A sketch

On 23 June 2021, the Financial Markets Authority (‘FMA’) released its report ‘MIS liquidity risk and management review’.

The report follows the August 2020 self-assessment survey completed by 51 managed investment scheme (‘MIS’) managers. It outlines the results of that survey and contains numerous recommendations on liquidity stress testing frameworks, processes, and procedures.

Overall, the FMA appears fairly unimpressed with the results of the survey, describing MIS managers as generally being ‘overly optimistic’ about their liquidity risk management capabilities. Key findings from the survey include the following:

• Liquidity stress testing – this is generally occurring infrequently and in an ad hoc manner, and is often missed during a fund’s product design phase. 43% of MIS managers surveyed did not provide a date for their last liquidity stress test, or said they could not remember it.
• Liquidity management tools (‘LMTs’) – many MIS managers do not have sufficient LMTs or documented ‘fair treatment’ requirements. Instead, there is an over-reliance on liquid assets as the default response to a liquidity crisis.
• Liquidity risk governance, frameworks, processes, and metrics – some analysis of asset liquidity is occurring, but there is room for improvement in depth and breadth. Metrics are not widely reported to senior management or the board, and 49% of MIS managers surveyed are not using any ‘early warning’ metrics.

The report contains a list of recommendations (ordered into low, medium, and high priority) for MIS managers to consider. These recommendations build on the principles set out in the liquidity risk management good practice guide released last year by the FMA.

The expectations set out in the report reflect the level of care, diligence, and skill that the FMA considers a prudent person in the profession would exercise in respect of liquidity risk management in most circumstances. It will be used as a benchmark when assessing a MIS manager’s capability to effectively perform licensed services and to exercise the level of care, diligence, and skill of a prudent MIS manager.

Who will this impact?

MIS managers, and their boards and investment teams will need to consider the recommendations set out in the report. At minimum, the FMA expects MIS managers to review and implement all high priority recommendations (see below) that are relevant to their funds.

MIS managers should also look out for a follow up survey from the FMA, aimed at understanding how they would react to two hypothetical liquidity risk scenarios. The timing of this proposed survey is yet to be confirmed.

What the FMA wants

The FMA encourages the MIS sector to review the report (together with the good practice guide) and consider implementing any relevant recommendations. At minimum, it would be prudent for MIS managers to review and implement the following recommendations (which are categorised as ‘high priority’):

Liquidity stress testing

• Undertake liquidity stress testing for all funds at least annually, and more frequently if fund structure or market conditions warrant it. MIS managers must still take responsibility for this where the testing is undertaken by a third party.
• Undertake sensitivity analysis/ stress-testing to gauge the potential impact of withdrawals by a fund’s largest investors.
• Review and constructively challenge the adequacy of your liquidity risk management frameworks, policies, and procedures and risk appetite against the obligations associated with your MIS manager licence.

LMTs

• Explicitly define the LMTs you have available for use. Assess the conditions under which they will be deployed and withdrawn and how their use ensures ‘fair treatment’.
• Review and expand your suite of LMTs, with a particular focus on LMTs that would be useful in the ‘pending’ phase (where a liquidity event is foreseeable but not imminent) of an emerging liquidity crisis.
• Consider the use of LMTs in conjunction with other complementary tools (such as early-warning metrics) to effect better outcomes.

Liquidity risk governance, frameworks, policies, procedures, and metrics

• Review your liquidity risk management policies in accordance with good practice principles and ensure they are implemented in a way that reflects the particular characteristics of each fund.
• Have an asset valuation policy that includes ‘fair valuation’ rules, particularly when market valuations are unavailable.
• If you are a fund-of-funds MIS manager, have good oversight of, and proactively consider on an ongoing basis, the liquidity stress testing and use of LMTs undertaken by the underlying managers.
• Have a definition of ‘illiquid assets’ suited to your funds’ asset composition (current and targeted) so that assets can be accurately monitored for liquidity.

Our thinking

• The MIS sector should take heed of the report – especially given the FMA’s comment that it sets out the benchmark by which liquidity risk management capabilities will be judged, subject to relevant circumstances.
• We expect liquidity risk to be a continued area of focus as the New Zealand MIS market continues to grow in size – and particularly in light of the current low interest rate environment.
• The report signals the FMA’s willingness to consider taking enforcement action if it considers that a MIS manager does not have adequate liquidity risk management capabilities (and therefore does not meet, or no longer meets, the requirements of a MIS manager licence). In these circumstances, FMA can censure a MIS manager, suspend or cancel its licence, and/or impose conditions on its licence.
• We expect that most MIS managers should have reviewed their liquidity risk management practices (or scheduled a review) following release of the good practice guide last year. Steps should now be taken to assess those practices against the specific recommendations contained in this report, and actions taken to address any gaps identified.
• Now would be an opportune time to review available LMTs (such as swing-pricing, anti-dilution levies, side-pocketing, and redemption suspensions) and consider making any necessary changes to fund governing documents to ensure liquidity risks can be managed. Appropriate disclosure of those LMTs in offer documents will also be required.