Implementing a European Liquidity Management Regime for Funds
Key takeaways
- AIFMD the most effective tool in achieving the goals of the Capital Markets Union. For there being little that needed fixing within the European alternative investment fund ecosystem European legislators used AIFMD II as an opportunity to address some shortcomings not exclusive to the existing regulatory architecture of the alternative investment fund management business.
- AIFMD II amended both AIFMD and the UCITS directive introducing provisions to establish a uniform European liquidity management regime applicable to AIFs and UCITS. The new regime provides for a mandatory selection of at least two liquidity management tools for open-ended AIF and UCITS (LMTs).
- There is acceptance already of the quantitative based LMTs as tools to deploy in exceptional liquidity stress scenarios. With the introduction of the European Liquidity management regime, the aim is to create a similar understanding for what concerns the anti-diluting LMTs and replace the traditional stigma for these tools with a new investor awareness about the inevitable costs of liquidity.
The market for alternative investment funds in Europe neared 7 trillion Euros by the end of 2022, making AIFMD the most effective tool in achieving the goals of the Capital Markets Union. That is with a growth rate of nearly 15% over the past years, in one with nearly 250 billion in private credit provided to businesses in Europe.
It does not come as a surprise that, when it came at reopening the legislative process for the mandated second iteration of the directive, there was little that needed fixing within the European alternative investment fund ecosystem. So as not to waste the legislative process, European authorities used AIFMD II as an opportunity to address some shortcomings not exclusive to the existing regulatory architecture of the alternative investment fund management business. Here we have a new European liquidity management regime for funds, which was missing so far, applicable also to UCITS.
The Legislative Mandate for ESMA
AIFMD II amended both AIFMD and the UCITS directive introducing provisions to establish a uniform European liquidity management regime applicable to AIFs and UCITS. The new regime provides for a mandatory selection of at least two liquidity management tools (one only for money market type funds) for open-ended AIF and UCITS (LMTs). These shall be chosen from the ones listed in the respective annexes to the directives and will be subject to certain restrictions and suggestions. The regime also provides for governance and investor disclosure obligations.
On the understanding that it would have not been viable to propose a one size fit all approach on LMTs, these shall be chosen by the AIFM or the UCITS manager after a suitability assessment relative to investment strategy, liquidity profile and redemption policy of a specific fund.
The European liquidity management regime introduced under AIFMD II is accompanied by a legislative mandate for ESMA to develop guidelines for the selection and calibration as well as regulatory technical standards on LMTs.
A consultation has been launched by ESMA on the draft second level regulation, which shall be presented for endorsement to the European Commission by April 2025.
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Types of Liquidity Management Tools
For the risk management at large – and the liquidity risk management in particular – being incumbent on AIFM and UCITS managers, the new European rules assign to them the choice of the mandatory LMTs to deploy for the open-ended AIFs and UCITS as well as the related suitability assessment.
It is noteworthy to mention that whilst AIFMD II and the amended UCITS directive list the liquidity management tools now available across the Europe Union, not all liquidity management tools are the same. These are divided into two categories. The quantitative or quantity based and the anti-dilution LMTs. The former category includes suspensions of redemptions, redemption gates and extensions of notice period. Dual and swing pricing, redemption fees and anti-dilution levy are instead part of the anti-dilution LMTs.
Based on the recommendations of the Financial Stability Board and considering that LMTs of different categories pursue also different liquidity management aims, managers should receive some guidance when choosing the most appropriate LMTs. According to ESMA, in selecting the two minimum mandatory LMTs, managers should seek to find a balance between LMTs to use in normal market conditions and the ones more suited to stress case scenarios.
At the same time, activation or de-activation of LMTs shall not exempt managers from their broader and general conduct of business and investment protection obligations, including ensuring best execution and fair treatment of clients, fair valuation and eligibility of assets as well as sound liquidity risk management.
The Value of Appropriate Investor Disclosures
Investor disclosure is at the heart of the European liquidity management regime, as evidenced by the provisions under AIFMD II and the revised UCITS directive. The second level regulation proposed by ESMA is essentially based on the recommendations from IOSCO on LMTs related disclosure. Accordingly, the published investor disclosure on LMTs shall be clear in the objective of the LMTs chosen by the manager, their operation and design.
One of the aims of LMTs disclosures shall be to improve investor awareness about the actual costs of liquidity of their investment. In other words, investors shall be offered an overview of the broad liquidity terms of the fund they plan to invest in. Through the pre-contractual disclosure received they shall be positioned to decide for an investment based on the understanding of the liquidity costs associated with portfolio transactions that are passed on to them by means of anti-dilution LMTs. The disclosure shall also distinguish between the use of LMTs in ordinary and extraordinary scenarios.
On an ex-post basis, LMTs disclosure also on the historical use might have its benefits. Not only for investors, but also for regulatory authorities, which would benefit from an enhanced oversight ability.
Governance and Oversight
The IOSCO recommendations in terms of governance arrangements on LMTs and liquidity risk management at large act as a base also for the new European rules as well as the second level regulation proposed by ESMA.
A principle of proportionality applies to governance. Related arrangements shall be commensurate to the size of the specific portfolio, complexity of the strategies, type of asset classes and relevant investment sectors. The governance framework shall be detailed and with sufficient controls ensuring for its periodical review and appropriate documentation and recordkeeping. Testing is especially important for LMTs. As part of the governance arrangements, managers shall be expected to regularly monitor, review and refine the calibration of LMTs also based on historical and market data available to ensure that the tools remain effective in achieving their objectives.
Conclusions
LMTs are not new and have been already in use for quite some time. Whilst the most immediately apparent aim of the introduced European Liquidity Management regime for funds is to fill existing gaps at national level and ensure that the entire spectrum of LMTs is available across Europe, there is also a less obvious intent.
There is an understanding and acceptance already of the quantitative based LMTs as tools to deploy in exceptional liquidity stress scenarios. With the introduction of the European Liquidity management regime, the aim is to create a similar understanding for what concerns the anti-diluting LMTs and replace the traditional stigma for these tools with a new investor awareness about the inevitable costs of liquidity.