Bank of England warns fund liquidity issues pose ‘systemic risk’

18 December 2019

The Bank of England has warned that liquidity issues surrounding open-ended funds pose a “systemic risk.”

As part of its ongoing review, the Bank found that the mismatch between the liquidity of some funds’ assets and the redemption terms means there is an advantage to investors to redeem ahead of others.

It could also result in forced asset sales, testing markets’ ability to absorb them, further amplifying asset price moves, transmitting stress to other parts of the system, and disrupting the availability of finance in the real economy.

To tackle the issue, the Bank outlined several proposals in its Financial Stability Report, including that the liquidity of funds’ assets be assessed either as the price discount needed for a quick sale of a representative sample of those assets or the time period needed for a sale to avoid a material price discount.

It also argues that redeeming investors should receive a price for their units in the fund that reflects the discount needed to sell the required portion of a fund’s assets in the specified redemption notice period.

Finally, redemption notice periods should reflect the time needed to sell the required portion of a fund’s assets without discounts beyond those captured in the price by redeeming investors.

According to the Bank, this would not only enhance the UK’s financial stability, but promote funds’ ability to invest in illiquid investments.

Ryan Hughes, head of active portfolios, AJ Bell, said: “The fact that the Bank of England has included vulnerabilities of the open ended fund market in its Financial Stability Report tells you just how seriously they are taking the issues that have dogged the asset management industry this year.

“Ever since Mark Carney made his ‘built on a lie’ comment regarding liquidity mismatches in open ended funds, the BoE was likely to step in to force change in the asset management industry.”

According to Hughes, the proposals set out make it clear that the current rules are not tough enough, despite the fact that the FCA only proposed tougher rules for certain types of funds in September.

He added: “The proposals could be interpreted that the use of daily trading for illiquid assets may be coming to an end. In addition, we may see more frequent use of ‘market value adjustments’ where the price of funds are manually marked down for those wanting to redeem to reflect the true value of the underlying assets.”

The Bank’s review will now consider how its principles could be implemented and in particular, the degree of market stress against which liquidity measures and redemption terms should be measured.

However, Ian Sayers, chief executive, the Association of Investment Companies, said the recommendations put forward by the Bank may not be effective in reducing systemic risks.

He commented: “We are not convinced that using pricing adjustments to manage the flow of redemptions will work. It would also be extremely confusing for consumers. If the discount that is applied increases at times of market stress, investors will still be incentivised to leave the fund earlier, before these pressures become acute.  This ‘first mover advantage’ is a primary cause of systemic risk and needs to be eliminated.

“These problems could be avoided by our proposal for ‘reliable redemption’, where the redemption terms of open-ended funds are fixed at the outset and matched to the time it would take to sell the assets in an orderly market.  This would be much simpler to convey to investors and does not penalise them simply for wanting to leave the fund. It also avoids flooding a weak market with assets at low prices and protects against systemic risks.”

The conclusion of the Bank of England’s review is expected in 2020 and will be incorporated into the FCA’s standards for open-ended funds.

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