Regulators issue guidance to help fund firms address liquidity risks in normal and stressed market conditions
Several months after the COVID-19-driven market-downturn sparked an investor rush that forced some fund managers to gate redemptions, the Canadian Securities Administrators (CSA) is encouraging the industry to take a preventative approach to avoid such problems.
In a recently issued note, the CSA sought to provide guidance to investment fund managers on how to develop and maintain an effective liquidity risk management (LRM) framework.
“Taking a preventative and proactive approach to liquidity risk management is critical to ensuring such risks are appropriately managed,” Louis Morisset, CSA chair and president and CEO of the Autorité des marchés financiers said in a statement. “We are publishing this guidance to support investment fund managers in their ongoing development and maintenance of robust, effective liquidity risk management frameworks.”
In its guidance, the CSA defined liquidity risk as the risk of a fund being unable to satisfy redemption requests without it materially impacting the remaining securityholders of the fund. “If a fund does not manage liquidity risk properly, there could be adverse outcomes for the fund and its investors,” the guidance said.
The guidance highlighted international regulatory and policy developments that have put LRM into greater focus – notably including recommendations from the FSB in 2017 and IOSCO in 2018 – along with domestic regulations that support an increased emphasis on liquidity risk.
“In Canada, the Bank of Canada (BoC) recently noted funds’ liquidity/redemptions mismatch as a potential area of structural concern,” the CSA said, adding that the central bank sees asset managers are apparently taking the appropriate mitigation measures.
It highlighted five key areas that characterize a robust and effective LRM framework, including:
- Strong and effective governance;
- Creation and ongoing maintenance;
- Stress testing;
- Disclosure of liquidity risks; and
- Use of LRM tools to manage potential and actual liquidity issues
Stress testing, the guidance said, is important to understand the implications of certain risks – including general market stress, interest-rate risk, credit risk, and reputational risk, among others – on a fund’s ability to meet redemption requests.
Disclosures of liquidity risk, the guidance added, must be made in a fund’s prospectus as it declares material risks to investors. The fund’s prospectus must also inform investors that, under extraordinary circumstances, their rights to redeem securities may be suspended, with a specific description of circumstances when a suspension could occur.