturity transformation by accident! – And all such concerns, even closed-end funds, should heed the fifteen principles enunciated here.
The principles are addressed to the entity or the entities responsible for the overall management of a CIS, notwithstanding any delegation of specific activities in which this responsible entity may engage.
Fifteen Rules
That responsible entity should:
- Draw up an effective liquidity risk management process, compliant with local jurisdictional liquidity requirements
- Set appropriate liquidity thresholds which are proportionate to its redemption obligations and liabilities
- Carefully determine a suitable dealing frequency for units in the CIS
- Include in the CIS’ constitutional documents the ability to use specific tools or exceptional measures which could affect redemption rights (where “permissible and appropriate, and in the interests of investors”)
- Consider liquidity aspects related to its proposed distribution channels
- Ensure that it will have access to, or can effectively estimate, relevant information for liquidity management
- Ensure that liquidity risk and its liquidity risk management process are effectively disclosed to prospective investors
- Support its liquidity risk management process by strong and effective governance
- Effectively perform and maintain its liquidity risk management process
10. Regularly assess the liquidity of the assets held in the portfolio
11. Integrate liquidity management in investment decisions
12. Maintain the ability to identify an emerging liquidity shortage before it occurs
13. Incorporate relevant data and factors into its liquidity risk management process in order to create a robust and holistic view of the possible risks
14. Conduct assessments of liquidity in different scenarios, including stressed situations, and finally
15. Ensure appropriate records are kept, and relevant disclosures made, relating to the performance of its liquidity risk management process.
The Commenters
As the caveats attached to principle 4 indicate, it is a good idea to avoid the use of extraordinary liquidity-management tools such as the suspension of redemptions wherever possible. The way to do that, perhaps preeminently, is to exercise the foresight suggested in principle 12.
The explanatory material attached to principle 14 refers to collateral, that is, to the desirability of including in stress tests an entity’s ability to settle anticipated margin calls on derivatives positions.
This final report discusses the feedback that IOSCO received in response to earlier drafts.
The European Fund and Asset Management Association, and the Investment Management Association both argued that the principles should include the management of inflows, which obviously affects CIS liquidity. IOSCO acknowledges that point, and simply says that it has decided not to address that matter in this report.
The EFAMA’s comments also included some continental self-congratulation: “The robust liquidity risk management processes put in place by European investment fund managers certainly explains in large part why the vast majority of European UCITS investment funds went through the global financial crisis in 2008 without major problems.”
With regard to principle 4, the Managed Funds Association took exception to the notion that side pockets are exceptional. For hedge funds, at any rate, they are run-of-the-mill. In response, IOSCO has added a footnote in this final report, acknowledging that in some jurisdictions, “side pockets may be considered to be ‘tools’ rather than ‘exceptional measures’ for certain types of CIS.”
Principle 6 drew a number of responses because of the emphatic wording employed. The earlier drafts, like this final draft, said that entities must “ensure” that they will have access to the necessary information. Commenters unsuccessfully requested that this be watered down to require that they “seek to ensure” such access.
IOSCO has held the line here.
In January 2012, IOSCO issued a related report, “Principles on Suspensions of Redemptions on Collective Investment Schemes,” available here.