The Financial Markets Authority (FMA) has released a consultation document on its proposed guidance on liquidity risk management (LRM) for Managed Investment Scheme (MIS) Managers and Supervisors under the Financial Markets Conduct Act 2013 (FMCA).
A link to the consultation document can be found here.
Who should read this? Why?
The proposed guidance will update and replace the FMA’s existing Liquidity Risk Management Good Practice Guide from April 2020. Supervisors and MIS Managers should read the proposed guidance to help inform their understanding of what the FMA considers to be “good practice”, however, the consultation is also aimed at advisers, industry, and consumer groups.
What does it cover?
Overall, the proposed guidance is aimed at ensuring more effective LRM in managed investment schemes. The FMA points out that effective LRM is integral to the overarching responsibilities of MIS Managers and Supervisors under the FMC Act to act in the best interests of investors and (in the case of MIS Managers) treating investors equitably.
The proposed guidance updates and replaces the current guide to better reflect recommendations made by the International Organisation of Securities Commissions (IOSCO) and the Financial Stability Board (FSB) but also states areas where MIS Managers and Supervisors need to do more, specifically in relation to monitoring and tools to manage liquidity risks in normal and stressed market conditions. The proposed guidance also expressly communicates the view that having, and overseeing, effective LRM is a legal obligation of MIS Managers and Supervisors, respectively.
The FMA also had regard to its report on MIS liquidity risk management from June 2021 (which contained recommendations from the FMA following its August 2020 self-assessment survey completed by 51 MIS Managers) when preparing the proposed guidance. The report identified the following key areas for improvement, which have been incorporated into the proposed guidance:
- Better frameworks, policies and procedures covering LRM
- More regular stress testing
- More tailored liquidity management tools (LMTs) made available for use.
The proposed guidance stresses that, while the responsibilities of MIS Managers will vary depending on the scheme(s) they manage, MIS Managers are expected to inform Supervisors of any significant changes in the liquidity profile of the funds they manage as soon as they occur.
The proposed guidance also outlines what is expected of Supervisors, namely that they regularly assess a MIS Manager’s LRM framework and consider if it achieves an adequate level of resilience. The FMA expect Supervisors to adopt a risk-based approach in undertaking these assessments, by tailoring frequency, scope, and intensity.
The proposed guidance sets out what the FMA considers to be 11 (eleven) key features of an effective LRM. The FMA do not prescribe how MIS Managers must adopt each feature, instead stating that MIS Managers have discretion about how each feature is used and developed in the context of the funds a MIS Manager is responsible for. The key features are:
- Overarching framework and strategy: documented process for identifying and manging liquidity risk, supported by robust contingency planning.
- Governance: good governance arrangements, including board and senior management approval, oversight and review.
- Contingency plans: formal contingency plan that clearly sets out strategies for addressing liquidity shortfalls in emergency situations.
- Product design: subscription and redemption terms are appropriate for a MIS Manager’s investment strategy and product offering.
- Disclosure and communication: ensuring investors are aware of a fund’s liquidity risk through ongoing disclosure and proactive communications.
- Monitoring framework: appropriate monitoring and reporting on levels of liquidity and liquidity risk in funds to allow effective oversight and decision-making.
- Liquidity management tools: having a range of appropriate LMTs readily available to deploy in specific circumstances, including where redemption obligations cannot be met in the ordinary course of business.
- Stress testing: having a stress testing framework for each scheme, with appropriate settings for governance and oversight, scenario testing, and ongoing liquidity risk management.
- Use of leverage to adjust risk/return: where leverage (whether traditional balance sheet or synthetic leverage) is used to boost expected investment returns, the risks and impacts for the fund and the broader financial system are well understood and taken into account in the MIS manager’s LRM policies and its disclosures to investors.
- Record keeping, data and systems: ensuring appropriate records are kept relating to the performance of its LRM processes.
- Evaluation and review: undertaking periodic evaluation and reviews (no less than annually) of LRM practices to ensure these remain effective and fit for purpose.
The proposed guidance elaborates on each of these key features, giving more detail as to the FMA’s expectations about what contributes to an effective MIS LRM practice.
Liquidity risk for managed investment schemes has been a concern for the FMA since at least April 2020 when FMA issued its 2020 Guide. That was in the context of the market turbulence of the first wave of Covid-19 impacts on the markets.
It is apparent that those concerns about liquidity risk in managed funds continue, as we are now in an environment in which many New Zealanders are under financial pressure with continuing inflation and volatile investment returns. In addition, the FMA is conscious of the increasing size of the managed funds market (particularly the growth in funds under management in KiwiSaver).
When the FMA ran its self-assessment survey in August 2020, it found that while MIS Managers generally appeared to have a positive view of their liquidity risk management capabilities, including stress testing, in FMA’s view, many MIS Managers were “overly optimistic” about this, causing the FMA to warn against the potential for complacency.
The FMA have now set out their expectations of MIS Managers and Supervisors in the proposed new guidance and indicated a willingness to utilise the regulatory tools at their disposal to respond to those whose LRM frameworks remain “below expectation”.
The proposed guidance makes it clear that effective LRM is considered a legal obligation of both MIS Managers and Supervisors, and that the FMA considers industry efforts to date have left room for improvement.
In our view, it is important to understand that this does not mean managed investment schemes can only be invested in highly liquid investments. Rather, it means MIS Managers should take into account, in the design and management of their MIS, liquidity requirements in both normal and stressed scenarios. As the FSB pointed out in its consultation, for open-ended fund managers, it may be appropriate that:
- fund design has redemption terms that are consistent with the investment strategy and liquidity of the fund’s projected asset holdings;
- the fund’s liquidity, is managed in normal and stressed market conditions, to remain consistent with the fund’s redemption terms;
- reviews of redemption terms are carried out at appropriate intervals.
Of course, in New Zealand, the case of KiwiSaver, there are statutory requirements to allow members to transfer their balances on short notice, which will need to be taken in to account. But it may still be acceptable to have a proportion of a scheme invested in less liquid investments, especially where that is built on an understanding of stress experienced through the global financial crisis and the Covid-19 pandemic.
We encourage MIS Managers (and Supervisors) to familiarise themselves with the FMA’s expectations and ensure that their LRM frameworks, including governance practices and LTMs, align with these new expectations.
Submissions on the consultation close on 10 November 2023. If you have any questions about the proposed guidance or need help with the consultation, please contact one of our experts.
This article was authored by William Ma, a Law Clerk in our Banking and Financial Services team.