The International Organization of Securities Commissions (IOSCO) has published consultations with final recommendations for all three of this report’s subjects. It published two consultation papers recommending best international practices for liquidity risk management for funds, both of which closed in September 2017. The first consultation sought to address structural risks identified by the Financial Stability Board (FSB) on liquidity risk management in the asset management industry. It focuses on exchange-traded funds and builds on the guidance set out in its 2013 report entitled “Principles of Liquidity Risk Management for Collective Investment Schemes.” The first consultation primarily concerns itself with investor disclosures, aligning asset portfolios with redemption terms, liquidity risk management tools and stress testing.
The second consultation is more concerned with detailing good practices for open-ended fund liquidity risk management. It serves as a reference on liquidity risk regulation for various jurisdictions and provides examples from the industry on liquidity risk management tools. It describes best practices for liquidity risk management for use by regulators, fund managers and investors.
The comments to this second consultation culminated into IOSCO’s final recommendations, released on 1 February 2018, which details additional liquidity management tools and adopts a principles-based approach:
“There are a number of techniques and tools available to fund managers to aid in the management of liquidity needs. These include a number of ex ante fund features that can either be embedded in the product in the design phase (which can contribute to a better management of liquidity risk) or are part of regulatory requirements:
Pass on the transaction costs to the subscribing/redeeming investor (swing pricing, redemption in kind); or
Restrict or slow down access to investor capital (notice periods, redemption gates, suspension of redemptions etc.); or
Test the robustness of liquidity requirement under different scenarios (stress testing).”
The European Union’s Markets in Financial Instruments Directive II (MiFID II) has been the main regulation facing fund managers, with other jurisdictions outside the US adopting all or some of its requirements. MiFID II went into effect in January 2018. The directive builds upon the 2007 version of the rules by including fixed income, FX and OTC derivatives within its ambit.
The second iteration of MIFID also has stricter transparency and reporting norms for all aspects of the financial institutions, however, best execution norms for fund managers is most relevant to the scope of this report. The rules require that best execution requirements apply for orders made by retail as well as professional investors. Investment firms must determine if they meet the definition of execution venue under the rules, and consequently whether they need to publish one or more of three deliverables - quarterly reports on execution quality, an annual top five execution venue report, and an annual report on execution quality monitoring of all used execution venues.
Firms must take all sufficient steps to obtain the best possible result for their clients, taking into account price and costs, speed, likelihood of execution and settlement, as well as size, nature or any other consideration relevant to the execution of orders.
Rule 22e-4, issued on 13 October 2016, defines liquidity risk as “the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.” The rule introduces security level risk assessment methodologies and minimum liquidity thresholds as well as board oversight. Funds with US$ 1 billion or more in net assets must comply with the rule by 1 December 2018, while smaller funds have until 1 June 2019.
The rule requires that funds adopt a liquidity risk management program for the classification of their portfolio holdings according anticipated redemption. The funds are also required to maintain a portion of their portfolios in “highly liquid” investments.
Key areas of focus in the rule are:
The Securities and Futures Commission (SFC) has required that firms “develop, document and implement” a liquidity risk management framework that they can justify to the regulator. The framework must be unique to each fund, taking into account relevant “market, trading, and investment-specific considerations,” along with market conditions, position sizes and redemption patterns. The regulation applies to both open-ended and closed-ended funds as well as discretionary accounts.
The framework’s main principles include:
Singapore’s proposed liquidity risk guidelines apply to four areas of the fund: governance, product design, ongoing liquidity risk management and stress testing.
Governance: The board of directors and senior managers are responsible for ensuring that the asset management firm has a liquidity risk management function with adequate oversight and powers. A clear line of accountability must be established for implementing the liquidity risk management framework and managing liquidity risk.
Product design: Asset management firms should ensure that their subscription and redemption terms are aligned with the fund’s investment strategy and liquidity profile. Asset managers should keep a record and understand investors’ historic and expected redemption patterns in their liquidity investment. They should also consider the appropriateness of liquidity management tools and ensure their use does not compromise on the fair treatment of investors. These tools should be disclosed in the offer documents with an explanation of how they may impact investor redemption rights.
Ongoing liquidity risk management: Asset management firms are required to monitor trends in their fund’s investor profile, including concentration and redemption patterns during a regular assessment of the fund’s liquidity profile. There must be internal thresholds for the fund’s liquidity that are proportionate to redemption obligations and other liabilities. Any decision to suspend redemptions should be reviewed and approved by the senior management and board of directors and be immediately notified to the MAS.
Stress testing: Asset management firms should conduct regular stress testing as well as a review of the underlying assumptions of the stress scenarios. Any asset management firms not conducting stress tests should document their reasons for not doing so, which should then be reviewed and approved by the board or senior management.
In addition to the above, money market funds must hold a minimum amount of liquid assets to ensure they meet redemption requests. At least 10% of a money market fund’s NAV needs to be in daily maturing liquid assets and at least 20% of a money market fund’s NAV must be in weekly maturing assets. The LRM framework also imposes an additional portfolio weighted average maturity limit of on money market funds to the tune of 60 calendar days for short-term money fund and six months for others.
Asset management firms have three months from 27 October 2017 to adopt and implement the guidelines.
The Hong Kong Securities and Futures commission (SFC) released its circular on best execution on 30 January 2018, outlining i’s standards for ensuring execution quality for licensed corporations. The focus of best execution policy, according to the regulator, is to get the “best available terms” for the client. The guidance focuses on governance, management supervision, monitoring and controls, echoing some of the requirements of MiFID II.
The SFC’s best execution guidance focuses on the following areas -
1. Governance and management supervision: The SFC called for sufficient oversight on matters relating to best execution. Firms should establish and regularly update best execution policies and procedures. The regulator suggested that best execution policies and procedures should address:
Policies should also address, where applicable, handling of client orders with multiple quotes or insufficient pricing information and disclosures to clients. The SFC identified best practices in best execution as including post-trade execution reports, testing order outcomes with various benchmarks like VWAPS, and practical guidance to staff on regional regulation.
2. Best Execution factors
Firms should take sufficient steps to obtain best execution, taking into account factors like price, cost, speed of execution/settlement, likelihood of execution/settlement and size and nature of the order. Specific instructions from a client will not release the firm from its best execution obligations.
3. Applicability of best execution
Best execution obligations apply when firms enter into agency or back-to-back principal transactions with clients. Firms should make their own assessment to determine if a client relies on them to protect their interests before entering into a principal (not back-to-back) transactions with clients in order to determine the applicability of best execution obligations.
4. Responsibilities of execution staff
Execution staff and their supervisors form the first line of defence in the trade execution process. They should demonstrate diligence while handling client instructions, monitoring execution outcomes and obtaining multiple quotes.
5. Controls and monitoring
Firms should have adequate controls and monitoring to review the quality of execution and to detect and address anomalies. Appropriate metrics and reference benchmarks should be used depending on the type of business being conduted.
6. Arrangement with affiliates
Firms should carry out due diligence on affiliates, connected parties or third parties involved in trade execution with a systematic process to continuously monitor execution outcomes. Even if orders are routed through affiliates, the primary responsibility to deliver best execution remains with the licenced corporation.
The Monetary Authority of Singapore (MAS) issued a consolation paper on best execution on 20 November 2017 to formalise its expectations on what constitutes best execution. The rules apply to asset managers, banks, merchant banks and securities firms. Similar to the SFC’s guidance, asset managers will need to have policies and procedures in place to ensure customers’ orders are executed on the best available terms.
Asset managers should also consider various factors in ensuring best execution including price, costs, speed, likelihood of execution and settlement, size and nature of order. Best execution obligation will apply to customers regardless of whether the order is being routed through an affiliate or placed directly to the market. The obligation for best execution applies regardless of the type of customer, except for when dealing with accredited, institutional or expert investors, wherein the asset manager can make a determination on its obligation depending on whether the client relies on it to execute his/her order on the best available terms. This is different from the obligation in Hong Kong where best execution obligations are determined based on the nature of the transaction with the client.
Another departure from the Hong Kong guidance is present in the MAS proposal that a firm is considered to have fulfilled its obligation for best execution if it follows specific customer instructions. In Hong Kong, the asset manager may not be relieved of its obligation for best execution even when a customer has provided specific instructions.
Asset managers must also consider and document the merits of selecting a venue or broker for best execution purposes when more than one is available. Asset managers must also periodically monitor their compliance with best execution policies and their effectiveness. Policies should be made available to customers before the placement or execution of customers’ orders.
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