The Securities and Futures Commission (SFC) has recently issued a circular on the outcome of its survey and inspection of selected fund managers regarding their liquidity risk management practices.
The SFC noted inadequacies and deficiencies in a number of areas. These are set out in the appendix to the circular, together with observations and examples of such inadequacies and deficiencies, and the SFC’s expected standards (see overview below).
Liquidity risk is a key risk faced by funds, particularly in light of the fact that the majority of SFC-authorised funds are open-ended funds that provide for daily subscription and redemption. This is why the SFC has seen the need to conduct a focused survey and inspection. The SFC has indicated that liquidity risk management will continue to be the focus of its supervision of fund managers in the coming year.
Fund managers should therefore:
- review their current policies, systems and processes in light of the regulatory requirements and the observations noted by the SFC, and take immediate action to rectify any inadequacies or deficiencies;
- perform more frequent and enhanced liquidity stress testing to assess the potential impact on liquidity as well as the adequacy of their action plans and liquidity risk management tools; and
- have in place appropriate action plans regarding how they would meet their funds’ liquidity needs should any of the stress scenarios materialise.
The SFC surveyed selected licensed fund managers which manage SFC-authorised funds to understand their liquidity risk management processes and conducted inspections of some of these fund managers to assess:
- their compliance with its July 2016 circular on liquidity risk management; and
- their implementation of enhanced requirements under the Fund Manager Code of Conduct (FMCC), which came into effect in November 2018.
The SFC has indicated that liquidity risk management, together with the other key areas enhanced in the revised FMCC (securities lending and repurchase arrangements, safe custody of fund assets, and disclosure of leverage by fund managers), will remain a key focus of its supervision of fund managers in the coming year. It reiterates that it will not hesitate to take action against fund managers which fail to comply with regulatory requirements or meet expected standards.
Areas of concern observed by the SFC
Overall liquidity risk management framework
Fund managers should have a liquidity risk management framework in place which can identify and respond to potential pressure points, taking into account the investment strategies of the funds, the liquidity profiles of the funds’ assets, the funds’ liabilities, obligations and redemption policies, and market conditions. They should set appropriate internal liquidity targets or indicators and review them on a regular basis.
The SFC noted that some fund managers did not have an adequate framework. For example:
- internal liquidity targets were not set to assess and monitor liquidity risks;
- even if such targets were set, they were not reviewed on a regular basis to ensure that they remained appropriate;
- no clear guidance was provided to staff on how to handle exceptional events.
Assessment of liquidity profiles of fund assets and liabilities
Fund managers should regularly assess the liquidity profiles of funds’ assets, including using appropriate metrics and other factors to assess liquidity and categorise assets. They should also regularly assess the liquidity profiles of funds’ liabilities, taking into account the types of investors in the funds and the historical and future redemption patterns associated with each type, and the liquidity demands which the funds will likely face.
The SFC noted that some fund managers did not conduct adequate assessments of the liquidity profiles of fund assets and liabilities. For example:
- liquidity risk of fixed income investments were assessed with reference to the maturity of the bonds but no account was taken of other factors such as bid-ask spreads;
- when assessing the liquidity profiles of the funds’ liabilities, no account was taken of the profile and historical and expected redemption patterns of the investors.
Fund managers should regularly conduct assessments of liquidity under different scenarios. They should also develop stress test scenarios based on historical market conditions and previous redemption demands on the fund or similar funds, and consider developing stress test scenarios based on forward-looking hypothetical scenarios where appropriate.
The SFC noted that some fund managers did not conduct ongoing stress tests on some or all of the funds they managed, or used inadequate stress test scenarios, such as those which did not include historical market conditions or all of the instruments invested by the funds.
Governance structure for risk management
Fund managers should maintain a risk management governance structure commensurate with the nature, size and complexity of their operations, and the investment strategy adopted by each fund. They should have in place:
- a liquidity risk management function (which is functionally independent of the portfolio investment function) to monitor the implementation of liquidity risk management policies and procedures;
- members of senior management (or a committee) who are responsible for overseeing the work of the liquidity risk management function.
The SFC noted that some fund managers did not have an adequate risk management governance structure. For example:
- the risk profiles of certain funds were not reviewed by the risk management committee;
- an individual who was responsible for the day-to-day portfolio investment function was also responsible for overseeing the risk management function.
Risk management reports
Fund managers should prepare regular risk management reports to monitor liquidity risk on a timely basis, and review the data source and formulae used to ensure the accuracy of the report.
The SFC noted certain deficiencies, such as reports being generated on a quarterly basis for funds which were daily dealing funds, and errors in the reports caused by missing data or coding errors.
Fund managers should maintain:
- clear and sufficiently detailed liquidity risk management policies and procedures in writing;
- proper documentation of the rationales underlying the choice of key risk management measures, including stress test scenarios, where applicable;
- proper documentation of the liquidity assessments conducted to demonstrate compliance with regulatory requirements and expected standards.
The SFC noted that some fund managers had not maintained documentation on the above.