Liquidity in open-ended funds – the BoE and FCA survey report

On 26 March 2021, the Bank of England (BoE) and FCA published a report, which sets out the findings of a joint survey which they conducted as part of their wider review of liquidity mismatches and open-ended funds.

Background

In December 2019, the BoE’s Financial Stability Report noted the view of the Financial Policy Committee (FPC) that the mismatch between some funds' redemption terms and the liquidity of their assets led to investors who redeem ahead of others being at an advantage over others, particularly in a stress situation. This, it was felt, could become a systemic risk and result in fire sales of assets, further amplifying asset price moves and disrupting the availability of finance in the real economy.

In the context of the joint Bank-FCA review into vulnerabilities associated with liquidity mismatch in open-ended funds, the FPC has established three key principles for delivering greater alignment between redemption terms and underlying assets:

• pricing adjustments
• liquidity classification; and
• notice periods/redemption frequency.

The BoE and FCA agreed to undertake a joint review into vulnerabilities associated with this liquidity mismatch in open-ended funds, including a joint survey of UK authorised open-ended funds and their liquidity management practices.

Who (and what?) did the survey cover?

The survey received responses from 272 of the 313 UK authorised open-ended funds approached. These were primarily corporate bond funds (including high-yield bond funds) but also included mixed-bond funds and a small number of small and medium cap equity funds.

Surveyed funds were asked to report on:

• the fund's characteristics and investment strategies
• the fund manager's approach to liquidity management and cash management tools (which were available and how these were used in practice)
• the fund's approach to pricing adjustments
• the governance of liquidity tools and
• the fund manager's approach to liquidity assessment and valuations.

As the survey ran between August and September 2020, it captured information both during normal market conditions (2019 Q4), and the extreme market stress across 2020 Q1-Q2 as a result of the COVID pandemic. 

The BoE and FCA considered that their results provide "an insight into the liquidity management of UK authorised funds investing mainly in less liquid assets, including the range of management practices and tools, and the challenges around their application" as well as demonstrating how liquidity management practices performed during a market stress period such as the early days of the COVID-19 pandemic in March/April 2020.

What conclusions have the BoE and FCA drawn?

The survey found that:

• funds have a large number of liquidity management tools available and, if set out in their prospectuses, their managers utilise them, particularly during stress events - but they predominantly use swing pricing 
• swing pricing and other anti-dilution mechanisms were widely applied to incorporate the liquidity costs associated with flows faced by funds during normal and stressed market conditions
• net outflows in March were much larger for funds with predominantly professional investors (institutional and/or intermediated) and lower for direct retail funds
• there was divergence in funds' approach to liquidity management, with significant differences in how similar funds facing similar flows applied swing pricing. Most funds managers did not factor market impact explicitly into their swing factors and few had models in place to estimate fixed-income spreads when needed
• varying levels of sophistication were seen in how fund managers measure the liquidity of their funds' assets - for corporate bond funds, fund managers' own classification of their holdings across different liquidity categories using an indicative framework varied substantially, partly reflecting the trade-off between flexibility and consistency in establishing liquidity classifications
• managers of most corporate bond funds were seen to overestimate how liquid their holdings were, with some funds being described as "particularly overoptimistic". Managers of most corporate bond funds classified most of their assets as either 'liquid' or 'less liquid with high valuation certainty' and some categorised most of their holdings as liquid under almost all market conditions, which - in the eyes of the BoE and FCA - appeared 'not realistic' on the basis of their exposure to less liquid assets.