March 2024
In December 2023, the International Organization of Securities Commissions (IOSCO) published a Report on the anti-dilution tools for liquidity risk management in collective investment schemes.
Previously, in 2021, IOSCO and the Financial Stability Board (FSB) jointly analysed the liquidity risk and its management in open-ended funds (OEFs)1 during the market turbulences due to COVID-19. Both bodies concluded that, although the “dash-for-cash” was one of the main drivers for the redemption of OEFs and for fund managers to decide to sell assets in March 2020, it is difficult to determine the extent to which the potential liquidity mismatch contributed to the market stress. In situations in which an adequate assessment of assets and the use of liquidity management tools (LMTs) are not enough to counter the liquidity mismatch, investors who first redeem their units in the fund can obtain an advantage with regard to those who remain in the fund. In parallel, IOSCO’s Assessment Committee carried out in 2022 a thematic review in which it analysed to what extent IOSCO’s members were applying measures that took into account the Recommendations of IOSCO regarding liquidity risk management2. In 2022 the FSB performed an assessment of its 2017 Recommendations regarding the financial stability risks arising from the liquidity mismatch3. In its report, this body indicated that there was a substantial variation in the way in which the LMTs were being applied. Moreover, both the FSB and IOSCO observed there was room for greater implementation of the LMTs.
In situations in which investors of OEFs do not bear the liquidity costs associated with the subscriptions or redemptions of the funds, this could harm the remaining investors, which would negatively affect investor protection and financial stability. LMTs can mitigate these effects insofar as the liquidity costs are passed on to the redeeming investors, by means of an adjustment to the price of the transactions. The assessment of the FSB specifically highlighted the need to include the LMTs in the constituent documents of the OEFs (such as prospectuses and offer documents) and the promotion of their use both under normal conditions and in situations of market stress.
Based on the comments received regarding the Consultation Report published on 5 July 2023 and so as to promote the use of LMTs, IOSCO’s Final Report provides guidance on the application of LMTs to the entities responsible.
Meanwhile, in December 2023 the FSB published a Report revising its 2017 Recommendations to face the structural vulnerabilities resulting from the liquidity mismatch in OEFs4.
Liquidity management is an essential element for OEFs to operate and to safeguard and protect investors. Generally, these funds offer their investors short-term liquidity (sometimes daily), although the liquidity of the assets invested in varies in the different OEFs and throughout time. When an investor subscribes or requests to redeem an OEF this is performed at the net asset value (NAV) per share or unit. However, the NAV does not always reflect the implicit or explicit costs of the transactions, which can mean that the cost of providing liquidity to redeeming investors could be borne by those investors remaining in the fund, as the value of their units may be diluted by the transaction costs.
This dynamic can affect financial stability when the investors in OEFs who act first have first mover advantage if redemption is requested in advance with the expectation that the investors remaining in the fund bear the transaction costs. This can occur in those OEFs that invest in less liquid assets with short redemption periods, which may cause larger mismatches between the liquidity of the assets and that of the OEFs, particularly during situations of market stress. Although it is difficult to quantify its effect, this behaviour of investors can lead to an increase in redemptions and, consequently, to an increase in the sale of assets to cover such repayments, which can contribute towards higher market volatility and affect the price of the assets.
In order to avoid these liquidity management adjustments in this type of fund, IOSCO’s Report includes recommendations on the design and use of LMTs, together with the supervision by the fund managers and custodians, details the information that must be provided to investors regarding the use of these tools and, finally, offers guidance on measures to overcome the barriers or elements that may discourage the use of LMTs.
¹ An OEF is a registered/authorised collective investment schemes that grants its investors redemption rights on their assets, in terms of their net asset value, periodically throughout their useful life, often daily, although this may be less frequently.
² FR13/22 Thematic Review on Liquidity Risk Management Recommendations (iosco.org)