UK regulators to tackle investment fund 'liquidity mismatches'

The Bank of England's Financial Policy Committee (FPC) said that the "mismatch" between redemption terms and the liquidity of some funds' assets "has the potential to become a systemic risk" to financial stability if not tackled.

The FPC used its twice-yearly financial stability report (123-page / 7.6MB PDF) for December to set out three principles for fund design: assessing liquidity based on either the price discount needed for quick sale or the time period needed to sell without a material price discount; reducing the payout to redeeming investors based on the discount needed to sell their units within the specified notice period; and lengthening redemption periods to reflect the time needed to sell those assets without discount.

The FPC said that aligning the rules governing funds to these principles "should also promote funds' ability to invest in illiquid investments" as well as enhancing financial stability.

The Financial Conduct Authority (FCA) and Bank of England "will now consider how these principles could be implemented in a proportionate and effective manner" as part of their ongoing work on fund liquidity, the regulators said in a joint statement. The conclusions of the review are likely to feed into the regulators' work internationally, "recognising the global nature of asset management", they said.

Funds which hold assets which cannot easily be converted into cash, such as property, can encounter liquidity difficulties if significant numbers of investors try to withdraw their money simultaneously at short notice. This can be particularly problematic where funds are traded daily, as is the case for the majority of the UK retail investment market.

In its report, the FPC cited several recent examples of UK funds struggling with redemption requests during periods of market volatility, including in the period around the UK's referendum on EU membership in June 2016. It warned that "fire sales" of assets at below market value in order to fulfil large-scale redemption requests "can amplify shocks to the wider financial system ... and lead to higher market volatility".

"The issue should be addressed before it grows further or interdependencies between funds and the rest of the financial system become more prominent," the FPC said.

In September, the FCA announced new disclosure, risk warning and oversight rules which will apply to non-UCITS retail schemes (NURSs) which fall into a new category of 'funds investing in inherently illiquid assets' from next year. The FCA also wrote recently to chairs of authorised fund management firms, including those managing UCITS, to remind them of their regulatory responsibilities with regards to liquidity management.

Financial regulation expert Elizabeth Budd of Pinsent Masons, the law firm behind Out-Law, said: "The FPC findings highlight the mismatch between redemption periods and liquidity of assets".

"The proposals to redeem at a discount and to lengthen notice periods will help to address the inherent risk in illiquid funds," she said.

"However, this is wider than simply changing the funds themselves. Changing notice periods in particular will have a material impact on tax wrap products and distributors such as platforms which require daily dealing. It also needs to be remembered that even assets which would be regarded as liquid can become illiquid in a stressed market," she said.