February 11, 2025
Submitted via survey link
RE: IOSCO Consultation Report, November 2024, “Guidance for Open-ended Funds for Effective Implementation of the Recommendations for Liquidity Risk Management,” (CR/07/2024)
Proposed Guidance 1 – Determining asset and portfolio liquidity
1. To what extent does Proposed Guidance 1 help responsible entities to better integrate quantitative and qualitative factors to determine the liquidity of the portfolio? Have all the critical elements been captured?
Comments are provided jointly on behalf of The Securities Industry and Financial Markets Association (“SIFMA”) and the Asset Management Group of SIFMA (“SIFMA AMG”).
SIFMA AMG brings the asset management community together to provide views on U.S. and global policy and to create industry best practices. SIFMA AMG’s members represent U.S. and global asset management firms that manage more than 50% of global AUM. The clients of SIFMA AMG member firms include, among others, tens of millions of individual investors, registered investment companies, endowments, public and private pension funds, UCITS and private funds such as hedge funds and private equity funds.
SIFMA is the leading trade association for broker-dealers, investment banks, and asset managers operating in the U.S. and global capital markets. On behalf of our members, SIFMA advocates for legislation, regulation, and business policy affecting retail and institutional investors, equity and fixed income markets, and related products and services. SFIMA serves as an industry coordinating body to promote fair and orderly markets, informed regulatory compliance, and efficient market operations and resiliency. SIFMA also provides a forum for industry policy and professional development. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association (“GFMA”).
Fund v. Market Liquidity
As a threshold matter, liquidity management for an individual fund under ordinary market conditions is a different matter than liquidity management for a fund when the entire market is challenged. Fund-specific liquidity construction in ordinary market conditions is manageable with prudent management.
Funds can take steps to mitigate liquidity risks if overall market liquidity changes. Market liquidity changes and the specifics of a particular significant market liquidity event, however, are difficult to predict. Both are important, but they have different fact patterns and available tools. The two are related but should not be conflated.
In the same way, the liquidity of individual instruments should not be conflated with overall fund liquidity and the ability to meet redemptions. The overall picture of fund liquidity is relevant to redemptions, not individual holdings viewed in isolation. Individual holdings and portfolio construction are important, but funds have different shareholder compositions with different behaviors and funds have different tools such as credit lines and interfund lending. As the IOSCO Consultation notes, notice periods and redemption terms can also be important mechanisms to help manage liquidity. In many cases, it is in the best interests ofshareholders and fund returns for some portion of the fund’s holdings to be in less liquid or even illiquid instruments. It is also important for issuers and the broader capital markets that funds be viable investors across asset classes with different liquidity profiles.
Pitfalls of liquidity criteria and liquidity thresholds
Proposed Guidance 1 focuses on determining asset liquidity. Investment and risk professionals managing a fund might conceptually think about liquidity assessment through a spectrum of liquidity. Having a vocabulary that references relative liquidity can be helpful. However, caution is advised before applying a system of prescriptive classification methodologies and mandated thresholds. Attempting to apply a one-size-fits-all approach will inevitably lead to debates about the appropriate thresholds and the methodologies used to drive the underlying classifications.
By way of illustration, the IOSCO Consultation’s definition of “Less liquid” includes assets that, in stressed conditions, might not be readily convertible into cash without significant discounts and whose valuations might become more difficult to assess with certainty (emphasis added). Operationally, a fund would be challenged to develop and maintain objective means of assessing classifications based on predictions of what might occur in the future in unknown market conditions.
Given the ambiguous nature of the criteria and arbitrary nature of the thresholds, they would become hard and fast guidelines that govern investment decisions. Funds would execute trades with an eye on the thresholds that may not have been needed otherwise. The IOSCO Consultation rightly notes the risk of threshold/cliff edge effects that distort behavior around arbitrary thresholds.
Stressed conditions
There are also drawbacks to letting a stress condition serve as the baseline for ordinary fund operations. Stress scenarios cannot be the baseline for assessing liquidity in ordinary fund operations. Most day-to-day market conditions are not stressed. Assuming a worst case liquidity scenario for all market conditions and all assets and managing a fund’s holdings as if the worst case scenario is real would impose costs on fund shareholders. At a minimum, investors would be deprived of returns that assets with higher risk-reward can provide. Strategies that are designed to seek returns rather than preserve capital would be infeasible. Stress testing can be a useful tool, but IOSCO guidance should not imply that funds should manage their assets in all market conditions presuming worst case stressed scenarios.
Metrics
The guidance also advocates quantifiable metrics in making liquidity assessments. While metrics can be helpful, they are not always applicable in the same way to all asset classes. For example, large cap equities trade differently than off-the-run fixed income. They could both be liquid and easy to convert to cash when traded, but the metrics could be very different. In addition, metrics are more reliable and useful in ordinary course markets than stressed scenarios when predictability diminishes. Pushing for more granular and prescriptive assessment techniques has diminishing value.
Principles Rather than Prescriptions
As a general proposition, effective liquidity risk management cannot be reduced to a prescriptive formula expressed through regulatory mandates. Markets are inherently dynamic and the future is never certain. Funds have different investment strategies and approaches and different investor bases with different behaviors. Funds with their own investment and risk professionals have their own views and methodologies and tools to assess and manage risk. New ideas emerge and old ideas evolve. Different funds with the same tools and strategies may still employ those tools in different ways.
The IOSCO Consultation references many aspects of liquidity risk management that are worthy of consideration and principles that funds strive to honor. Funds have their own commercial reasons to be thoughtful and prudent and make decisions that are in the best interests of fund shareholders. Attempting to impose prescriptive solutions can impede rather than promote effective fund liquidity risk management.
Proposed Guidance 2 – Consistency between portfolio liquidity and redemption terms
2. Are there any additional considerations or examples that should be added in the Proposed Guidance 2 regarding consistency between portfolio liquidity and redemption terms?
Mismatch Management – Fund Liquidity Features and Asset Liquidity
Proposed Guidance 2 focuses on matching portfolio liquidity with redemption terms. Redemption terms are important to consider when designing and maintaining an open-end fund vehicle. Portfolio composition is a critical part of managing liquidity. Funds with strategies that focus on less liquid instruments typically do not maintain investments exclusively in those instruments without other holdings and/or other mechanisms like credit lines. The holistic picture of fund liquidity is just as important as the liquidity of a specific instrument or asset class. Otherwise, fund vehicles would be limited to investing only in assets with same-day liquidity which would be adverse to investors, issuers and the capital markets more broadly.
Identifying Future Liquidity Shortages Before they Occur
Recommendation 10 references a fund having a liquidity risk management process to “facilitate the ability of the responsible entity to identify an emerging liquidity shortage before it occurs.” Funds have no crystal ball and no way to tell the future, particularly with respect to exogenous market events. A fund can maintain vigilance for how it manages its affairs and the decisions it can control and mitigate the risk of being in a bad liquidity position. A fund can maintain flexibility and agility to address market conditions as they emerge and change. A fund can distinguish itself by decision making during a time of stress. IOSCO should not imply in any form, however, that funds have the ability to identify market events before they occur.
Fund Redemption Features to Manage Outflow Pressures
The guidance highlights the possibility of lowering redemption frequency, increasing notice periods, and anti-dilution liquidity management tools (LMTs).
First, investors have a multitude of investing options. They are not limited to, nor compelled to invest only through open-end funds. They choose open-end funds for the unique features, including daily liquidity. This hallmark feature should be preserved and urge caution before imposing any measures that make it more difficult for investors to trade in and out of open-end funds. Open-end fund investment vehicles are a critical part of a vibrant capital market and should be encouraged rather than impaired.
Second, funds are not homogenous and therefore are in the best position to know their specific fund characteristics and make decisions about fund design. Even funds with similar strategies using similar asset classes make different investment decisions, take different approaches to manage risk, and have different shareholder compositions.
Such measures may be appropriate for a fund to consider at inception when designing its strategy, determining instruments for investment and associated guidelines/limits, and considering shareholder redemption frequency. Product design also considers fund distribution and flow behavior (including timing, velocity, and scale) and investor concentration. Investor behavior may may change during the life of a fund and future investor behavior will not be known with absolute certainty. Funds may have facilities such as lines of credit to help manage liquidity or provide more tools in times of unexpected flow activity. A fund’s use of such measures may vary depending on market conditions. For example, notice periods for a private fund might be extended during stressed conditions if the fund manager thinks prudent to manage liquidity and outflows. Not all aspects of all tools must remain fixed throughout the life of a fund. For all these reasons, funds are best positioned to determine how to organize and manage their operations and features.
Third, some measures may not always be feasible given operational logistics or regulatory hurdles in a particular jurisdiction. For example, notice periods, lock-ups, and redemption caps are at odds with existing law for US funds under the Investment Company Act of 1940. They also have potential downstream operational impacts for funds and distribution channels. The IOSCO Recommendations rightly acknowledge both operational and regulatory realities and should continue to do so. To the extent there are regulatory implications, IOSCO recommendations should bias in favor of reducing regulatory impediments or mandates and giving funds all available tools to manage liquidity risk. One-size-fits-all solutions will inherently be constraining and an awkward fit for all.
Fourth, mechanisms such as temporary redemption suspensions or redemption caps can have the effect of accelerating outflows rather than mitigating them. Money market funds in the United States experienced this effect when they were obliged by law to impose such features. The SEC later rescinded such requirements. Notice periods can also be a helpful feature in times of market stress.
Private funds, for example, have typically maintained longer notice periods or longer periods to meet redemptions than registered funds. Some private funds maintain mechanisms that allow them to flexibly waive or extend notice periods, as is warranted by market conditions. Where permitted by law, these mechanisms should be available to a fund if the fund believes it is appropriate or prudent for their facts and circumstances. However, such measures should not be mandated by law for all funds, all strategies and all asset classes.
Proposed Guidance 3 – Overall framework for the design and use of LMTs and other liquidity management measures
3. Do you agree with Proposed Guidance 3 regarding the inclusion of quantitative LMTs and/or other liquidity management measures within the overall liquidity risk management framework that OEF managers should have in place at all times?
Material Dilution
Proposed Guidance 3 envisions a broad set of liquidity management tools and rightly retains the focus of LMTs on material dilution. However, market conditions where material dilution is a potential risk are unlikely to be ordinary market conditions. Some measure of stress is likely to be involved to widen bid-ask spreads beyond normal levels. The guidance should avoid implying that LMTs should be deployed in the daily operation of a fund to make micro refinements. Any LMT use should be calibrated only to address risk of material dilution. The notions of employing LMTs on a daily basis but only when there is material dilution are potentially contradictory.
LMT First Mover Premise Remains Unvalidated
The July 2023 IOSCO Consultation assessment stated that “[i]t is difficult to quantify and determine the materiality” of a potential first mover advantage. Questions remain about the rationale that LMTs solve a “first mover” advantage caused by investors moving quickly to avoid transaction costs. This motivation for investor behavior remains unvalidated.
Investors are driven by the desire to move out of a fund, strategy and/or asset class for investment reasons rather than transaction cost avoidance reasons. In times of stress, flights to quality to preserve capital are a major part of investor behavior and could overwhelm concern about avoiding transaction costs. Further work is required to confirm that transaction cost avoidance actually drives significant investor redemption behavior and therefore LMTs would have a positive impact for funds and the market.
LMT Principles
To the extent that dialogue regarding LMTs continues, the following key principles should guide the discussion.
Defer to Funds
Given those principles, not all funds require active anti-dilution programs. Maintenance and administration of LMTs imposes a cost on shareholders – even if never activated. LMTs should only be employed when there is a compelling benefit to address material dilution that outweighs the costs. Otherwise, funds should not be obliged to maintain LMT mechanisms and regulators should defer to the judgment of the fund and manager to determine whether anti-dilution measures are necessary or appropriate for their fund and, if so, what specific anti-dilution measures are appropriate for their fund.
Factors considered by a fund include, but are not limited to other regulatory implications, shareholder acceptance, assets, strategy, shareholder concentration, distribution (i.e., implications for intermediaries and retirement platforms), practicality of implementation, availability of data, and potential benefit for the costs and burdens involved. These elements are not a checklist but are illustrations of factors that a fund could incorporate into its considerations. A fund with unconcentrated but highly liquid holdings and a diverse shareholder base that trades infrequently has a low risk of material dilution. A fund should have the deference to assess its facts and options and make decisions it believes are in the best interest of its shareholders.
LMTs might not always be Viable
In addition to fund holdings/instruments or strategy, there are valid reasons why an LMT may not be available, reasonable, or warranted for a fund to implement. For example, swing pricing might not be viable because of unavailable timely fund flow information, liquidity fees may not be viable because the funds are wrapped into other insurance or contractual arrangements prohibiting added fees and dual NAV may not be viable because of the major operational and technology overhaul required. Bid-ask pricing based on direction of flows may not be viable because of the lack of timely flow information and market trading conventions that utilize bid-ask pricing only in certain asset classes. LMTs also may not be compatible with fund distributors and the various systems for processing and keeping records of fund investor activity.
Market participants may not be able to accurately and credibly identify and measure “slippage” or “market impact.” While interest in the concept of including implicit costs is understandable in theory, a regulatory mechanism will not credibly establish a credible, repeatable, and objective means of measuring implicit costs through “market impact” or “slippage.”
The number of dynamic market factors involved makes such estimates inappropriate inputs for assessing actual costs to shareholders. This is particularly the case for fixed-income instruments where variances in bid-offer spread changes, differences based on size, and dislocations between and among sectors and sub-sectors are integral characteristics of liquidity at any point in time.
4. Is Proposed Guidance 3 appropriate for all types of OEFs in its scope, and proportionate for all types of responsible entities to implement? If not, please explain.
Market, operational and regulatory factors influence what mechanism are available to individual funds. With respect to LMTs, not all funds require anti-dilution programs. Maintenance and administration of LMTs imposes a cost on shareholders. LMTs should only be employed when there is a compelling benefit to address material dilution that outweighs the costs.
Proposed Guidance 7 – Types of Quantity-based LMTs and Other Liquidity Management Measures
5. Has the proposed guidance identified all of the quantity-based LMTs and other liquidity management measures commonly used by responsible entities? Are there any other LMTs that share the same objectives and that could be included in this guidance? If so, please describe them.
Proposed Guidance 7 focuses on suspension of redemptions and subscriptions, redemption gates, extension of notice periods, extension of settlement periods, side pockets, and redemptions-in-kind. See response to Proposed Guidance 2 for commentary on implications and limitations of such measures.
The section on redemption gates warrants particular comment. IOSCO appropriately recognizes the risk of redemption caps inducing outflows rather than mitigating them. Any such measures should be approached cautiously with the benefit of the role such mechanisms played in the past. Mechanisms such as temporary redemption suspensions or redemption caps can have the effect of accelerating outflows rather than mitigating them. Money market funds in the United States experienced this effect when they were obliged by law to impose such features. The SEC later rescinded such requirements. Where permitted by law, these mechanisms should be available to a fund if the fund believes it is appropriate or prudent for their facts and circumstances but should not be mandated by law for all funds, all strategies and all asset classes.
In addition, the IOSCO Consultation in Box 6 appropriately recognizes the role of credit facilities and interfund lending. While neither should be mandatory, both can be useful tools for fund managers.
6. Are the identified quantity-based LMTs and other liquidity management measures described correctly? Do the features or characteristics of the different tools and measures vary or do they generally operate as described?
Each of the measures described as advantages and disadvantages. All are variations on ordinary course operations, which means added complexity and cost and opportunity for error. Descriptions may be factually correct, but logistics and administration implications and impact on investors will vary.
As a general proposition, funds may develop their own variations or come up with new ideas. No IOSCO recommendations or guidance or regulatory requirement should prohibit any credible mechanism or only permit specified features.
7. What additional key elements should Proposed Guidance take into consideration regarding the use of each quantity-based LMT and liquidity management measures identified? Are there any particular types of OEFs that are not suitable to use some of these tools and measures?
See prior comments in response to Question 3.
Money market funds in the United States experienced outflows when they were obliged by law to maintain redemption gating mechanisms. The mere possibility that a gate might be employed drove outflows. The SEC later rescinded such requirements.
The difficult experience in the United States with the SEC’s proposed amendments to Rule 22e-4 should be considered before issuing new guidance of recommendations. Based on nearly universal objections, significant operational challenges, and the costs involved to fund shareholders, the SEC has chosen not to move forward with its proposal.
8. Do you have any practical examples on the use of these quantity-based LMTs and other liquidity management measures that could be included in the implementation guidance?
While the COVID-era liquidity shocks were unpleasant, open-end funds held up remarkably well. There was no industry-wide phenomenon of funds closing or being unable to continue operation. In the case of US mutual funds, effective management did not involve redemption suspensions, side-pockets, lengthened notice provisions or mandatory redemptions in-kind. Funds investigated every avenue and available tool but ultimately failing funds were the exception.
Proposed Guidance 8 – Appropriate Activation and deactivation of Quantity-based LMTs and Other Liquidity Management Measures
9. Do you agree with Proposed Guidance 8 regarding the considerations on activating and deactivating quantitative LMTs and/or other liquidity management measures? Are there any additional key elements that responsible entities should consider in this regard?
LMTs are not costless mechanisms
The IOSCO Consultation contemplates a pre-established mechanisms that can be agreed, disclosed and administered when and if triggers are tripped. Pre-set mechanisms can provide potential benefits for investor clarity and operational predictability. However, maintaining all available tools to effectively address different facts and circumstances is at odds with prescribing everything in advance. Funds should have the ability to utilize tools when and if they believe prudent and in the best interests of shareholders. In addition, there are costs to maintaining a LMT framework – even if never activated.
In addition, some mechanisms can be costly and complicated to maintain. Anti-dilution measures, for example, require significant planning and infrastructure whether or not they are employed. This is one reason that such mechanisms should be reserved only for those funds with a significant risk of material dilution.
The IOSCO Consultation correctly notes the range of unintended effects of liquidation management measures, including a lack of investor confidence in the markets or the fund. As noted elsewhere, the mere presence of measures may cause excessive redemptions. Funds should have the ability and flexibility to establish such mechanisms rather than the mandate. With proper disclosure, investors can take those measures into account when decisions are made to invest, maintain or redeem assets.
When the liquidity issue is one of an individual fund, the financial performance of that fund is relevant for that fund and its shareholders. It is not relevant for the market. When the liquidity issue is a market-wide matter, it is important that funds have a variety of tools to effectively navigate challenges based on their own strategy, assets, shareholder base, and vehicle design. Given the breadth of facts and circumstances, no one-size-fits-all pre-established mechanical solution will be effective.
Proposed Guidance 9 – Stress Testing
10. Do you agree with the stress testing elements identified in Proposed Guidance? Are there any additional considerations or good practices that should be covered by this section?
Reasonable stress testing can be a means of ongoing validation of product design decisions at fund inception. Funds working in good faith could find that facts and circumstances have changed, and stress testing is one avenue of good practice to facilitate ongoing internal awareness of liquidity risk management.
Three cautionary notes are relevant for stress testing. First, stressed scenarios cannot be the baseline for ordinary fund operations. Most day-to-day market conditions are not stressed. Assuming a worst case scenario for all market conditions and managing a fund’s holdings as if the worst case scenario is real would impose costs on fund shareholders. At a minimum, investors would be deprived of returns that assets with higher risk-reward can provide. Strategies that are designed to seek returns rather than preserve capital would be infeasible. Stress testing can be a useful tool, but IOSCO recommendations should not imply that funds should manage their assets in all market conditions presuming worst case stressed scenarios.
Second, stress testing is not a panacea. It may be very useful to facilitate internal dialogue and decision making, but loses its effectiveness if it becomes formulaic and inflexible. In particular, stress testing is not a crystal ball. IOSCO recommendations should affirmatively refrain from the temptation to state or imply that stress testing can reliably pre-empt or predict sharp market changes. There is a material difference between using stress testing to help position a fund while markets are otherwise ordinary and functioning and using stress tests to predict the future.
Third, stress testing should not be static by regulation. Funds with their own investment and risk professionals have their own views and methodologies and tools to assess and manage risk. New ideas emerge and old ideas evolve. Stress testing should never be set by regulation to be a single particular process or checklist. There should be no presumption that today’s good ideas are the only good ideas that could ever exist.
Fourth, the commentary in the IOSCO consultation in support of Recommendation 12 rightly states that fund level stress tests may not be required where it would be disproportionate, taking in account the size, investment strategy, nature of the underlying assets and investor profile of the fund. There is an element of cost and administrative burden associated with conducting stress tests and considering results for potential action. Disproportionate costs and burdens that could be required by regulation and do not have a compelling benefit for shareholders should be viewed skeptically. This principle applies to all aspects of liquidity risk management and fund management in general.
Other
11. Do you have any practical examples regarding governance arrangement and disclosure about the use of LMTs and/or other liquidity management measures that could be included in the implementation guidance?
Calibrated Governance
With respect to governance, any recommendations must recognize the difference between a board exercising oversight and providing direction and becoming involved in operational decision making. There may be a temptation to presume that more involvement from a board will result in better shareholder outcomes. In some cases, that may be true, but board involvement should be appropriately calibrated.
Setting the bar too low for items that require immediate escalation results in over-reporting or escalation and adds operational friction in a process that otherwise requires full attention (especially in times of market stress). The end result might be more documentation of earnest labor but the labor might be better allocated to the primary goal of taking care of shareholder interests.
LMT Disclosure Requires Balance
With respect to disclosure of LMTs, investors should be given enough information prior to investing in the OEF to enable them to have a good understanding of the implications of anti-dilution LMTs. As a general matter, shareholders are entitled to clear disclosure regarding the material elements of funds in which they invest.
If the premise of an LMT is that investors need to know that transaction costs may be allocated to their redemption or subscription orders, disclosure that a fund has such a feature is sufficient. Funds can clearly disclose the presence and use of LMTs.
Specific details about the mechanism, calculations, trigger thresholds, ranges of cost adjustments, etc. are subject to board or other governing body oversight, but LMTs should be treated similar to other operational aspects of fund operations in terms of whether they are sufficiently material to warrant detailed disclosure.
Funds should not be required to publicly disclose threshold triggers or swing factors. Disclosure could provide an avenue for savvy investors to attempt to “game the system” by strategically timing their purchases and redemptions based on expected swings. Although a few European funds selectively disclose their swing factors and swing pricing thresholds, many have chosen not to publicly disclose this information and only disclose the maximum factors for these same reasons.
Shareholders should have a sense of the realistic maximum that they might be charged and a sense of whether such charges are applied in the ordinary course or limited to unusual circumstances. We believe that can be accomplished without providing a granular description of methodology, calculation inputs, etc.
Shareholder disclosure should be sufficiently evergreen such that a fund can change logistics and details of the LMTs without waiting to update prospectus disclosure for all shareholders or send update notices to all shareholders. LMT mechanics should be viewed like valuation methodologies – the relevant fund actors and committees are charged with maintaining the program and making changes but not every aspect of the program or change requires disclosure. This principle suggests that general disclosure about the presence of an LMT is preferred over more specific disclosure about the operation of an LMT.
Disclosure may be warranted for larger changes that directly impact operational logistics such as moving from swing pricing to liquidity fees or bid-ask pricing. Transparency would be prudent because shareholders would see differences in their trade order confirmations and need disclosure to understand the economics of their trade. In part, this is for the benefit of shareholders, but
implementation logistics may also require notice to other impacted parties (such as intermediaries and recordkeepers). More disclosure and more preparation time required for implementation means that funds will not be able to quickly change LMTs being utilized.
If LMTs are authorized, ex-post reporting should be permitted but not mandated. If there is shareholder interest, funds could elect to disclose information about the magnitude and frequency of LMT adjustments and activations. Not all shareholders may be interested in the data or would take the data into account when they make investment decisions. Fund policy and practice is a balance that each individual fund should be able to set.
While shareholder transparency is generally preferable, individual shareholder interest in the granular details of estimates and calculations may impose operational cost and friction on the fund that other shareholders or the fund’s sponsor and advisers would bear. It might also require disclosure of methodologies and mechanics that could give an individual shareholder an advantage over others. Recommendations or guidance should recognize the role of the fund board or other oversight body and auditors rather than shareholders in terms of oversight of the mechanics of LMT tools.