Cyprus: Liquidity management tools in collective investment schemes
Xenia Kalogirou of Elias Neocleous & Co discusses the liquidity management tools in collective investment schemes in Cyprus and the EU Commission’s proposals to amend AIFMD and the UCITS Directive
The investment fund industry has grown strongly over the past decade, both in the EU and globally. At European level, as reported by the European Fund and Asset Management Association (EFAMA), the net sales of UCITS and AIFs rose to €866 billion in 2021, compared to €650 billion in 2020 while the net assets of European investment funds grew by 17%, to reach €22 trillion.
Low or negative interest rates and balance sheet constraints in the banking sector, enhanced the role of investment funds in financial intermediation which is anticipated to further increase. While, such developments may strengthen the efficiency and resilience of the financial system as a whole, there are concerns that increased financial intermediation by investment funds may cause amplification of any future financial crisis.
Notably, the complex range of potential behaviours of investment funds and the resulting investor redemption requests in reaction to market stress, eventually exacerbate the market shock and contribute to financial instability.
The current regulatory framework governing investment fund liquidity management in the EU includes specific provisions on liquidity management which have been generally adequate so far. However, the results of the surveys of European Systemic Risk Board (ESRB), European Securities and Markets Authority (ESMA) and International Organisation of Securities Commissions (IOSCO) on existing practices, have revealed that there are still some areas in the general liquidity management environment which could be improved.
This article concentrates principally on the liquidity management tools (LMTs) which could ultimately contribute positively to the management of liquidity risk.
Existing regulatory framework for investment fund liquidity
The AIFM Directive (2011/61/EU) (AIFMD), incorporated into the national law by the Republic of Cyprus through the adoption of ‘The Alternative Investments Fund Managers Law 56(I)/2013)’ as amended, and its implementing acts lay out the liquidity risk management requirements, in particular in the context of the establishment of a general permanent and independent risk management function (Article 15 of the AIFMD and Article 39 of the delegated regulation (No.231/2013) to the AIFMD).
This function shall, firstly, implement effective risk management policies and procedures in order to identify, measure, manage and monitor on an ongoing basis all risks (including liquidity risk) relevant to each AIF’s investment strategy, and secondly comply with the obligation to monitor compliance with the above risk limits (Article 44 and Article 48 of the delegated regulation).
In addition to the general risk management requirements, the Article 16 of the AIFMD provides that AIFMs shall for each fund managed which is not a closed-end fund employ an appropriate liquidity management system, including procedures to monitor the liquidity risk of the AIF and to ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations. It is further added that the AIFMs must also ensure that the AIFs’ investment strategy, their liquidity profile and their redemption policy are consistent.
Under Article 46(2) of the AIFMD and Article 108(3)(b) of the delegated regulation, the competent authorities and the managers respectively, have the power to require the suspension of the repurchase or redemption of units in the interest of the unit-holders or of the public in terms of management of the AIF’s liquidity. Similar provisions are also included in The Alternative Investment Funds Law of 2018 L.124(I) of 2018 (Article 43).
Article 47(1) of the delegated regulation describes the specific details of the liquidity management system and procedures for each AIF. In respect of the LMT, it is specifically provided that the AIFM shall consider and put into effect the tools and arrangements, including special arrangements, necessary to manage the liquidity risk of each AIF under its management.
The AIFM shall identify the types of circumstances where these tools and arrangements may be used in both normal and exceptional circumstances, taking into account the fair treatment of all AIF investors in relation to each AIF under management. The AIFM may use such tools and arrangements only in these circumstances and if appropriate disclosures have been made in accordance with the relevant provisions of the delegated regulation.
UCITS have been designed principally for the retail market as open-ended diversified and liquid products.
A key principle of the UCITS Directive (2009/65/EC), implemented in the Republic of Cyprus by the adoption of the Open-Ended Undertakings for Collective Investment (UCI) Law 78(Ι)/2012 as amended, is the portfolio diversification based on the so-called ‘5-10-40 rule’, set out in Article 52(1) and (2) which refers to maximum permitted exposures per issuer.
Accordingly, the general rule as reinforced by a list of eligible and non-eligible assets under the Article 50, requires that, a UCITS shall invest no more than 5% of its assets in transferable securities or money market instruments issued by the same body. The above 5% limit may be raised to a maximum of 10%, with a further aggregate limitation of 40% of net assets on exposures of greater than 5% to single issuers.
Apart from the above principle which guarantees the liquidity of the UCITS product in line with the general obligation under Article 84(1) of the UCITS Directive, whereby a UCITS shall repurchase or redeem its units at the request of any unit-holder, the UCITS Directive includes liquidity risk management requirements for UCITS management companies corresponding to those under AIFMD.
Specifically, Article 51(1) of the UCITS Directive provides that a UCITS management company shall employ a risk- management process which enables it to monitor and measure the risk of the positions and their contribution to the overall risk profile of the UCITS portfolio at any time.
Article 12 of the implementing Directive 2010/43/EU (as incorporated into national law via the ‘CySEC Directive DI78-2012-03 regarding the Conditions for Authorization and Ongoing Obligations of a Management Company and the Agreement between a Depositary and a Management Company of UCITS)’ further requires the management company, where appropriate and proportionate in view of the nature, scale and complexity of its business and of the UCITS it manages, to establish and maintain a permanent risk management function which shall be hierarchically and functionally independent from other operating units of the management company. Amongst others, it shall additionally implement the risk management policy and procedures, ensure compliance with the UCITS’ risk limits and provide relevant advice and reports to the board of directors and the senior management.
Furthermore, Article 38(1) of the implementing Directive 2010/43/ EU provides that management companies shall address at least the following elements in the risk management policy:
The techniques, tools and arrangements that enable them to comply with their obligations in respect of measurement and management of risk and compliance with limits concerning global exposure and counterparty risk;
The allocation of responsibilities within the management company pertaining to risk management.
By way of derogation from the general obligation under Article 84(1) of the UCITS Directive, a UCITS may, in accordance with the applicable national law, the fund rules or the instruments of incorporation of the investment company, temporarily suspend the repurchase or redemption of its units and its competent authorities may require the suspension of the repurchase or redemption of units in the interest of the unit-holders or of the public (Article 84(2) of the UCITS Directive).
Article 39(1) of the implementing Directive 2010/43/ EU obliges UCITS management companies to assess, monitor and periodically review the effectiveness of their risk management policy, their level of compliance with it and the adequacy of measures taken to address any deficiencies in the performance of the risk management process.
In addition, Article 40(3) of the implementing Directive 2010/43/EU, provides that UCITS management companies shall employ an appropriate liquidity risk management process in order to ensure that each UCITS they manage is able to redeem at any time the investors’ units upon their request. Paragraph 4 further adds that UCITS management companies shall ensure that for each UCITS they manage the liquidity profile of the investments of the UCITS is appropriate to the redemption policy laid down in the fund rules or the instruments of incorporation or the prospectus.
Liquidity management tools for redemption
Apart from the regulatory requirements under the EU legislation across the AIFM and UCITS regimes as analysed above, there are certain complimentary operational tools recognised and used in many European jurisdictions by management companies for the management of liquidity.
The availability and implementation of LMTs for collective schemes varies significantly across jurisdictions. Thus, there are differences in the availability of LMTs as well as the specific procedures governing the use of a-LMT across jurisdictions as evidenced by the survey conducted by IOSCO, the Recommendation of the European Systemic Risk Board of 7 December 2017 on liquidity and leverage risks in investment funds (ESRB/2017/6) February 2018 (the ’ESBR Recommendations’) and the survey of member states conducted by ESMA.
The most commonly available tools in member states are the following: (a) redemption fees; (b) redemption gates; (c) redemptions in kind; (d) side pockets; (e) suspension of redemptions; (f) anti-dilution levy; (g) swing pricing; (h) mandatory liquidity buffers; and (i) side letters.
Available LMTs in Cyprus
LMTs, and the circumstances under which they can be used, must typically be listed in the constitutional documents of the investment fund, which are subject to approval by Cyprus Securities and Exchange Commission (CySEC). These tools are reinforced by the funds’ internal risk management and control system, which ensures that material risks are properly identified, assessed, measured, monitored and controlled.
According to the ESBR Recommendations, the regulators are not generally allowed to activate tools. The general exception to this is the suspension of redemptions, which may be imposed by the regulator if it is deemed to be in the public interest. It is further observed that in general the fund managers do not need regulatory authorisation to activate a-LMT.
However, in some jurisdictions including Cyprus, the use of the power to suspend redemptions is subject to previous permission of the regulator which may require more intensive oversight and prescriptive requirements.
In Cyprus, there is a set of a-LMTs which can help to mitigate liquidity risks for open-ended funds. These mechanisms include: (a) ex-ante tools, such as swing pricing and anti-dilution levies, which can be used to mitigate first mover advantage and systemic risk; and (b) ex-post tools, such as gates, side pockets, redemption-in-kind, notice periods and suspension of redemptions, allowing fund managers to manage investment fund liquidity by controlling or limiting outflows.
Swing pricing: The purpose of this tool is to protect existing investors from unfavourable price effects caused by transactions executed by other investors.
In practice, a swing pricing mechanism enables a manager to charge, or ‘swing’, the relevant transaction costs attributed to the net subscriptions, or net redemptions, respectively on the incoming or outgoing investors. Effectively, the NAV of the investment fund is adjusted downwards (upwards) in the case of large outflows (inflows) so that the transaction costs are borne by the investors buying or selling the shares rather than the existing investors.
It is observed that two types of swing pricing exist, being the ‘full’ and ‘partial’ swinging. Under full swing pricing, the relative costs are allocated and NAV is adjusted any time there are net inflows or outflows in a fund, hence swing pricing is applied to all subscriptions and redemptions by investors.
Under partial swing pricing, the costs are allocated and the NAV is ‘swung’ only when net inflows or net outflows exceed a predefined threshold expressed as a percentage of a fund’s NAV, hence swing pricing is applied to subscriptions and redemptions beyond a certain threshold.
Anti-dilution levy: The anti-dilution levy is a similar tool to the swing-pricing as it aims to protect existing or remaining investors against the adverse performance impact of new or leaving investors. This tool involves investors paying an additional charge to the investment fund when they subscribe to or redeem investment fund shares, in an attempt to offset any potential effect on the fund’s NAV resulting from the additional transaction costs. Compared to the swing pricing mechanism, it does not involve any adjustment to the value of the portfolio (e.g. NAV).
Redemption gates (deferred redemptions): A mechanism that temporarily defers the right of shareholders to redeem their shares in the fund and gives more time to management companies to permit realisation of assets in a more orderly and controlled manner in order to decrease the risk of fire sales under stressed market conditions.
This deferral may be full, so that investors cannot redeem their shares at all, or partial, so that investors can only redeem a certain portion of their shares.
Redemption gates can also be structured in such a manner that when redemption requests reach a certain threshold, a fund management company can decide to meet on a pro-rata basis any redemption requests and carry forward any residual requests over that threshold to the next dealing period.
Such gates may be imposed either at the fund-level (i.e. prohibition of redemptions if aggregate fund redemptions over a given period exceed certain percentage of the fund’s assets) or at the investor-level (i.e. prohibition from withdrawing more than certain percentage of investor’s interest in the fund) with differing thresholds.
Side pockets: This mechanism allows the segregation of the illiquid or difficult to value portion of a fund’s portfolio from remaining liquid investments of the investment fund via the creation of side pockets classes for the former. While the remainder of an investor's shareholding can be redeemed in the normal manner as described in the fund's constitutional documents, shares in the side pocket class cannot be redeemed until such time as the underlying assets become sufficiently liquid.
Therefore, side pockets are especially suitable whenever a fund has diverging investor interests. In this respect, investors needing liquidity can still cash in the liquid part of the investment fund’s investments at, presumably, low liquidation cost while investors who wish to remain in the investment fund are protected since the fund management company is not forced to liquidate assets at or under market prices if faced with high redemption demand.
Redemption-in-kind: Redemptions in-kind (or in specie) consist of non-cash payments (i.e. securities) to the redeeming investor of assets in the fund instead, in whole or in part, of cash. There would therefore be no need to liquidate large amounts of assets in the event of large-scale redemptions, thereby protecting both remaining and redeeming investors from any high transaction costs which might otherwise arise and avoiding any market price impacts.
Due to its operational challenges (such as complex transfer process and valuation procedures) and involved costs, this mechanism may be suitable for large redemption orders from institutional investors and it is generally less suitable for redemptions by retail investors.
From financial stability standpoint, such tool does not necessarily deal with contagion issues as the impact on the market might be the same, irrespective of whether it was the investment fund itself or the investor who sold the underlying assets into a falling market.
Notice periods: This tool provides fund management companies with additional flexibility to manage their liquidity without the need to sell assets at discounted price.
A notice period is stipulated in the constitutional documents of an investment fund and refers to the period of advance notice that investors must give to fund managers when redeeming their investments.
Some managers use a slightly different form of notice period whereby investors are subject to a redemption fee (i.e. a charge that a fund levies to investors when exiting the fund) unless the investor provides notice of the redemption.
Suspension of redemption: An extraordinary instrument of last resort for open-end fund structures, which allows fund managers or regulators to suspend redemptions during a liquidity crisis or for public interest or financial stability reasons, when no other option is available. For instance, a suspension of redemptions may be implemented when the market trading the underlying assets is closed or during exceptional market events affecting a large proportion of the underlying assets or the settlement system for payments (such as TARGET2) is closed on specific public holidays.
There are various reasons to suspend redemptions. Commonly reported reason as identified by IOSCO based on their report on Open-ended fund liquidity and risk management – good practices and issues for consideration, is to prevent a sudden outflow of capital, which may have additional adverse impacts for the fund, such as:
The compulsory sale of assets at prices that would disadvantage remaining investors;
A resulting portfolio for non-redeeming investors that is largely concentrated in illiquid assets and falls outside the risk tolerance horizon of the fund; and
A resulting portfolio that may be too small for the intended strategy of the fund.
EU Commission’s proposals to amend AIFMD and the UCITS Directive
On November 25 2021, the European Commission has published its legislative proposal to amend both the UCITS and AIFMD frameworks together with an Annex (together the ‘proposal’). The proposal includes significant developments in respect of the LMTs.
Specifically, following the ESBR Recommendations, the European Commission has proposed the harmonisation and convergence of the availability and use of LMTs to UCITS funds and open-ended AIFs in terms of protection of the value of investors’ money, reduction of liquidity pressure on funds and mitigation against broader systemic risk implications in situations of market-wide stress.
Minimum list of LMTs
The European Commission further proposed that member states ensure that the LMTs listed below are available to AIFMs managing open-ended AIFs and UCITS management companies:
Suspension of redemption and subscriptions;
Redemptions in kind; and
In addition to being able to suspend redemptions as explicitly provided under the current regulatory framework, the management companies would also be required to:
Choose at least one other appropriate LMT from the points 2 to 4 of the above list which harmonises the minimum list that should be available anywhere in the EU;
Implement specific policies and procedures for the activation and deactivation of any selected LMT and disclose to investors the specific circumstances in which the relevant LMT can be used; and
Notify the regulator without delay about activating or deactivating an LMT.
Under the proposal, ESMA is tasked with developing draft Level 2 technical standards (RTS): (a) to define and specify the characteristics of each of the above-mentioned LMTs; and (b) on the selection and suitable use of the LMTs.
The European Commission proposed that national competent authorities be empowered to require a fund manager to activate or deactivate an appropriate LMT, subject to prior notification to other relevant authorities, ESMA and ESRB. ESMA is mandated to develop RTS indicating when the competent authority’s intervention would be warranted and in which situations a competent authority may exercise its powers in respect of LMTs.
EFAMA’s position paper
While EFAMA welcomes the decision of the European Commission to adopt a targeted approach in its review of the AIFMD and UCITS Directive by including a list of LMTs as a means of managing liquidity risks and ensuring the fair treatment of investors, it considers that it is critical that the management of liquidity risk remains the responsibility of the fund manager.
Specifically, the management of liquidity risk as a function is directly linked to the investment strategy of the fund, its underlying assets and nature of its investor base. Removing this function from the manager or introducing automatic or prescriptive triggering of similar LMTs under similar circumstances would give rise to pro-cyclical effects, for example by creating a risk of rush for redemption where the imposition of a particular LMT is expected by investors in the market.
Importantly, EFAMA recommends that NCAs and ESMA be granted the power to request the manager to suspend redemptions or impose redemption gates in exceptional cases where circumstances so require, having regard to the interests of the unit-holders and to any financial stability risks, in consultation with the manager.
Similarly, any specification as to the criteria for the selection and use of appropriate LMTs by managers should adopt a principles-based approach by reference to existing guidance across EU jurisdictions as opposed to setting out prescriptive rules as regards instances where specific LMTs should be triggered.
European Parliament’s proposal
On May 16 2022, the European Parliament has issued its draft report on the European Commission's proposals to amend the existing AIFMD framework after discussions and feedback from regulators and stakeholders.
There are three important proposed areas of improvement related to the liquidity management provisions:
The range of LMTs from which an AIFM must select at least one as part of its liquidity management policy are proposed to be expanded to include swing pricing, anti-dilution levies and side pockets in addition to the original list of redemption gates, notice periods and redemption fees.
Clarity that the AIFM has primary responsibility for decisions on LMTs. In this respect, ESMA should allow time for the market to adapt before it applies the technical standards on selection and use of LMTs, in particular for existing AIFs.
Intervention by competent authorities in an AIF's liquidity management is intended to be a last resort and limited to exceptional circumstances and after consulting with the AIFM. Importantly, the report also proposes completely removing the ability for competent authorities to require non-EU AIFMs marketing in the EU to activate or deactivate LMTs.
Although there is still scope for change of the proposed amendments, the report is important in terms of formulating the final text of the AIFMD II.
Liquidity risk management has long been an important area of consideration for policy makers and the asset management industry.
Overall, fund managers shall consider the implementation of suitable risk management at the prelaunch (product development) stage and the postlaunch (ongoing management) stage of the product lifecycle taking into account the market conditions and the macroeconomic environment.
Existing regulatory frameworks have improved the functioning of markets, their transparency and ultimately the protection of investors. In the context of heightened attention for fund liquidity risks, questions have been raised regarding the sufficiency of the existing regulatory regime and whether additional rules are required.
Although the proposal does not seek to introduce extensive changes in respect of investor protection and financial stability, it proposes important changes in a number of areas including the LMTs.
In this context, the impact of Covid-19 and the Ukraine war and crisis on financial markets are closely monitored by ESMA in coordination with national competent authorities. The challenge of course is to focus on liquidity issues and the use of appropriate LMTs to ensure the orderly functioning of markets, financial stability and investor protection.