FCA Warns Asset Managers on Liquidity Risk
Posted by Colin Lambert. Last updated: July 10, 2023
The UK’s Financial Conduct Authority (FCA) says it has reviewed liquidity management in asset managers and found that firms need to increase their focus on liquidity risk – as things stand, the regulator says, gaps observed in liquidity management could lead to a risk of investor harm.
The observations are potentially very ominous given asset managers in particular are seen as vulnerable to operational risk resulting from next year’s shift by US securities markets to T+1 settlement. This means international investors will be managing cash flow in a much more complex environment given how the European Union remains at T+2 and is highly unlikely to move any time soon.
The FCA says in its report that asset managers need to manage liquidity effectively. “Doing so is vital so investors are able to withdraw their investment in line with their expectations and at an accurate price that reflects its value,” it states. “Poor liquidity management can bring with it serious risks for investors and to wider market stability.”
It was not all bad news, however, for the FCA says some firms demonstrated very high standards, with the review highlighting good practices seen. There was, however, a wide disparity in the quality of compliance with regulatory standards and depth of liquidity risk management expertise, it adds, notably a minority of firms in the review had inadequate frameworks to manage liquidity risk.
The review found that the building blocks and tools for effective liquidity management were usually in place at firms, but they lacked coherence when viewed as a full process and were not always embedded into daily activities. It also found that many firms attach insufficient weight to liquidity risk management in their governance oversight arrangements, as well as insufficient challenge and escalation, particularly in volatile environments.
A wide range of approaches to liquidity stress testing were observed, with some methodologies insufficient to assess actual liquidity of the portfolio, using assumptions that were not appropriately conservative. “For example, some firms’ models assumed that they would always sell the most liquid assets, without ever giving regard to the liquidity of selling a ‘vertical slice’ of the portfolio,” the FCA states.
Firms typically had governance and organisational arrangements in place to meet large one-off redemptions but did not have sufficient arrangements in place to oversee cumulative or market-wide redemptions that could have a significant impact on a fund. Also, wide variations in the application of anti-dilution tools such as swing pricing, which could affect the price investors receive when redeeming, were observed.
“We have seen examples in the market where liquidity risk has crystallised and the impact this can have on investors,” says Camille Blackburn, director of wholesale buy-side at the FCA. “This review should serve as a warning to all asset managers that they need to get this right. We expect boards to discuss our findings and assure themselves that their firms are not amongst the minority with serious gaps in managing liquidity risk.
“It’s vital the outliers take quick action,” she adds. “They risk regulatory intervention if they don’t take this opportunity to address weaknesses.”