Liquidity Risk Management in Alternative Funds

Liquidity Risk Management in Alternative Funds

2 Liquidity Risk Management in Alternative Funds

Contents

Executive Summary 3

Introduction 7

Policy debate on the management of fund liquidity risk 91.1 Mainrisksidentified 10

1.2 Potentialpolicyapproachestosolvetheidentifiedissues 14

Liquidity and professional investor funds: a problem with many solutions 162.1 Liquidity attributes of professional investor funds 17

2.2 Professional investor funds’ overall liquidity risk 22

2.3 Currentquantitativerestrictionsforretailfunds 24

2.4 QuantitativerestrictionsarenotsuitablefortheLRMofprofessionalinvestorfunds 30

Which industry practices are important? 35

3.1 Robust LRM maintained throughout the life of the fund 36

3.2 Understanding funding liquidity constraints and tools to mitigate related liquidity risks 38

3.3 Understanding of some other key issues 39

Which rules are important? 404.1 High-levelprinciplesand/orprocessapproach 41

4.2 Disclosuretoinvestors 42

4.3 Streamliningthereportingexercise 42

4.4 Accesstoliquiditytools 43

4.5 Actionsthatfavourinnovation 45

4.6 Supervisorsshouldsharemoreinformationwithmanagersofinvestmentfunds 46

Concluding remarks 48

Annex: Managing fund liquidity in the time of COVID 49

Endnotes 56

© The Alternative Investment Management Association March 2021

33

Executive Summary

Liquidityriskmanagement(‘LRM’)ofinvestmentfundshasattractedgrowingregulatoryattentioninrecentyears.ManypolicymakersareassessingwhethercurrentLRMrequirementsandpracticesarestillfitforpurposeandwhetherchangesareneeded.ThispaperprimarilyexaminesLRMin‘professionalinvestorfunds’,whichforpurposesofthispaper includes alternative investment funds in the European Union and private funds in the UnitedStates.ConsiderationisalsogiventohowLRMrequirementsof‘retailfunds’,whichencompassUndertakingsforCollectiveInvestmentsinTransferableSecurities(‘UCITS’)andinvestmentcompaniesregisteredundertheU.S.InvestmentCompanyActof1940,asamended,differfromtheLRMrequirementsapplicabletoprofessionalinvestorfundsandwhythosedifferencesareappropriate.

Many authorities are concerned that investment funds’exposuretoilliquidassets(orassetsthatcould become relatively illiquid) could raise the risk of liquidity and redemption mismatches (aswellastheriskoffundingexposuressuchas margin calls on derivatives or interest paymentsonborrowingsnotbeingmet),resultinginpotentialfinancialinstability.Someauthorities have advocated a tightening of LRM requirementstoalleviatetheserisks,andtheadoption of measures aimed at better protecting investorswhoremaininvestedinthefundatthetimeoffinancialstress.Forcertaintypesofinvestmentfunds,somebodiesrecommendfollowingaquantitativeapproach,withtheimposition of limits or prescriptive approaches related to one or more liquidity attributes.

We argue that the current regulatory approach for retail funds is not appropriate in the contextofprofessionalinvestorfunds.Existingprinciples-basedrequirementsforprofessionalinvestorfundscoupledwiththeobservanceofbasicsoundpracticesidentifiedbytheindustryhave proven to be robust in the face of even the most challenging conditions.

Theliquidityofprofessionalinvestorfundsisacomplexissuethatembracesatleastfourattributes:

• investorliquidity,• assetliquidity,• strategyliquidity,and• funding liquidity.

Investor liquidity hinges on terms such as the redemption frequency and the redemption noticeperiod,andonwhetheradditionaltoolssuch as redemption gates can be used. Asset liquidityencompassesmanydimensions(e.g.,assetcharacteristics,marketstructure),thusmakingitsmeasurementcomplex.Strategyliquidity partly depends on the necessary holding periodofassets,nomattertheliquidityoftheseassets. Funding liquidity relates to the ability tocarryoutastrategywheneverfinancialorsynthetic leverage is used to achieve returns.

ExistingrulesonliquidityandLRMdiffermarkedlybetweenretailfundsandprofessionalinvestorfunds.Thecoreassumptionbehindretail fund regulatory requirements is that investors are entitled to receive their money backpromptly(i.e.,inflexibleinvestorliquidity),and,asaresult,therangeofpermissiblestrategiestoslowredemptionsintimesofstressisoftensmallerthan/differenttothatofprofessional investor funds. In order to ensure thatretailfundscanmeettheseexpectations,

Executive Summary 3

Introduction 7

Policy debate on the management of fund liquidity risk 91.1 Mainrisksidentified 10

1.2 Potentialpolicyapproachestosolvetheidentifiedissues 14

Liquidity and professional investor funds: a problem with many solutions 162.1 Liquidity attributes of professional investor funds 17

2.2 Professional investor funds’ overall liquidity risk 22

2.3 Currentquantitativerestrictionsforretailfunds 24

2.4 QuantitativerestrictionsarenotsuitablefortheLRMofprofessionalinvestorfunds 30

Which industry practices are important? 35

3.1 Robust LRM maintained throughout the life of the fund 36

3.2 Understanding funding liquidity constraints and tools to mitigate related liquidity risks 38

3.3 Understanding of some other key issues 39

Which rules are important? 404.1 High-levelprinciplesand/orprocessapproach 41

4.2 Disclosuretoinvestors 42

4.3 Streamliningthereportingexercise 42

4.4 Accesstoliquiditytools 43

4.5 Actionsthatfavourinnovation 45

4.6 Supervisorsshouldsharemoreinformationwithmanagersofinvestmentfunds 46

Concluding remarks 48

Annex: Managing fund liquidity in the time of COVID 49

Endnotes 56

© The Alternative Investment Management Association March 2021


certain quantitative restrictions have been adopted for asset and funding liquidity.1Thesetypesofspecificregulatorythresholdshavetheeffectoflimitingthetypesofstrategiesthatcanbeofferedthroughretailfunds.Rulesforprofessional investor funds do not contain hard limits on investor liquidity and permit contractual freedom to manage the speed of redemptions intimesofstressthroughtheuseofawidevarietyofLRMtools(someofwhicharenotoftenavailabletoretailinvestorfunds(e.g.,lockupperiods,redemptiongatesandsidepockets)),whichcanresultinamoreflexibleproductdesign.

Theflexibilitytochoosehowtoaddressinvestorliquidityrisksallowsstrategyconsiderationstodriveproductdesign.Sophisticatedstrategieshave evolved over time to meet professional investordemand.Thankstotheabsenceofquantitativerestrictionsontheliquidityofferedtoinvestorsinprofessionalinvestorfunds,themarket for these funds provides a multitude of liquidity schemes and a variety of LRM practices that are dependent on multiple factors and not necessarily focused primarily on asset liquidity.

Thefreedomtodeterminesoundmethodstomanage the LRM of the funds they manage permits managers to choose investment strategies that meet the need of professional investorswhilealsostrengtheningcapitalmarkets and the real economy. Many strategies adopted for professional investor funds increase the sophistication and resilience of capital markets.Forinstance,strategiessuchasrelativevalue arbitrage contribute to reduce unfounded pricedistortionsincapitalmarkets.ThankstothehighdiversityininvestorLRMtools,managersof professional investor funds are able to build abroadanddiversifiedinvestorbase,boostingliquidity in capital markets.

Managers of professional investor funds can also support the real economy in a manner whichcomplementstheactivitiesofretailfunds,notablybydevelopinglong-termstrategiesthatofferlittleliquiditytoinvestorsbutfundkeyactivities(e.g.,constructionsector,promisingstartups).

Imposing quantitative restrictions on the liquidity attributesofprofessionalinvestorfunds,asitisthecaseforretailfunds,wouldjeopardisethemultiplebenefitsthesefundsbringtocapitalmarketsandtherealeconomy.However,othertypes of actions may be taken to strengthen the LRMofprofessionalinvestorfunds’managers,firstlybymaintainingandreinforcingindustrysoundpractices,andsecondlybyeffectivelyenforcingexistingrules.

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Somesoundpractices for the managers of professional investor funds that our members haveidentifiedinclude:

Managersshouldtakecarewhendesigningandestablishingprofessional investor funds to provide for an appropriate rangeofex-anteandex-postLRMtools,buildingthoseintotheorganisational documents of the fund and making appropriate disclosurestoinvestorsinthefund’sofferingdocuments.

Managers should ensure that appropriate disclosure is made to fund investors about LRM tools that may be employed and the circumstancesinwhichtheymaybeemployed,althoughwhatisappropriatewillvary.

ManagersshouldcarryonwithrobustLRMthroughoutthelifeofthefund(design,post-launchandpotentialfundliquidation)anddevelopeffectivedocumentationontheirLRMprocessesand performance throughout the life of the fund.

Funds’assetliquidityshouldbewellalignedwithfunds’redemptionprofileandotherliabilities.Avarietyoftoolsshouldbe considered to achieve this outcome depending on the investment strategy.

Theconductoffrequentandeffectiveliquiditystresstestingshouldhelppredictingpossibleliquidityissues,thusenablingmanagerstotakecorrectiveactions.Stresstestingshouldinclude the potential scenarios of null asset liquidity and stressesonfundingliquidity(e.g.,suddenandlargerthanusualspikes in margin costs) and develop contingency plans in case such a scenario materialises.

Managers of professional investor funds should have a proper understandingoffundingliquidityconstraintsand,whenfeasibleandrelevant,adopttoolsandapproachesthatmitigaterelated funding liquidity risks.

Managersshouldmaintaincloserelationshipswithcounterparties in order to negotiate appropriate margin requirements,collateral,haircuts,repo,etc.Theuseoftechnologies such as treasury management analytic tools should assist managers in minimising funding liquidity risks.


IntheEUandtheU.S.,thereisnoneedtoamendtheexistingprinciples-basedlegislationgoverningtheLRMofprofessionalinvestorfunds.Allthenecessaryliquidityrulesalreadyexistandsimplyneedtobecontinuouslyandeffectivelyenforced.Prescriptive and quantitative rules are unsuitable for the LRM of professional investor funds.

Professional investors must have access to tailored information onliquiditydesignandLRMprocesses,inordertomakeinformeddecisions.HomogeneousrulesonwhataspectsofLRMshouldbedisclosedfitspoorlywiththediversityof investors and strategies of professional investor funds. Therefore,authoritiesshouldavoidadoptingone-size-fits-alldisclosure requirements.

Therelevanceandcoherenceoftheinformationrequiredbysupervisorsshouldbeimproved.StreamliningandharmonisingtheexistingreportingrequirementswithrespecttoLRMwouldbenefitboththemanagersofprofessionalinvestorfundsandtheir supervisors.

Access to a full range of LRM tools should be ensured for allprofessionalinvestorfunds,inordertoempowerfundmanagerstocurbfinancialinstabilityandprotectmorepatientinvestors in critical moments. Professional investors should continuebeingfullyinformedoftheexistenceanduseofsuchtools.Whererelevantandappropriate,suchtoolscouldalsobemade available for retail funds.

Authoritiesshouldsharemorequalitydataonliquiditywithmanagersofinvestmentfunds.TheEuropeanSecuritiesandMarketsAuthorityandtheU.S.SecuritiesandExchangeCommissionalreadypublishaggregatedataonliquiditytrends,andweencouragethecontinuedprogresstowardaEuropeanconsolidatedtapeandcontinueddevelopmentofTRACEintheUnitedStates.However,authoritiesshouldbeabletodevelopmorecomprehensivestatisticsonliquiditydynamics,notablybybreakingdownunnecessarydatasiloswithinandbetweenauthorities.

Thepaperhasidentifiedseveral actions that authorities should consider (or in fact refrain from) to help managers strengthen the performance of their LRM:

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Introduction

Fundmanagementisacomplexandhighlyregulatedbusiness.Whiletheportfolioselectionandmanagementaspectsoffundmanagementoftengetthemostpublicattention,recently,the risk management aspects of the business have been getting the most regulatory attention.Newsofhigh-profilefundliquidityeventshasincreasedtheintensityofliquidityriskmanagement (‘LRM’) conversations among various authorities2andwithinindustry,withmanyauthoritiesconsideringwhethercurrentLRMrequirementsforfundmanagersareworkingproperlyandwhethertheyneedtobeenhancedwithmorespecificinterventions.

Members of the Alternative Investment Management Association (AIMA)3 have reacted totheinterestinLRMprocessbyreflectingontheconcernsbeingraisedinthepolicydebate,howtheyviewLRMforthefundstheymanage,whatthekeypracticesforsoundpracticesLRMareandwhattypesofpolicyresponsesmightbemore or less helpful to enhancing their ability to performrobustLRMwithrespecttothefundsthey manage.

ThispaperexaminesLRMinrelationto“alternative investment funds” (or ‘AIFs’)4 and “private funds”5 (collectively referred to in this paper as ‘professional investor funds’)6 as these are the predominant types of funds managed byAIMAmembers.ThepaperalsoexploreshowtherequirementsforLRMdifferasbetweenprofessionalinvestorfundsandretail-focusedfunds such as Undertakings for Collective InvestmentsinTransferableSecurities(‘UCITS’)and investment companies registered under the Investment Company Act (referred to collectively in this paper as ‘retail funds’’).


Section 1 of the paper analyses the current policy debate on the LRM ofinvestmentfunds,identifying the key concerns being postulated and recommendations made by key authorities.

Section 2 of the paper discusses thedifferentliquidity attributes of professional investor funds (as wellasthoseofretailfunds)inanefforttobetter understand the various shapes of liquidityriskandhowit can manifest itself. Thisapproachhelpsdefinepotentialissuesand the nature of the actions that could be taken to further address these risks for professional investor funds.Section2then compares the legislation of retail funds and professional investor funds in the EU and theU.S.,andshowswhytheregulatoryapproach for retail fundsdoesnotfitprofessional investor funds.

Section 3 of the paper emphasises the sound practicesidentifiedby the industry that should be continuouslyfollowedby managers of professional investor funds to ensure robust LRM.

Section 4 of the paper provides some recommendations to enhance managers’ ability to conduct robust LRM processes withrespecttotheprofessional investor funds they manage by focusing on the enforcement of existingrulesandsome other forms of support from authorities.

1 2 3 4

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Policy debate on the management of fund liquidity risk

1


1.1 MainrisksidentifiedWhile there are many counterarguments that canandhavebeenmade,thefollowingstressfactorshavebeenidentifiedbyglobalauthoritiesas liquidity risks in the fund management industry that may impact liquidity:

• Central banks have continued to ease their monetarypoliciesinrecentyears,throughcutsinpolicyratesand/orpurchaseprogrammestargetingspecificfinancialassets,whichhascontributed to reduce the yield spreads of manyfinancialassets,notablycorporatebonds;7

• Changes to central bank limits on the capacity ofbankstointermediateinvariousmarkets,suchastheU.S.Treasurymarkets,duringtimes of surging market volatility may restrict liquidity for certain assets in times of stress whichcanaffecttheliquidityofafund’sassets,especiallyassetsthatnormallyrelyonbanksactingasmarketmakers,andincreasethe costs of funding and the ability to obtain and maintain it in times of stressed market conditions;8

• When the cost of funding increases or the ability to obtain and maintain funding (through marginorotherwise)isconstrained,fundsthatrelyonthatfundingcanfindthemselveshaving to liquidate assets to close out open positions or to raise liquid assets for purposes ofmeetingmargincalls,whichcanincreasethe stress on markets that may already be volatileandmayhavedownstreamimpactsonother types of funds and market participants;9

• Vulnerabilitiesinthebankandnon-banksectors may lead to contagion across the entirefinancialsystemduetoahighdegreeofinterconnectedness;10

• Whenfundsofferdailyredemptionswhileinvestinginilliquidassets,someinvestorsmay be incentivised to try to redeem ahead of others,particularlyinstressedconditions;11

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• Thelowinterestratesenvironmenthasresulted in a rising search for yield and a growingpreferenceforlessliquidassets.12 Reactingtothesechangingpreferences,manyfund managers have increased their funds’ exposuretoilliquidassets,includinginfundsthatareopen-endedwithveryhighfrequencyintheirredemptionsand/orsignificantshort-termfinancingobligationsinconnectionwithfinancialorsyntheticleverage;13 and

• Inparticular,“fixed-incomeinvestmentfunds have reacted to declines in interest rates by shifting the composition of their portfoliostowardriskierandlessliquidinvestments.”14Thismaymakethemmorevulnerable to liquidity shocks in stressed market conditions.15 “Any future redemptions pressuresfromopen-endedfundswithshortredemption periods could result in fund managerssellingless-liquidassetsquickly”,whichcanleadtoadeteriorationofliquidityconditions in the corporate debt markets.16 Thedifficultyofsomeinvestmentfundstocopewithrisingoutflowscouldtriggerfiresales,whichcouldadverselyaffectotherfinancialmarketparticipantsthatownthesame or closely correlated assets.17

Covid-19hasbeenamajorcatalystinshaking-up traditional LRM practices and has put greateremphasisonreviewingandreinforcingexistingmodelsinlightofthetypesofLRMrisksdiscussedabove.InJuly2020,AIMAhostedaseriesofroundtablediscussionswithitsmanagermemberstodiscusstheeffectsofCovid-19onarangeofdifferentassetclassesandthetrendsthatmembersobservedinLRMduringthefirsthalfof2020.OverthecourseofthesediscussionsseveralcoreLRM-relatedlessonsemergedwhicharediscussedbelow,togetherwiththeresultsofa survey AIMA conducted to help illuminate the Covid-19LRMexperienceofitsmembers.TheresultofthesediscussionsisincludedinBox1.

AstheglobalCovid-19pandemiccontinues,itis possible that “further declines in the market value of assets or a sharp increase in market volatilitycouldpromptrenewedoutflowsfromfunds” 18havingknockoneffectsforothermarket participants and markets themselves. Althoughthesetheoreticalrisksexist,theydo not inevitably materialise in periods of market stress.19 A case in point is the investor redemptionexperienceofprofessionalinvestorfundswithrespecttotheearlymonthsoftheCovid-19pandemicasexploredfurtherintheAnnex.


i Box 1: Case Study Covid-19 and LRMThefirsthalfof2020sawtremendousvolatilityacrossmanyassetclasses.Thisaffectedtheliquidityriskforfundsindifferentways,butonekeydifferentiatorwasthetypesofassetsthatfundswereholding.WhencomparedtoQ4of2019,almostathird(31%)ofAIMA’ssurveyrespondentsexperiencedalarge decline in market liquidity in the assets theytradedwhilemorethanathird(38%)onlyobservedaslightdecline.Thekeydriversbehindthisvolatilityidentifiedbythesurveyrespondentsweretheshifttoworkingfromhomeformost,ifnotallmarketparticipants,thehighdemandofcorporatesforshort-termfunding,andtheoveralllargedeclinesinglobal equity markets.

TowardstheendofMarch2020,stresslevels in almost all markets and strategies wereincreasinglyfragile.GiventhehighvolatilityobservedthroughoutMarch,therewereexpectationsofverysignificantnetoutflowsforQ1andQ2inhedgefunds’markets,althoughthisappearednottohavecrystallisedintheend,withredemptionlevelsfor most funds remaining at or near normal levels(seeBox2).

Thereweremultiplereasonsfortherestrainedoutflowsofferedbutitwasclearthat investment fund managers seemed to have a better overall risk management frameworkinthiscrisiswhencomparedtotheglobalfinancialcrisisof2007-08,includingaroundLRM,withfewerliquiditymismatchesinlessliquidstrategies.Thespeed and scale of government intervention wasunprecedentedandcontributedtomaintaininginvestorconfidencewhohave,sincetheglobalfinancialcrisis,becomemore

long-termorientedandlesssusceptibletopanicandliquidationofpositions.Thesuddenbutseamlessshifttoremoteworkingplayed a contributing factor to the industry’s operational stability.

Performanceofthehedgefundsectorwasrelativelygoodinthefirsthalfof2020,leadingtofewerthanexpectedinvestorwithdrawalsduringthesecondquarterof2020.Whilehalf of the survey respondents observed a slight improvement in market liquidity in the assetstheytraded,almostone-fifth(19%)noted a slight decline. Most asset classes experiencedhigheroverallvolumesoftradingaccompanied by increased transaction costs suchaswideningbid-askspreads.Becauseofthis,simultaneousoccurrenceofhigheroverallvolumes,highpricevolatilityandwideningofthebid-askspreads,managersandinvestorsdidnotexperiencethelevelofliquiditythattheywouldgenerallyexpectattheprevailingvolumelevels.Transactionsizesbecamesmallerinmanymarketsandtheabilitytoexecutewithoutlargeimpactdecreasedsignificantly.Thisphenomenonhas important implications for quantitative models that heavily rely on average daily volumes as indicators of ‘good’ liquidity conditions.

EventhemostliquidmarketssuchasU.S.Treasurymarketsexperiencedsevereliquidityissueswheretraditionalintermediariessuchasbanksareunabletousetheirownbalancesheetstomakemarkets.Thereasonsforthisare multiple but the impact of banking and other regulatory reforms on the ability of traditional intermediaries like banks to make markets in stress situations is likely among themaincauses.Theleverageratiorestrictionisoneexampleofaregulatoryconstraintthathas limited the capacity of intermediaries toprovidebalancesheetasa‘marketplace’,

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even for the supposedly safest asset classes. WhentheU.S.FederalReserveactedtolifttheleverageratiorestriction,albeitonatemporarybasis,neartheendofMarch,intermediarieswereimmediatelyabletoreturn to providing markets for instruments throughtradingofftheintermediary’sownbalancesheetwhichhadtheeffectofeasingthe liquidity strain in the markets and calming thevolatility,althoughitisworthnotingthatmorethanhalf(53%)ofthesurveyrespondents indicated they did not see any largestressesinthefundingoftheirpositions,withonly23%havingobservedstressesintherepo market.

Broker-dealersintheexchange-tradedandOTCmarketsfacingregulatorycapitalconstraintsexacerbatedbythevolatilitycrisiswerecompelledinMarchandApriltoincrease the levels of initial margin charged onderivativestransactions,causingmanymanagerstoexperienceseveralroundsofcapitalcallsforexistingtransactions.Thisin turn caused managers to seek liquidity in marketsliketheU.S.Treasurymarkets–aprocyclical result. Initial margin increases wereanticipatedgiventhevolatilityinthemarketsandthewaymarginrequirementswork.Ofthesurveyrespondents,almostone-third(31%)reportedanincreaseininitialmarginofbetween0-50%whileothers(31%)notednoincreaseininitialmarginrequirements.Somelevelof“padding”is

understandableonthesideofbroker-dealerswhoweretryingtoprotectthemselves.Thevaryinglevelsof“padding”amongbroker-dealersintroducesanoftennon-modellableandpotentiallypro-cyclicalelementintoinitialmarginincreases,makingitmoredifficultformanagerstoestimatethepotentialextentofmargin increases they may face in the future. Surveyrespondents,however,foundthattheincreasesininitialmarginwere,toagreat(22%)ormoderate(25%)extentbasedonobservable and modellable criteria.

Markets,hedgefundmanagersandregulators have improved the tools at their disposalsincetheglobalfinancialcrisis,fromimproved technology to sophisticated liquidity monitoring and management infrastructure. However,thereisstilleconomicdownsideriskthroughcreditdowngrades,defaultsanddecliningmarketvalueswhichcouldincreaseredemption pressure on the investment fund sector in the future in one or more asset classes. Accurate monitoring of the true liquidity of the fund assets remains essential in order for fund managers to ensure an appropriateandeffectiveresponsetotheebbsandflowsofinvestoractivityintimesofextremeuncertainty.

Generalprinciples

Process

Quantitativelimits

General principlesA general principles approach focuses on the high-levelideathatfundsshouldbemanagedto avoid liquidity mismatches and placing legal responsibilityformaintainingeffectiveLRMonthe fund manager.20

ProcessAprocess-drivenapproachfocusesonprescribing the actions managers should take and the monitoring priorities they should set whenperformingLRM.21Theapproachoftenalso includes a detailed description of the type of information that has to be disclosed to authorities22and/orinvestors,includingthe appropriate labelling of funds to provide additional transparency on liquidity risks.23Theprocess approach also includes requirements to perform liquidity stress testing.24 Also included withinthisapproacharerequirementsapplicablewhenusingex-anteLRMtoolssuchasswingpricingandredemptionfeesandex-anteLRMtools such as redemption gates and suspensions. However,ithasbeenrecognisedthataone-size-fits-allapproachtothesetypesofrequirementsisnotalwaysappropriate.25

Quantitative limits The“quantitativeapproach”considerstheminimum portfolio requirements investment fundswillhavetoadheretoaswellastheimposition of quantitative restrictions (see Section2.3).Becauseoftherequirementon retail funds to maintain daily (or at least bi-weeklyinthecaseofUCITS)investorredemptions,authoritiesoftenimposestrictlimitsontheliquidityoftheassets,26aswellasrequirementsfordiversificationandlimitsonconcentration),theimpositionofcertainLRMtoolstolimitorslowredemptions27 and limitations on the levels of leverage.


1.2 PotentialpolicyapproachestosolvetheidentifiedissuesSomejurisdictionshavealreadyputinplaceregulations,requirementsandapproachesdesignedwiththegoalofreducingpossibleliquiditymismatchofcertaininvestmentfunds.Ingeneral,authoritieshave adopted approaches that include a combination of approaches:

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Acombinationofthesedistinctapproaches,whichwillnecessarilyvarybetweenretailfunds and professional investor funds as the approachesbecomemoreprescriptive,allowsauthorities to adopt a holistic and pragmatic viewwhenputtinginplaceapplicablerulesandguidance,takingintoaccountthespecificsoftherelevantmarkets,recenttrendsaswellasinvestment-specificconsiderations.Inmanyinstances,authoritiesmayintroducehigh-levelprinciples,followedbytheadoptionofprescriptiverules,outliningspecificrequirementsthatfundswillneedtomeet.Finally,whereappropriate based on the structure and terms ofthefundandthenatureoftheinvestors,quantitativelimitscanbeintroducedwhichinclude restrictions on liquidity attributes (see Section2.3).


Liquidity and professional investor funds: a problem with many solutions

2

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2.1 Liquidity attributes of professional investor funds

Theliquidityofprofessionalinvestorfundsencompasses at least four attributes: (i) investor liquidity,(ii)assetliquidity,(iii)strategyliquidity,and (iv) funding liquidity.

Investor liquidityInvestorliquiditycoversthepre-definedconditionsunderwhichinvestorsmayredeemsome or all of their shares and receive back the then current net asset value (‘NAV’) of those shares. A fund’s normal redemption frequency is setwhenthefundisestablished.Foropen-endfunds,typicalredemptionfrequenciesincludedaily,weekly,monthly,quarterly,semi-annualand annual redemptions.

A lock up period and a redemption notice period canalsobeadded(seeTable1).Forclosed-endfunds,sharesareonlyredeemedbythefundand not at the request of investors.

Inthedesignphaseofafund,additionaltoolsdesignedtoslowdownredemptionsorrestrictinvestor access to their invested capital can be included in the fund’s organisational documents (seeTable1).Someofthesefeaturesareshapedtofunctioninnormalcircumstances,whileothers are meant to be used in stressed liquidity orotherexceptionalcircumstances.Thedegreeof investor liquidity is proportionate to these pre-definedconditions.

Table 1. Liquidity tools used by managers of professional investor funds

Feature Description

Usual liquidity tools

Lock up period Aninitialperiodduringwhichtheinvestorisnotallowedtoredeemshares

Redemption frequency Oncethelockupperiodexpirationpasses,investorscanredeematcertain points in time

Redemption notice period Investors are required to give advance notice before any redemption

Additional liquidity tools

Protecting fund capital

Redemption gates Partialrestrictionstoinvestors’abilitytoredeemtheircapital,generallyonapro-ratabasis(restrictionsontheamountthatcanbewithdrawnasaproportionoftheinvestor’scapitalinthefund,onthe fund’s total NAV or on the funds held under a particular class of shares)

Sidepockets Arrangementsthatsegregateilliquidorhard-to-valuepositionsfromthe main pool of assets in a fund until such time as they are realised orarenolongerdifficulttoprice

Suspensionofredemption Temporarymeasurethataimsatpreventinginvestorsinthefundfromwithdrawingtheircapital


Feature Description

Protecting remaining investors by passing transaction costs on to redeeming investors

Swingpricing Processforadjustingafund’sNAVtoeffectivelypassontransactioncostsstemmingfromnetcapitalactivity(i.e.,flowsintooroutofthefund)totheinvestorsassociatedwiththatactivityduringthelifeofafund,excludingramp-upperiodortermination

Anti-dilutionlevy Charge paid by investors on the fund’s NAV price to protect the value interest of remaining fund investors from any dilution through large transactions

Preventing short-term trading

Redemption fees Feechargedtoaninvestorwhensharesaresoldwithina pre-definedperiodafterthelaunchofthefund

Other lines of action

In-kindredemptions Toolthatallowsthefundtoofferredeeminginvestorsapaymentotherthancash,oftensecuritiesonapro-ratabasis

Source:AIMAandIOSCO28

Managers of professional investor funds generally have broad access to the types of tools describedinTable1,althoughsomerestrictionspersistinsomedomesticjurisdictions(seeTable6inSection4.4formoreinformationinthisregard).

Ofthefourliquidityattributes,investorliquidityislikelytheeasiesttoquantify.Thelongerthelockupperiod,thelowertheredemptionfrequency and the longer the redemption notice period,forexample,thelowertheinvestorliquidity.Thepresenceofadditionalliquiditytools in the clauses of the contract can also reduce investor liquidity.

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Asset liquidityAssetliquidityreferstohoweasilyandquicklyassets can be converted into cash. As this liquidityattributeembracesmultipledimensions,it remains challenging to quantify asset liquidity. TheBankforInternationalSettlements(BIS),

BaselCommitteeonBankingSupervision(BCBS)developedahelpfulsystemin2014(seeTable2).Thismatrixprovidesthedifferentcharacteristicsofassetliquidity,aswellaspossiblecriteriabehind each characteristic and possible metrics to measure the related degree of liquidity.

Table 2. Characteristics, criteria and metrics of asset liquidity

Characteristics Criteria Examples of metrics/measures

Asset characteristics

Asset quality

Probability of default

Ratings

Spreads

Price drops during distress

Flight to quality (performance during

distress)

Performancerelativetorisk-freeasset

Correlationwithfinancialstress

VolatilityImplied and actual volatility

Duration/timetomaturity

Transparency and

standardisation

Collateral eligibilityEligible/haircutsatFMIs*

Across private counterparties

Standardisation

Smallnumberofstandardisedproducttypes

Standardisedriskmodeling

Well understood risk properties

Market structure

characteristics

Price transparencyPre-tradepricingbroadlyavailable

Post-tradepricingbroadlyavailable

TradingvenuesElectronic (including hybrids)

Exchange-traded

Activeandsizeablemarket

SizeVolumes (number of trades and dollar value)

Outstandings

Relatedfinancingmarkets

Repofinancingavailable

Othersecured/forwardfinancing

Related hedging markets

Market participationBreadthofinvestors(lowconcentration)

Large number of active market makers

Market liquidity Liquidity

Depth/priceimpactoftrading

Amihud ratio (price changes relative to volume)

Autocorrelations of returns

BreadthEffectivebid-askspreads(expost)

Quotedbid-askspreads(exante)

ImmediacyAverage number of trades per day

Numberofdayswithzeroreturn/volume

*:FinancialMarketInfrastructures–FMIscouldincludepaymentsystems,centralsecuritiesdepositories,securitiessettlementsystems,traderepositoriesandcentralcounterparties.

Source:BIS-BCBS29


Strategy liquidityAparticularinvestmentstrategymaybeconfinedtohighlyliquidfinancialinstrumentsandassetsyetexhibitmuchlessoverallliquiditythanisimpliedbyitsassetstotheextentthatitrequireseither longer holding periods or additional catalyststocometofruition.Forexample,manyarbitragestrategieswillrequiretheholdingofthe respective positions until price convergence. Theconvergenceperiodmaybedrivenbytheinstrumentcharacteristics(e.g.,expiryofafuturescontract)orbyadifferentexternalcatalyst(e.g.,approvalofamerger).Eitherway,the manager and investors cannot simply look at the liquidity of the assets used in the strategy in isolation.

Similarly,strategiesoptingforhighlyconcentrated positions tend to be less liquid than the average liquidity of the traded securities.30 Shareholderactivismcanalsodisentanglethestrategy liquidity from the asset liquidity.31 For instance,whileactivisthedgefundstypicallyholdliquidassetsthatarepubliclytraded,theaveragetime for a complete investment cycle and the realisation of returns can be relatively long.

Funding liquidityFunding liquidity relates to the availability andtermsofcredittofinancethepurchaseoffinancialassetsortheeasewithwhichonecansupport synthetic positions through margining. Asisthecaseforassetliquidity,fundingliquidityencompasses many dimensions. Among the mainfactorsaffectingfundingliquidityare:(i)asset/collateraltype;(ii)asset/collateralliquidity;(ii) funding terms; (iii) funding costs; and (iv) the number and type of funding liquidity providers.

Managers of professional investor funds often borrowmoneytobuyassetsinexcessoftheirinitialinvestmentequity.Theyobtainfundingand use the purchased assets as collateral (‘marginlending’).Similarly,professionalinvestorfundscanenterinto‘repo’transactionswherebytheyobtainfinancingthroughrepurchaseagreementswhich,thoughtakingadifferentlegalformthancollateralisedlending,havethesameeconomiceffect.Usingderivatives,whetherOTCorexchangetraded,willrequirefunds to manage initial margin and variation margininsuchawayastobeabletomaintaintheirdesiredexposure.Whetherengaginginborrowing,repoorderivativestransactions,funds need to have adequate liquidity to be able to meet their obligations arising from adverse market changes.

Whether these changes manifest themselves inincreasesofinitialmarginrequirements,higher haircuts for repo transactions or variation margincalls,fundsneedtoensurethatadequateamountsofunencumberedcashorfinancialinstruments are available in order to avoid forcedunwindingoftheirpositions.Suddenmarketfinancialstressthatreducesboththevalue and the liquidity of the fund’s assets could reduce funding liquidity.

2121

Theabilitytomeetmargincallswillalsodependon future levels of volatility and the ongoing resilience of funds’ liquidity management.32

Thetermsofthemarginlendingorrepoarrangements,asagreedbetweenthefundandthecounterparty,cansignificantlyimpactthefundingliquidityofthefund.Forexample,shorter lending term periods heighten rollover risk(theinabilitytocontinuefinancinganexistingposition).Theabsenceofapre-noticeperiod before changes in margin requirements becomeeffectivecanalsoraisethefundingliquidity risks faced by leveraged funds.33

Finally,counterpartyrisksaregenerallyunrelatedtothefunds’performanceorbehaviour.Theycanmaterialisewhenthecounterparty,oftenaprimebrokerorrepocounterparty,decidesto change its internal strategy or has to face a suddenchangeinliquidityconditionswithinmarkets.Inbothcases,thecounterpartymightstopfinancingordramaticallychangethetermsoffuturefinancingwhichmayleadtosignificantchanges to the fund strategy. Fund managers couldbeforcedtoliquidatefundpositions,oftenat a high cost (in particular for illiquid positions). Highcounterpartyrisksthereforetendtoreducefunding liquidity and can be alleviated by the adoption of certain risk mitigation approaches (seeSection3.2).


2.2 Professional investor funds’ overall liquidity risk

Thequantumofaprofessionalinvestorfund’soverallliquidityriskwillbeafunctionofhowthefundbalancesredemptionfrequency,thetypes of redemption restrictions that may be

imposed,theliquidityoftheassetsheldandtherequirements for maintaining funding liquidity. Fundswithdifferentanswersoneachofthesefactors can have the same overall liquidity risk as explainedinBox 2.

i Box 2: Quantificationofinvestment funds’ overall liquidity riskIntheseriesofillustrationsbelow,theoverallliquidityriskfacedbyafundisquantifiedbytheareaofaspecific“liquidityrectangle”,anddepends on four “liquidity factors”:1

(i) fund managers’ choices regarding the liquidity of funding;

(ii) fund managers’ choices regarding the liquidity of assets;

(iii) the chosen redemption frequency; and

(iv)theavailableex-postredemptionrestrictions such as gates or redemption suspensions.2

1 Forthesakeofsimplicity,strategyliquidityhasnotbeenincludedintheseanalyses.

2 Thefirstillustrationincludesthe“lack”ofredemptionrestrictionsinordertobealignedwithliquidityfrequency.Theeffectofahigherlackofredemptionrestrictionscanbesimilartotheeffectofanincreaseinliquidityfrequency.Themeasurementofthelackofredemptionrestrictionscanforexamplebeapproachedbyaquotientthatincludesthenumberofredemptionrestrictionsinthedenominator.

Increasesinassetilliquidity,fundingilliquidity,redemptionfrequencyand/orthelackofredemption restrictions boost the overall liquidityriskofthefund.Thegrowingliquidityrisk is mirrored by an increasing area of the liquidity rectangle and therefore a larger ‘risk’ area.Shouldamanagerwishtomaintainidenticalliquidityriskovertime,anychangeinoneofthefourliquidityfactorswouldrequire a change in at least one of the three otherliquidityfactors,inordertokeepthe‘risk’areaconstant.Forexample,anincreaseinredemptionfrequencywouldautomaticallyraisefundingliquidityriskifnoadjustmentsare adopted for the other factors.

0 +00+00

+00

+00

Asset illiquidity

Funding illiquidity

Lack of redemption restrictions

Redemption frequency

Neutral model

0 +00+00

+00

+00

Asset illiquidity

Funding illiquidity



Retail model

2323

DifferentapproachestowardsLRMcanbeadopted.The“neutral”model(seethefirstillustrationinFigure4)considersthatliquidityrisk is equally distributed across the four factors,nomattertheareaoftheliquidityrectangle. Any change in one of the four factorsshouldresultintheadjustmentofoneormoreoftheotherfactorsifthereweretobe no increase in liquidity risk as compared to theneutralmodel.Inthatcontext,araiseinredemptionfrequencyforafund,wouldimplytheneedtoadjustassetliquidity(increase),fundingliquidity(increase)and/orrequiretheabilitytoimposemoreex-postredemptionrestrictions.

As long as the fund manager is capable of appropriatelydefiningtheoverallliquidityrisktolerance(thesizeoftherectangle),thefundmanager should be able to design the fund and the strategy in more than one manner toensuretheresultingliquidityrisksarewellmanaged.

Hedgefunds’LRMcanvaryfromamodelwithhighliquidityinassetsandfunding,toamodelcombininglowliquidityinboth these factors (see the third chart in Figure4).Bothmodelscankeepanoverallliquidity risk that is broadly equivalent to the neutral model provided that redemption frequency and redemption restrictions are appropriatelyselected.Forexample,themodelwithilliquidassetsandfundingshouldexhibitlowerredemptionfrequencyand/ormoreredemptionrestrictions.Dependingonthefund,adifferenttrade-offcanbemadebetweenredemptionfrequencyandredemption restrictions.

Forexample,ahedgefundcouldadopthighredemptionfrequencybutwithasignificantamountofredemptionrestrictionswhilestillhaving the same ‘risk’ area as the neutral model.Theliquidityshapewouldthenbeshiftedfurthertothetopoftheverticalaxisin the illustrations but the overall ‘risk’ area wouldremainthesame.

Bywayofcomparison,open-endedprivateequity funds typically purchase highly illiquid assetswithlimitedleverage.34 In order to keep a liquidity risk that is identical to the optimalmodel,privateequityfundswouldneedtoadoptlowredemptionfrequencyandasignificantamountofredemptionrestrictions.LRMforthesefundswouldthenberepresentedbyahorizontalrectanglerepresentingits‘risk’area.Forclosed-endprivateequityordebtfunds,assetilliquiditywouldbecomelessofanissuegiventheinability of investors to redeem their shares before the fund manager is capable of liquidatingthefundassets.TheshapeoftheLRM‘risk’areawouldthenalmostblendinwiththehorizontalaxis.

Toconclude,foranequivalentoverallliquidityrisk,investmentfundscanadoptvery diverse distributions of this risk across theliquidityfactors:redemptionfrequency,redemptionrestrictions,assetliquidityandfundingliquidity.Thismeansthatmanagersof professional investor funds can adopt multipleapproachestowardsLRMwhichisfullycompatiblewithbothinvestorprotection/preferenceandfinancialstabilityneeds of the system.

0 +00+00

+00

+00

Asset illiquidity

Funding illiquidity



Hedge fund models

+00+00 Asset illiquidity

Funding illiquidity


Private equity model

0

+00

+00



2.3 Current quantitative restrictions for retail funds

Twomainlegalapproacheshavebeenembracedto oversee the liquidity attributes of investment funds:oneforretailfunds,35 the other one for professional investor funds. Rules are applicable to the fund itself in the case of retail funds but apply to the fund’s manager in the case of professional investor funds. Rules for retail

fundsare,inessence,product-basedregulationand include strict liquidity standards for that purpose. Rules for professional investor funds aim at ensuring an appropriate behaviour of the managerwhomanagestheliquidityriskprofileofthefund.Ahigh-levelcomparisonoftheliquidityrequirementsisincludedintheTable3below.

Table 3. Restrictions on liquidity attributes: comparison between UCITS, open-end registered investment companies,36 AIFs and private funds

UCITS (EU)Open-End Registered Investment Companies (U.S.) AIFs (EU)

Private funds (U.S.)

Investor liquidity

Liquidity to investors

Minimum once every twoweeks

Daily No limit No limit

Gatetoinvestors

Yes,butlimited Not permitted Permitted Permitted

2525



Funding liquidity

Fund level borrowing

10%maxfortemporaryborrowing

Canonlyborrowfromabankandlimitedto300%assetcoverage37

No limit No limit

Measures of leverage (gross market exposure)

Achieved through the useofderivatives.Twoapproaches are used to calculate leverage:

(i) commitment approachwherederivatives cannot exceed100%NAV;

(ii) VaR approach. Cappedat20%NAVmonthlyat99%confidencelevel.TheVaR approach can be further subdivided into an absolute and a relative VaR approach. TheabsoluteVaRlimitdepends on the risk profileofafundbutthemaximumabsoluteVaRlimitis20%overa20-dayholdingperiodbasedonaconfidenceintervalof99%.TherelativeVaRlimitistwicethe VaR of a derivative free benchmark.

Use rules that came into effect19February2021andmustbecompliedwithby19August2022.ArelativeVaRtestisthedefaultwhereVaRof the fund’s portfolio cannot exceed200%(or250%forclosed-endedfundswithanoutstanding class of senior securities that is a stock) of the VaR of a designated reference index.Ifthederivativesriskmanager is unable to identify adesignatedreferenceindexthat is appropriate for the fund taking into account the fund’sinvestments,investmentobjectivesandstrategy,thefund must instead comply withanabsoluteVaRtest(VaRof the fund’s portfolio cannot exceed20%(25%forthetypesofclosed-endfundsqualifyingforthe250%limit)ofthevalueof the fund’s net asset value). TheseVaRmodelsarerequiredtousea99%confidencelevelandatimehorizonof20trading days.

Twoapproaches are used to calculate leverage: (i) gross method and (ii) commitment method. None ofthetwoiscapped.TheAIFM shall demonstrate that the leverage limits fixedex-anteare reasonable and respected ex-post.38

No rule39




Asset liquidity

Illiquid investments

10%unlistedsecurities(not unregulated funds)

Upto15%(illiquidifittakeslonger than 7 days to liquidate in the normal course)

No limit No limit

Maximumpositionsizein one issuer

10%(increasedto25%forbondsissuedbyEU/EEA credit institutions subjectbylawtospecialpublic supervision designed to protect bond holders and up to100%forsovereignissuersprovidedsixormore issuers and no morethan30%inoneissue)

Generally,25%ifdiversified No limit No limit

Positions over 5%ofNAV(aggregate size)

40%max(forbondsissued by EEA credit institutions80%max)

25%maxifthefundis“diversified”(otherwise50%maxunderU.S.InternalRevenueService’sSubchapterMdiversificationrule)butconcentration limits may also apply

No limit No limit

2727

Incontrasttoprofessionalinvestorfunds,current liquidity rules for retail funds include tightquantitativerestrictions.Thekeycriterionconcernsinvestorliquidity–i.e.,theabilityofinvestors to sell back or redeem their fund shares forcash.ThisislimitedtominimumonceeverytwoweeksforUCITS40anddailyforopen-endregistered investment companies (commonly referred to as ‘mutual funds’).41Inaddition,theaccess of retail funds to additional liquidity tools (seeTable1)isusuallymorerestrictedthanforprofessionalinvestorfunds.Forexample,intheU.S.(seeTable3)orUK,42 redemption gates are allowedonlyfornon-retailfunds.Basedontheseprimaryconstraints,manyotherquantitativerestrictionsonassetliquidity,strategyliquidityandfundingliquidityhavebeenadopted,inorderto ensure that funds meet the required investor liquidity conditions.

Asregardsassetliquidity,investmentinunlistedsecuritiescannotbeabove10%offund’sNAVundertheUCITSregime.Similarly,U.S.mutualfundscaninvestnomorethan15%oftheirnetassets(10%formoneymarketmutualfunds)inilliquidsecurities(definedassecuritiesthatcannotbesoldwithinsevendaysatapproximatelythepriceatwhichtheyarecarriedby the mutual fund).

Furthermore,boththeUCITSDirectiveandtheInvestment Company Act include strict limits for thediversificationandconcentrationofassets.InUCITS,asshowninTable3,the5/10/40rulerequires that:

• TheUCITScannotinvestmorethan10%ofitsNAV in securities issued by a single corporate issuer; and

• ThesumofallexposuresinsuchissuersinwhichtheUCITSinvestsgreaterthan5%shouldnotexceed40%oftheUCITS’NAV.

Thisrule,andotherrestrictionsonspecifictypesofUCITS,aimatlimitingexcessiveexposuretoanysingleissuer’srisk,maintaininghigh liquidity in the fund and restricting the universe of possible investments.43IntheU.S.,registered investment companies must opt forastrict“diversified”or“non-diversified”form.44 Registered investment companies are also required to state in their prospectus any objectivetoconcentratemorethan25%oftheirnetassetsintoaspecificindustryorgroupofindustries.

While there is no quantitative restriction on strategyliquidityperse,strictceilingsimposedon other liquidity attributes limit the possibilities intermsofstrategyliquidity.Forexample,theobligation of providing daily liquidity to investors limits the ability of mutual funds to adopt illiquid strategiesthatareoftenprofitableonlyafterarelatively long holding period.45


Quantitativerestrictionsapplytofundingliquidity.UndertheUCITSDirective,boththe commitment approach and the value at risk (‘VaR’) approach can be used to limit the exposureofthefund.46ThecommitmentapproachissuitableforUCITSthatdonottradederivativesextensively(derivativescannotexceed100%NAV)orusecomplexderivatives.Thisapproachisbasedonthemarketvalueofthe asset underlying the derivative and sums up the aggregate absolute value of the underlying exposures’notionalvalues.ForaUCITSusingthecommitmentapproach,derivativesareconvertedinto their equivalent position in underlying assets.Theexposureisthencalculatedfollowingnetting.TheVaRapproachestimatesthemaximumpotentiallossatagivenconfidenceleveloveraspecifictimeperiodinnormalmarketconditions.TheVaRapproachcanbefurthersubdivided into (i) an absolute and (ii) a relative VaRapproach.ThemaximumabsoluteVaRlimitissetat20%overa20-dayholdingperiodandbasedona99%confidenceinterval.TherelativeVaRlimitistwicetheVaRofaderivativefreebenchmark.AUCITSmustreportonaregularbasistoitshomeMemberStateregulatordetailingitsexposuretofinancialderivatives,related risks and limits and the methods used to estimate those risks (the frequency of reporting differsbyjurisdiction).AUCITSusingtheVaRmethod must provide additional information initsprospectusontheexpectedlevelofleverage and the possibility of a higher level of leverage.AlternativeUCITSoftenusethemoresophisticatedVaR-basedapproachasaresultofthe types of investments being made.

Tocalculateleverage,ESMArequiresUCITStouseanothersimplercalculationmethod,theso-called“sumofnotionals”method.Thesumof notionals method adds together all notional amountsofanyderivativepositionswithoutusing any netting or hedging (often resulting in arguably misleadingly high numbers).

Thismethodhasthebenefitofprovidingacommon comparative standard among various funds,thoughitsapplicabilityacrossdifferentstrategiesmayvarysignificantly.

IntheU.S.,bankborrowingofmutualfundscannotexceedonethirdofthefunds’assets.TheSECalsolimitstheusageofleveragebybanningtheissuanceof‘seniorsecurities”,asdefinedinSection18oftheInvestmentCompanyAct.Seniorsecuritiesarethosethatnotablyconstrainthe fund to make a payment in the future or supplysecurities.TheSEChasidentifiedalistof transactions that have the ability to create seniorsecurities:repurchaseagreements,writtenoptions,futuresandoptionsonfutures,forwardcontractsoncurrenciesorsecurities,firmcommitmentagreements,standbyagreements,shortsales,enteringintowritingcalloptionsonfutures,writingcalloptionsorenteringintoswaps.TocomplywithU.S.rules,funds must cover the obligation created by a seniorsecuritiestransactionwithliquidsecuritiesand/or cashinthefund’sportfolio.47

TheSECrecentlysignificantlychangedtheexistinglegalframeworkfortheuseofderivativesbyopen-endregisteredinvestmentcompanies.48TheSEChasacknowledgedthatthecurrentinstrument-by-instrumentapproachbasedonindustrypracticesandstaffguidancehas often resulted in a lack of consistency in thewayfundstreatsimilartypesofderivatives.Therefore,theprimaryobjectiveofthenewapproach is to impose a consistent set of rules.

Amongthekeychanges,fundshavetonominate a derivatives risk manager and build comprehensiveriskmanagementframeworksfor derivatives. Funds are required to comply dailywitharelativeVaRtest(VaRofthefund’sportfoliocannotexceed200%(or250%forclosed-endedfundswithanoutstandingclass

2929

of senior securities that is a stock) of the VaR of adesignatedreferenceindex).Ifthederivativesrisk manager is unable to identify a designated referenceindexthatisappropriateforthefundtakingintoaccountthefund’sinvestments,investmentobjectivesandstrategy,thefundmustinsteadcomplywithanabsoluteVaRtest(VaRofthefund’sportfoliocannotexceed20%(25%forthetypesofclosed-endfundsqualifyingforthe250%limit)ofthevalueofthefund’snetassetvalue).TheseVaRmodelsarerequiredtousea99%confidencelevelandatimehorizonof20tradingdays.Specificreportingrequirementshavealsobeenimposedforthefundstoshowcompliancewiththenewleveragelimits.Finally,“limitedderivativesusers”–availabletoafundthatlimitsitsderivativesexposureto10%ofitsnetassets-areexemptfromsettingaderivativesriskmanagementprogramme,theVaR-basedlimit on fund leverage risk and the related board oversight and reporting requirements.

Toconclude,themainpriorityoftherulesforthe LRM of retail funds is that a high degree of investorliquiditycanbeprovidedanytime.Theliquidity structure of retail funds is built under thisconstraint,whichjustifiesthemultitudeof quantitative restrictions on the types and concentrations of assets the funds can invest in,andtheamountandmeasurementofleverageusedbythefunds.Collectively,theseLRM-relatedrequirementscanhavetheeffectof limiting the types of strategies that can be offeredthroughaUCITSoramutualfund.


2.4 Quantitative restrictions are not suitable for the LRM of professional investor funds

Liquidity risk and its management in professional investor funds can be perceived as a problem withmanysolutions.Foranygiveninvestororfundliquiditylevel,theunderlyingliquidity49 resultsfromaseriesoftrade-offsthatcanbedesignedinmultipleways.Foreachliquidityattribute,managersofprofessionalinvestorfundscanadoptdifferentapproaches,providedthat investors’ redemptions are met throughout thelifecycleofthefund.Therelaxationofthecore assumption behind the retail style products

that investors are entitled to receive their money backpromptly(seeTable3)opensupalargeuniverseoffund/strategydesignpossibilities.

Investor liquidity varies markedly across professionalinvestorfunds,thankstotheabsenceofquantitativerestrictions.Forexample,morethan70%oftheU.S.hedgefunds’NAVrecorded an investor liquidity above one quarter. Redemptionfrequencyalsodiffersmarkedlyacrossstrategies,asrevealedbyFigures2and3,andTable5.Overall,thevarietyofinvestorliquidity mirrors a vast diversity in investment strategiesandlinesofactiontowardsLRM.

Figure 1. Redemption frequency for AIFs in the EU

Source:ESMA50

0%

25%

50%

75%

100%

TotalEU

FoF Hedgefund

Privateequity

Realestate

OtherAIF

None

Daily Weeklyto monthly

Quarterly Quarterlyto yearly

Other

Note: Investorredemptionfrequenciesallowedbyopen-endAIFsmanagedand/ormarketedbyauthorisedEUAIFMs,endof2018,in%ofNAV.EUandnon-EUAIFsbyauthorisedEUAIFMsmarketed,respectively,w/andw/opassport.FoF=FundofFunds,None=NoPredominantType.Datafor25EEAcountries.Sources:AIFMDdatabase,NationalCompetentAuthorities,ESMA.

3131

Table 4. Investor liquidity for certain types of private funds in the U.S.

(% of aggregate NAV, as reported on Form PF)

Liquidation period Qualifying hedge funds (Questions9and50)

Q3 2017 Q2 2018 Q2 2019

At most 1 day 8.3 9.0 8.1

At most 7 days 14.6 15.2 14.0

At most 30 days 27.5 27.8 27.3

At most 90 days 48.2 47.5 46.4

At most 180 days 61.6 58.8 57.4

At most 365 days 73.6 73.5 70.2

Source:SEC51

Figure 2. Redemption frequency for funds of funds and real estate funds in the EU, across main strategies

Note: Investorredemptionfrequenciesallowedbyopen-endfundsoffundsmanagedand/ormarketedbyauthorisedEUAIFMs,endof2018,in%ofNAV.EUandnon-EUAIFsbyauthorisedEUAIFMsmarketed,respectively,w/andw/opassport.FoF=Fundoffunds,PE=Privateequityfund,HF=HedgeFund.Datafor25EEAcountries. Sources:AIFMDdatabase,NationalCompetentAuthorities,ESMA.

Funds of funds Real estate funds

Note: Investorredemptionfrequenciesallowedbyopen-endrealestatefundsmanagedand/ormarketedbyauthorisedEUAIFMs,endof2018,in%ofNAV.EUandnon-EUAIFsbyauthorisedEUAIFMsmarketed,respectively,w/andw/opassport.RE=Realestate.Datafor25EEAcountries. Sources:AIFMDdatabase,NationalCompetentAuthorities,ESMA.

Source:ESMA52



Other Daily Weeklyto monthly


Other

0%

25%

50%

75%

100%

Fund of HF Fund of PE Other FoF0%

25%

50%

75%

100%

Commercial Industrial Multi-strategy RE

Other RE Residential


Figure 3. Redemption frequency for private equity funds and other AIFs in the EU, across main strategies

Note: Investorredemptionfrequenciesallowedbyopen-endprivateequityfundsmanagedand/ormarketedbyauthorisedEUAIFMs,endof2018,in%ofNAV.EUandnon-EUAIFsbyauthorisedEUAIFMsmarketed,respectively,w/andw/opassport.PEQF=PrivateEquityFund.Datafor25EEAcountries. Sources:AIFMDdatabase,NationalCompetentAuthorities,ESMA.

Private equity funds Other AIFs

Note: Investorredemptionfrequenciesallowedbyopen-endAIFsclassifiedasOthermanagedand/ormarketedbyauthorisedEUAIFMs,endof2018,in%ofNAV.EUandnon-EUAIFsbyauthorisedEUAIFMsmarketed,respectively,w/andw/opassport.Datafor25EEAcountries. Sources:AIFMDdatabase,NationalCompetentAuthorities,ESMA.

Source:ESMA53

Foraspecifiedinvestorliquidity,differentdesigns can be adopted to ensure that liquidity andredemptionmatch(seeTable5).Consideranexampleoftwounleveragedopen-endedfundsthatoffersimilarinvestorliquidity.Thesefundscouldoptforlowerinvestorliquidity,forinstancethroughquarterlyredemptions,andshapeverydifferentunderlyingliquidity.Onecould purchase highly liquid assets but adopt a

strategy that requires long holding of the assets forittowork(e.g.,anactivist),54whereastheother one could be investing in more illiquid assets such as broadly syndicated loans. For both typesoffunds,theliquidityoftheassetmayplaya role but other considerations enter into the equationwhichmakeitsothatresultinginvestorliquidityis,intheend,lowerthantheliquidityofthe underlying assets.



Other Daily Weeklyto monthly


Other

0%

25%

50%

75%

100%

Growthcapital

Mezzaninecapital

Multi-strategy

Other PE Venturecapital

0%

25%

50%

75%

100%

Commodity Equity Fixedincome

Infra-structure

Otherfunds

3333

Table 5. Liquidity of hedge funds by attribute and across main strategies, globally

Asset Strategy Funding Investor

Convertible arbitrage 1 2 1.5 2

CTA/ManagedFutures 3 3 3 3

Distressed 1.5 1 3 1

Emerging 2 2 1 1.5

EventDriven 3 1.5 2 1.5

FixedIncomearbitrage 1.5 2 1.5 2

Long/shortequities 3 2 3 2

Macro 2.5 3 3 2.5

Multi-strategy 2 1.5 2 2

Private credit 1 1.5 3 1

Source:AIMAEfficientFlows55

Note:liquidityattributesrangefromalowdegree(=1)toahighdegree(=3)

Conversely,thesetwounleveragedopen-endedfundscouldofferdailyredemptionsandstillselectdissimilarunderlyingliquidity.Onefundcouldinvestinhighlyliquidassets,suchasglobalfutures,andmaintainahighlyliquidstrategy.Theotheronecouldprimarilyfavourlessliquid,yettradeableassets,suchasloans,butmaintainaninvestor-levelgate,incombinationwithaportion of more liquid assets such as high yield bonds,toensureredemptionscanbemanagedappropriately. Both funds should therefore be abletosatisfythedailyredemptions,butwithverydifferentstrategiesandlimitationsonthenatureofdailyliquidity,especiallyintimesofstress.

Diversityinliquiditydesignsisevenhigherforleveragedopen-endedfunds.Twofundscanforexamplemaintainsimilarfundingliquidity,whiledisplayingverydifferentfundleverageratios.

No matter the asset liquidity and strategy liquidity,moderateleverageratioshavelittle

impactonLRM,resultinginhighfundingliquidity.Formacrostrategies,highassetliquidity(duetoinvestmentsinoptions,futures,forwards,etc.)entailsthatfundscouldeasilysatisfypotentialmargincalls,eveninstressedconditions,andwithhighmarginrequirementsand/orhighleverageratios.Therefore,aprofessional investor fund that is highly leveraged,andthatinvestsinhighlyliquidassetsand/ormaintainlargeliquiditybuffersiscapableof proposing high investor liquidity.

Overall,becausetheuniverseofAIFandprivatefundstrategiesispotentiallyinfinitelydiverse,amoreprinciples-basedandflexibleapproachtobalancinginvestorliquidity,assetliquidity,strategyliquidityandfundingliquidityisrequired.Forthisreason,todate,therehavebeen no strict quantitative restrictions on any ofthesetypesofliquidityintheAIFMDorintherequirements applicable to managers of private funds(seeTable3).


Managers are left to manage LRM in the manner subjecttoexistinghigh-levelrequirements,provided that there is appropriate disclosure to investorsand,whererequired,totherelevantregulator(s).56 While no quantitative limitation existsontheinvestorliquidityofprofessionalinvestorfunds,theyshouldbeabletomeetanyinvestor’sredemption,undertheconditionspre-definedbythefundandthemanager.Managersof professional investor funds are free to settle ontheliquiditystructurethatwillmeettheseconditions(seeBox2),balancingthefrequencyofredemptionswithoneormoreofthetypesofinvestor liquidity management tools discussed in Table 1.

By freely settling on the LRM of professional investorfunds,managersstrengthenthecapital markets and real economy. Many of the adopted strategies increase the sophistication andresilienceofcapitalmarkets.Forexample,strategies based on arbitrage contribute to reduce unfounded price distortions in capital markets.

Throughthehighdiversityininvestorliquidity,funds are able to meet the liquidity needs of a multitudeofinvestors.AsshownbyBIS,abroadanddiversifiedinvestorbase,withdifferentriskprofilesandtimehorizons,tradecontinuouslythus boosting asset liquidity.57Conversely,marketswithfullyhomogeneousinvestorbasesaremoreexposedtoliquidityrisk,asinvestorstend to enter or leave over a short period of time,without“counterbalancingorderflowsfrom other investor groups”.58

Thehighvarietyininvestorliquiditycancurbfinancialcrises.If,asaresultofunexpectedmarketstress,manyinvestorsdesiretoredeemandcashintheirshares,highheterogeneityinliquidity terms across funds should limit the risk ofsynchronisedfiresales.

Finally,bycombininginvestmentsinfundswithdifferentriskstrategies,investorscandevelopadequateliquiditydiversification.

Duetotherelaxationoftheconstraintoninvestorliquidity,professionalinvestorfundscansupporttherealeconomywhichcomplementsthe funding provided by retail funds to public markets.Thisnotablyconcernslong-termstrategies,thatofferlittleliquiditytoinvestors,butcanfundkeyactivitiesoftherealeconomy,often providing an alternative to bank funding. Forinstance,realestatefundssupplylargefinancialresourcestotheconstructionsector(residential,commercial,industrial,etc.),generallywithlowredemptionfrequencyforitsinvestors(exceptforcommercialstrategies,asrevealedinFigure2).Oftenmoreeffectivelythanbanks,privateequityfundscanfundpromisingstartups.

Therefore,imposingquantitativerestrictionsonthe liquidity attributes of professional investor funds,asitisthecaseforretailfunds,wouldjeopardisethemultiplebenefitsbroughtbyprofessional investor funds to capital markets and the real economy. While preserving these benefits,whatactionswouldreinforceLRMinprofessional investor funds and ensure that all funds can meet their clients’ redemptions at anytime?Onthebusiness’side,theindustryconstantly promotes sound LRM practices and shouldcontinuedoingso.Onthelegalside,allthenecessaryrulesalreadyexistandshouldbecontinuouslyenforced.Inaddition,specificinitiatives of authorities could help professional investor funds’ managers strengthen their LRM.

3535

3 Which industry practices are important?


3.1 Robust LRM maintained throughout the life of the fundRobustLRMshouldcontinuebeingperformedatallstagesoftheproduct(design,post-launchandpotentialfundliquidation).Inparticular,anappropriatealignmentbetweenassetliquidityandredemptionstermsshouldbemaintainedthroughoutthelifecycleoftheproduct.Forthatpurpose,managersofprofessionalinvestorfundsshouldcontinuefollowingthebelowsoundpractices:

Duringthedesignphase,managersare responsible for drawingupeffectiveLRMprocesses.Thedefinedliquidityprovision should bealignedwiththetargeted audience’s riskappetite,well-documented and incorporated in the fund’s organisational documents.Thepre-definedliquiditythresholds (in terms ofdiversification,shareofliquidassets,etc.) should be in line withtheliabilitiesandredemptions of the fund.

Ex-anteand ex-postliquiditytools,other relevant LRM processes,suchaspossiblepre-definedliquiditybuffers,and the overall expectedliquidityrisk of the fund shouldbeeffectivelydisclosed to investors and prospective investors(seeSection4.2).Managersshould ensure that appropriate disclosure is made to fund investors about LRM tools that may be employed and the circumstances in whichtheymaybeemployed,althoughwhatisappropriatewillvary.

Managers should carryonwithrobustLRM throughout the life of the fund (design,post-launchand potential fund liquidation) and developeffectivedocumentation on their LRM processes and performance throughout the life of the fund.

Duringthelifeofthefunditself,thedata collected and processed should be robust enough to give an accurate picture of the fund’s liquidity (broadlydefined).Theimpact of investment decisions on the overall liquidity of the fundshouldalwaysbe assessed to ensure that investment decisions do not reduce the ability of the fund to meet its liabilities in terms ofliquidity.Shoulda manager decide to depart from the original strategy and objective,59 investor consent to the change should be obtained and robust LRM processes should be put in place to effectivelyaddress the risks caused by theneworientation of the fund.

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Potential mismatches betweenthedifferentliquidity factors should be frequently assessed through effectiveLST.Whenrelevantandpossible,theLSTexerciseshould include the risks of counterparties and other third parties,aswellasthe interconnection ofliquidityriskwithother factors such as market risk or reputational risk. Liquidity analysis should be capable of identifying potential areas of liquidity stress,thusenablingthe manager to take corrective actions before stresses materialise.

Duringthewholelifeofthefund,theconduct of robust LRM requires a proper understanding of the risk behaviour of the fund’s professional investors.Thisentailsthe monitoring of possible changes in investors’riskappetite,through adequate modellingand/orthe maintenance of close relationship withinvestors,whenpossible.Modelling should notably integrate towhichextentthefund’s professional investors have control on key investment decisions such as fund redemption. Forexample,should the fund’s exposuretohighlyleveraged investors increase over time (implying a possible higher volatility in redemptions),thefund’s manager might consider broadening the fund’s liquidity buffer.60

Thenatureoftheintermediary chain betweenprofessionalinvestor funds and their investors shouldalsobewellunderstood.Theuse of nominee accountsand/orthird-partymarketingcompanies tends to distance the fund’s manager from the fund’s professional investors.Thehigherthedistance,thehigher the risk that the fund’s manager misconceives changes in the fund’s investors’ risk appetite. In order to address thisrisk,thefund’smanager should workcloselywiththedistributing managers to ensure that the latter is informed and awareofchangingbehaviours of investors. Provided that the applicable data protection rules arerespected,fund’smanagers can ask distributing managers to share pertinent data on fund’s investors.

Potentialfundliquidation,forexamplebecauseofpoorperformance,shouldbe prepared in advance. AspartoftheLSTexercise,thetimeneededto liquidate each type of asset at a reasonable price should be assessed continuously,bothundernormal and stressed conditions.Theestimationof the cost incurred by asset liquidation should alsobeestimated.Thisinformation should give the necessary time and costtoliquidatethewholefund and should provide a preliminary roadmap to conduct that liquidation in an orderly fashion. In case the liquidation of the fund materialises,theconductof rigorous LRM still applies.Themanagementand liquidation of assets should be performed in aprudentandefficientmanner,inordertominimise revenue losses over the liquidation period and ensure the distribution of surplus assets to creditors and investors as quickly as possible.


3.2 Understanding funding liquidity constraints and tools to mitigate related liquidity risks

Managers of professional investor funds should have a proper understanding of funding liquidity constraintsand,whenpertinent,adopttoolsand approaches that mitigate related liquidity risks.61Theyshouldhaveagoodcomprehensionof the main terms used by counterparties and of their implications in terms of LRM (see “liquidity funding”inSection2.1).

Themanagershouldhaveaclearappreciationofthe main liquidity risks inherent to the strategy of thefund.ThemanagershouldalsohaveagraspofthedifferentoptionsavailableandofhowtheywouldbestfitthestrategyandLRMofthefund.Themanagershouldnotablyunderstandtheliquidityimplicationsofoptingforderivative-basedleverage(inoptions,futures,andothersecurities),shortingorrepo(generallythroughaprime-broker),embeddedleverage(usingbespokederivativesproducts),etc.

Thankstothisknowledge,themanagerwillhavetheopportunitytointeracteffectivelywiththecounterpartyandbuildleveragewitharobustLRM.Giventhelackofstandardisedpractices,funds’ managers and counterparties should agreeoncommonlanguage,standarddefinitionsformarginandcollateral,andconsistentmeasures of risk and value. Counterparties such as prime brokers often perceive clients in differentwaysbasedontheiroverallbusinessand client base.

Whenrelevantandpossible,managersshouldpro-activelytalktotradingdesksinordertoassesswhethertheycouldbevaluableclientsandensureliquidityriskswouldbeadequatelyaddressed.OpendialogueisparticularlybeneficialinOTCmarketsandfortheuseofbespoke derivatives products that are tailored totheneedsofthefunds.Overall,adoptingapro-activeapproachwithcounterpartiessuchasprime brokers has become more important since theadoptionofnewbankingrulesunderBaselIII.62

Eventually,fruitfulinteractionswithcounterpartiesshouldallowmanagerstonegotiateappropriatemarginrequirements,repo,creditoragreements,haircuts,borrowinglinesand/orthesizeofderivativestrategies.SuchnegotiationsshouldalwaysintegratetheLRM component as a key selection criterion.

Onekeydecisionconcernsthechoiceofcollateralthatwillminimiseliquidityrisks.Prime brokers often use contractual levers to encourage their clients to post those assets as collateral that are most advantageous for thebankfromaprofitability,regulatoryandrelationship standpoint. Managers should nonethelessconducttheirownassessmentand,forthatpurpose,usetechnologiessuchasspecifictreasurymanagementanalytictools.Thesetoolsshouldhelpmanagersdefineoptimalcollateralmixandmargins,andprocessandinterprettheever-growingamountofdatathatcan say something about liquidity risk.

In order to reinforce their LRM through better monitoringandmodelling,funds’managerscouldbenefitfromthesharingofqualitydatabybothcounterpartiesandauthorities,asoftenasitispracticable(SeeSection4.6).

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Finally,thedebateremainsopenontheoptimalnumber of counterparties that should be used. Managers and investors are often advised to use several counterparties in order to mitigate their exposuretoanysinglenegativeeventwhichonecounterpartymightexperience(seeSection2.1).Thisapproachappliestoalltypesofcontracts,strategies and professional investor funds. However,concentratingrelationshipscouldhavebeneficialimpactontheabilitytotradeinlessliquidmarkets,asbecomingavaluedclientcouldmakeanimportantdifferenceintimesofmarketstress.

3.3 Understanding of some other key issues

Managers of professional investor funds should have the necessary understanding of some other keyissues,suchastheextremesituationofanullliquidity,andthedevelopmentanduseofeffectivefund’sdocumentation.

Null liquidityManagers of professional investor funds should understandindetailtheextremescenarioofliquiditydroppingtozero,oreffectivelyso.Thisknowledgeshouldhelpmanagersinperiodsofcrisismanagementifsuchextremescenariostakeshape.Incasenullliquidityaffectscertainassetsclasses,properdiversificationoftheportfolioandtheexistenceofeffectiveredemption restrictions throughout the life of the fund should help the fund’s manager coping withshort-termissues.Atamacroeconomiclevel,operationofredemptionrestrictionslimitsfire-saletransmissionmechanismsfromoneassetclasstoanother.Shouldthenullliquiditybegeneralisedtoallassetsintheportfolio,theonlyoptionforfunds’managerswouldbetoblockallredemptionsandtowaitforthematuritydateoftheassets,whererelevant,in order to receive the proceeds and pay the investors accordingly.

Use of the fund’s documentation in case of financial stressEffectivedocumentationiskeytoensurerobustLRMunderstressedconditions.Forexample,atthedesignphase,alltheliquiditytoolsthatcan be used in case of high volatility should bespecifiedinthefund’sdocumentation(redemptionfees,redemptiongates,swingpricing,etc.).Atbest,foreachgivenstressedsituation,thedocumentationshouldprovidetheoptimaltool.Thechoiceoftherighttoolcoulddependontheintensityofthecrisis,thenumberandtotalamountoftheredemptions,etc.

Maintainingeffectivedocumentationisalsoessential after the launch of the fund. A contingency funding plan should set out the procedurestofollowincaseofliquiditycrisisand should be regularly tested and kept up todate.TheoutcomeofeachLSTexercise(toknowwhetherparticularactionhasbeentakeninlightoftheresultsoftheLST)shouldbewelldocumentedbytheresponsibleentities.TheperformanceoftheLRMshouldbedocumented,reviewedanddisclosedtotherelevantentities(includingsupervisorswhenrequested)throughout the life cycle of the product.

Fund managers should also be operationally prepared and regularly conduct operational scenario planning for episodes of market volatility.Thiswillensurethatallpartiesinvolvedunderstand and apply the necessary escalation procedures.


4 Which rules are important?

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4.1 High-level principles and/or process approach

Severalrulesarenecessarytolimittheriskofliquidity mismatch of some professional investor funds.Mostoftheserulesalreadyexistandneedto be continuously supervised and enforced. Theyarecorrectlybasedona‘generalprinciplesapproach’and/or‘processapproach’ratherthanon a ‘prescriptive’ or ‘a quantitative approach’ (seeSection1.2).AsshowninSection2.4,oneof the main roles of professional investor funds is notably to develop strategies that cannot be assumed by retail funds and to fund activities of the real economy that cannot be funded by retail funds.Thefulfilmentofthisrolerequiresacertaindegreeoffreedom.Theadoptionof‘quantitativerestrictions’forLRMwoulddefinitelyharmthisequilibrium and mission.

The‘generalprinciplesapproach’ofU.S.andEUrequirements provides the necessary rules to address potential liquidity issues and to ensure that supervisors can perform their tasks in goodconditions.IntheU.S.,rulesstatethattheinvestmentadvisershould“identifyconflictsandother compliance factors that create risks for [the firm],andthendesignpoliciesandproceduresthat address those risks.”63Inparticular,investment advisers have to address issues related to portfolio management processes. Theseinclude“theallocationofinvestmentopportunities among clients and consistency of portfolioswithclients’investmentobjectives,disclosurestoclients,andapplicableregulatoryrestrictions.” LRM and the need to align the liquidityofthefundwiththeliquiditydemandofinvestors are therefore accounted for in these principles.

Article39oftheAIFMDLevel2Regulationemphasises that AIFMs shall establish a “permanent risk management function.” Thisfunctionhasto“implementeffectiveriskmanagement policies and procedures in order to identify,measure,manageandmonitoron

an ongoing basis all risks relevant to each AIF’s investmentstrategytowhicheachAIFisormaybeexposed”.

ThemanagerhasalsotoensurethattheAIF’sriskprofiledisclosedtoinvestors“isconsistentwiththerisklimitsthathavebeensetinaccordancewithArticle44of[theAIFMDLevel2Regulation]”.64

Morespecifically,Article16oftheAIFMDrequiresthatmanagersshall,foreachfundtheymanagewhichisnotanunleveragedclosed-endedAIF,employ “an appropriate liquidity management system,includingprocedurestomonitortheliquidity risk of the AIF and to ensure that the liquidityprofileoftheinvestmentsoftheAIFcomplieswithitsunderlyingobligations”.Inthesamearticle,theEUlegislationrequiresAIFMsto“regularlyconductstress-tests,undernormalandexceptionalliquidityconditions“inrespectofsuchAIFs.Theserequirementsappeartobemostrelevanttoopen-endedAIFs,aseachofthe liquidity types discussed earlier in this paper wouldgenerallyapplytothoseAIFs.

However,Article16oftheAIFMDalsoappliestoleveragedclosed-endedAIFs.ForthoseAIFs,althoughinvestor,assetandstrategyliquidityissuesarelesslikelytoberelevant,AIFMsmaydecideitisappropriatetocomplywiththeAIFMDrequirements by incorporating funding liquidity aspects into their liquidity management and stress-testingprocesses.Thiscouldpotentiallyinclude addressing the risk that investors may defaultontheircommitmentstothefund,ifrelevant.TheESMALSTGuidanceprovidesadetaileddescriptiononhowLSTmaybeconducted and relates to a “process approach” rather than a “general principle one”.65TheESMALSTGuidancesupplementstherequirementsonLSTcontainedintheAIFMDandbecameapplicablefromSeptember2020.


4.2 Disclosure to investorsBothpre-contractualandpost-contractualinformation should be accessible to all investors. IntheEU,Article23oftheAIFMDadoptsa‘process approach’ and requires the AIF to disclose to investors details on the investment strategyandobjectivesoftheAIF,thetypesofassetsinwhichtheAIFmayinvest,thetechniques it may employ for that purpose and thetypesofrelatedrisks.Thedescriptionofthe‘AIF’s LRM’ focuses on “the percentage of the AIF’s assetswhicharesubjecttospecialarrangementsarising from their illiquid nature” and “any newarrangementsformanagingtheliquidityoftheAIF”.Article108(2)oftheAIFMDLevel2 Regulation also requires the AIF to disclose information on any possible arrangements they mayuseforilliquidassets(redemptiongates,sidepockets,etc.).66

AccordingtotheKPMGreportontheoperationofAIFMD,67 the EU disclosure requirements have somewhatreinforcedconsistencyinpracticesandeasedcomparability.Theserulesondisclosure to investors should be continuously enforced.However,giventhediversityofinvestment strategies and investors’ types in the alternativespace,theadoptionofalonglistofstandardiseddisclosurerequirements,asitiscommonforretailinvestors,isnotproportionatefor professional investor funds.

4.3 Streamlining the reporting exercise

U.S.andEUruleshaveextensivereportingrequirements for liquidity risk. In both jurisdictions,formsincludefirm-levelandfund-levelsections.TheU.S.FormPFhassevensections,basedonthesizeandstrategyofthemanager and the professional investor funds. Additional separate sections have been designed forlargehedgefunds,liquidityfunds,andprivateequity funds.68Somethresholdsofsizewereadoptedtocoveronlythosespecificprivatefundsthatcouldsignificantlyimpactfinancialstability.IntheEU,theArticle24(2)oftheDirective2011/61/EUprovidesthegeneraltypesof liquidity information that AIFs have to report to their national competent authority (detailed itemshavebeenincorporatedintotheAnnexIVof the delegated Regulation).

Bothformshavesimilarities.Theyrequirefunds to provide information on the liquidity oftheportfolioandtoestimatehowmuchofa portfolio can be liquidated in the prescribed time period.69Theyalsorequireinformationonliquidityfinancing,inparticularthevalueofcashfinancing,unencumberedcashandborrowings.Finally,supervisedfundshavetodescribeinvestorliquidity,aswellaspotentialrestrictions on investor redemptions and investor concentration.70

Numerous managers emphasise that parts of the reportingexercisehavemadenopositiveimpactonLRM,whilestillbeingburdensome.ManydatapointsintheAnnexIVhavelittlerelevanceforfinancialstabilityandsomemightevenprovideafalse interpretation of liquidity.71

Therefore,authoritiesshouldstreamlinethisexercise,byimprovingtherelevanceandcoherence of the required information.72

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4.4 Access to liquidity toolsForcing professional investor funds’ managers tosatisfyredemptionrequests,nomatterthemarketconditions,cansparkdamagingeffects.Undergeneralisedmarkedstress,liquiditybuffersofinvestmentfundscouldquicklyvanish.73Thesystematicfulfilmentofinvestors’requestswouldaccentuatefiresalesoflessliquidassets,harmingthepositionsofmorepatient investors and threatening other parts of thefinancialsystem.Thecostsofmeetingthesesudden redemption requests are often borne bytheremaininginvestorswhichcangiverisetoafirst-moveradvantageandcancontribute to redemptions in times of stress.74

Dependingonthejurisdiction,managersofprofessional investor funds have access to some oralloftheexistingliquiditytoolsaimedatdiscouraging or delaying redemption requests underadversesituations(seeTable1inSection2.1foradefinitionofeachtoolandTable6belowfortheavailabilitybyjurisdiction).Theavailability of instruments such as redemption gates ensures both the protection of more patientinvestorsandfinancialstabilityincritical moments. Authorities should therefore preservetheuseofsuchtoolswhenrelevant.Onekeyconditionforthesuccessfuluseoftheseinstruments is that funds continue providing professionalinvestorswithfullex-anteand ex-posttransparencyontheinstruments’features.


Table 6. Availability of liquidity tools for managers of professional investor funds, by jurisdiction

Tools AU1 BE2 FR3 DE4 IR IT5 LU NL PO6 RO7 ES UK US8

Swingpricing ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Redemption fees ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Anti-dilutionlevy ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Redemption gates ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Redemptions in kind ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Sidepockets ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Suspensionofredemptions

✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓ ✓

Source:IOSCO75

Notes:

Someofthedatalikelyneedstobeupdated.[NB:WenotethatsincetheoriginalIOSCOpublicationcitedhereasthesourceofthisinformation,someofthe listed countries have amended their legislation topermitbroaderuseofthesetypesoftools,e.g.,changesinGermanyandSpaintopermitswingpricing.]

1. Applies to retail funds and alternative funds includingclosed-endfunds.Limitsonilliquidinvestmentsapplywherethefundoffersongoingredemptions.

2.Non-retailfundscancontractuallydeterminethepolicy tools available.

3. Maturity restrictions apply only to [money market funds(‘MMFs’)].Someofthetoolsmentionsuchas the limits on asset concentration may vary depending on the type of funds considered.

4.Minimuminvestmentperiodsandliquiditybuffersapplytoopen-endedrealestatefunds.Forfundswithmorethanoneinvestor,redemptionsinkindaresubjecttotheconditionsofverticalslicing(i.e.the redeemed assets have to mirror proportionally the composition of the fund’s portfolio).

5.Gatesandsidepocketscanonlybeusedinother(non-retail)funds,aslongastheinterestsofthefunds’ participants are upheld.

6. Redemption gates apply only in the case of real estateCIS.

7. Maturity restrictions apply only to MMFs. Illiquid asset investments generally refer to unlisted companies.

8.Theresponsesaregenerallyapplicabletoopen-endfunds.However,theuseofsidepocketsisgenerallyapplicableonlytohedgefundsandnotopen-endorclosed-endfunds.Responsescorrespondingtosuspensionofredemptions,redemptionfees,redemptiongatesandredemptions-in-kindaregenerallynotapplicabletoclosed-endfundsbecausetheydonotgenerallyofferredemptionprivileges.

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4.5 Actions that favour innovationPolicymakers have several tools at their disposal tosupportinnovationinLRMprocesses.Theycanrelaxcertainrulesduringapredefinedperiod and under certain conditions (the so-called“regulatorysandboxes”),inordertoallownewprocessestobetested.76Otherpossibilitiesconcernthefinancialeducationof

fintechcompanies,lowerregistrationcostsandbetteraccesstofundingforstartups,subsidiesforinnovationlabsandaccelerators,and/ortaxcuts.Eachofthesepolicyoptionscontainsprosandcons,andthefinalchoiceamongthemdependsonthejurisdictionandlocalcircumstances.

Box 3: Innovation in the measurement of asset liquidityMethodologies used by professional investor funds’ managers to measure and manage assetliquidityareinlinewiththelatesttechnologicaldevelopments.Significantinvestments have been made over the last decadetorefinemeasurementandimproveresponsivenesstoliquidityshocks.Thefast-growingvelocity,volumeandvarietyofdata on several assets classes and securities haveposednewproblemsforstoringandanalysing liquidity data. In order to solve the storageissue,professionalinvestorfundshave increasingly adopted cloud computing. Public clouds in particular have likely contributed to reduce operational costs and facilitate the analysis of liquidity data.

Automation in liquidity analyses has become thenorm.Therehasbeenanincreasing

use of advanced algorithms and predictive analyticstobetterestimate,anticipate,prevent and react to potential liquidity stress.

As a result of unequal access to data acrossassetclassesandsecurities,innovativeintensitydifferssignificantlyacross investment strategies.77 Least liquid strategiestendtoincludeassetswithpoormarketinformation,limitingtheabilityoffunds to apply robust data analytics.

Ontheotherhand,innovativeintensitytendstobehighforliquidstrategies,aslarge volumes of data are available on targetedassets.Forthosestrategies,fundsare capable of continuously assessing the asset liquidity. Based on detailed behaviouralscenarios,complexalgorithms,continuousdatacollection/productionandpossible‘liquiditycaps’,stresstestingcanbeeffectivelyconductedathighfrequency(typicallydaily),whichempowersmanagerstoadjustinvestmentspromptly.

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4.6 Supervisors should share more information with managers of investment funds

Theuseofhigh-qualitydataisnecessaryforinvestmentfunds’managerstoconducteffectiveLRM.“Qualitydata”impliesanappropriatedegreeofaccuracy,breadthanddepth.Accuracymeans correctness and factuality in the data. Breadthreferstothenumberofsecuritieswithineachassetclassforwhichdistinctdatacanbeproduced.Finally,depthreflectsthegranularityofthedatathatcanbeidentifiedforeachsecurity.

Supervisorscouldfacilitatetheaccesstoquality data for investment funds’ managers by (i) ensuring that the sharing of quality databyrelevantstakeholdersiseffectiveandgeneralised,and(ii)embracingamorepro-activeapproachandproducingtheirownqualitydata,makingthatavailabletomarketparticipants,through,forexample,aEuropeanconsolidatedtapeandthedevelopmentofTRACEintheUnitedStates.

Supervisorstypicallyhaveaccesstolargeamountsofdata,throughmandatoryreportingoffundsandinteractionswithotherauthorities(at both national and international levels). Provided that they allocate the needed resources tostructureandanalysethisdata,supervisorscanhaveamoreholisticviewofliquiditydynamicsthanmostfundscan.Someauthoritieshave already published aggregate data on liquidity trends.78Nevertheless,authoritiescould develop more comprehensive statistics onliquiditydynamics(forexample,bytakinginspirationfromtheBIS-BSCSTable2discussedinsection2.1ofthispaper).Suchstatisticswouldbebeneficialformarketparticipants,especiallythesmalleroneswhichdonothavelargedistribution channels at their disposal to produce relevant data.

Tobeeffective,theproductionandsharingofqualitydatabysupervisorsshouldfollowcertainprinciples.Themannerthedataissharedandusedmustcomplywithalltheapplicabledataprotectionrules.Furthermore,authoritiesthatcollect and aggregate reporting data should assesstowhichextentthisdataisconsistentacrossfunds,investmentstrategy,assetclasses,localjurisdictions,etc.(seeBox4).

Supervisorsshouldalsobreakdownunnecessarydatasilos.Forexample,thesupervisionoftrading venues and investment funds’ managers mightbeensuredbytwodistinctdepartmentsthat collect data separately and do not have any possibilitytocrosstheirdatawiththeoneoftheotherdepartments.Forexample,theEuropeanCentral Bank collects statistical data on funds’ balance sheets but does not typically share this withnational,localsupervisors.However,whenitisshared,thedatapointscollectedbytheECBisoftencollatedandpresentedinadifferentwaythatisnotfungiblewiththemannerthroughwhichothersupervisorswouldcollectandpresent this data.

Therefore,commonplatformsanddatabasesshouldbeestablishedbetweenthedifferentdepartments in charge of the supervision of differentpartsofcapitalmarkets.Theremovalofbarriersbetweendatabasesisessentialfortheproduction of comprehensive measures.

When several authorities have distinct mandates tosupervisecapitalmarkets,theyshouldensurethatrelevantdatacanbesharedbetweenthem.Thisisthetypicalcaseofa“twinpeak”modelwherecentralbankssupervisefinancialmarketinfrastructures,andaseparateentityisinchargeoffunds.Finally,ascapitalmarketstendtobeglobal,globalconvergenceintheindexespublished by authorities should facilitate a smoother monitoring of liquidity risks.

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Box 4: Diversity in the methodologies used to measure asset liquidityHighdiversitycanbeobservedinthemethodologies and tools used to measure the degree of asset liquidity of portfolios. Practices hingelargelyonbusinessmodels,investmentstrategy,assetclasses,localjurisdiction,typesofdatabaseused,accessibilitytoqualitydataornot,etc.Forexample,theuseornotofliquiditybuckets,thatistheclassificationofassets according to their degree of liquidity (usuallywithacleargradation),isdependentonthetypesofassetsinwhichthemanagersof professional investor fund invest. While well-acceptedmethodologiesdoexisttoclassifythedegreeofliquidityoffixed-incomeproducts,over-the-counterderivativestypically do not have such metrics. Regarding professional investor funds’ managers that usebucketing,thescalesandmetricscandiffermarkedly,notablydependingontheaccuracy,consistencyandgranularityofthedataidentified.

Overall,theamountofavailabledatatoassessliquiditycanvarysignificantlyacrossassets.Ononehand,vastamountsofdatacan generally be collected for assets that are continuouslytradedonlargestockexchanges:marketablesecurities,treasurybills,foreigncurrencies,etc.Ontheotherhand,littleorno data can be found for assets traded in certainjurisdictions(whereex-ante/ex-posttransparencylawsareratherlimited)orthroughspecifictradingchannels(suchasOTCtradingwherepricesareoftennotpubliclydisclosed).

Theperceivedilliquidityofsomeassetscanbearesultoftheirlowtradingvolumesandlack of data on the market values achieved on transactions involving these assets: private equityshares,complexderivatives,distressed

debt,mortgage-backedsecurities,etc.Manyprofessional investor funds’ managers then adoptspecificapproachestoseekalternativedata sources that can help them assess asset liquidity.Theyoftenleveragealltypesofinformationthatisproducedwithinthefund,notably data on quotes’ dynamics at their trading desks.

Oneofthemainchallengesforriskmanagersistoestimateand,ifpossible,anticipatechanges of liquidity over time. Many managers of professional investor funds have created platformsthatcombinethefund’sdatawithmarketdata.Theobjectiveofsuchinitiativesistodesignschemeswheresignalsaretriggeredoncepre-determinedilliquidthresholdshavebeenreached.Ifneeded,managerscanthenrealigntheweightingofportfolioassetstorecoverpre-definedliquiditylevels.

Thedifficultyofmeasuringassetliquidityis heightened by the potential diversity of liquidityprofileswithineachassetclass.Forexample,sovereignbondsforagivenmaturitytend to be much more liquid in core markets suchasGermanythaninemergingeconomies.Withineachassetclass,theliquidityofseveralsecuritiescanfollowdifferentpaths,dependingonexternalfactorsimpactingtheseproducts.Inordertoaddressthiscomplexity,a large share of professional investor funds’ managers is able to conduct pertinent analyses at security level.

Toconclude,highheterogeneityacrossfundsand asset classes can be observed in the mannerassetliquidityismeasured.Giventhediversityofdatabases,modelsandinvestmentstrategiesofprofessionalinvestorfunds,fullconsistency in these measures could hardly beachieved.Asaconsequence,supervisorsshouldbecautiouswhenaggregatingliquiditydataofprofessionalinvestorfunds,astheaggregate has sometimes little relevance.

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Concluding remarks

TheEUandtheU.S.alreadyhavesuitablelegislationfortheLRMofinvestmentfunds:theUCITSDirectiveandtheInvestmentCompanyActandrelatedSECrulesforretailfunds,andtheAIFMDandprivatefunds’rulesforprofessionalinvestorfunds.Thecoreassumptionofretail funds’ legislation is that investors are entitled to receive their money back promptly. Assuch,manyquantitativerestrictionshavebeenadoptedforthefundstomeetthisexpectation.

Rules for professional investor funds do not contain such a primary constraint and give morefreedomforproductdesign,providedthatinvestors’ redemptions are met throughout the lifecycleofthefund.ThebuildingofLRMresultsfromaseriesoftrade-offsthatcanbedesignedinmultiplewaysacrossthefourliquidityattributesofthefund.Thisfreedomisjustifiedby the characteristics of professional investors and by the need to develop a more diverse range of strategies than in the retail space. By freely settling on the LRM of professional investorfunds,managersstrengthenthecapitalmarketsandthefundingoftherealeconomy,notablythroughthecreationoflong-termilliquidstrategies.

Therefore,thenecessaryrulesalreadyexistandshouldbeenforcedcontinuouslyandeffectively.Effectivedisclosuretoprofessionalinvestorsshouldcontinue.Thereportingexerciseneedstobestreamlinedforthemutualbenefitofauthorities and professional investor funds’ managers. Access to liquidity tools that can be

usedunderfinancialstress(redemptiongates,redemptionfees,swingpricing,etc.)shouldbemaintainedorexpandedwhendomesticrestrictions persist. Authorities should also take action to support innovation in LRM processes (forLST,algorithms,etc.),especiallyforilliquidstrategiesthatgeneratelittledata.Finally,authorities should share more consolidated liquiditydatawithmanagersofprofessionalinvestor funds.

Soundpracticesidentifiedbytheindustryalsoneedtobeenhancedcontinuously.Inparticular,managers of professional investor funds should apply robust LRM throughout the life cycle of the fund,adjustingpracticesasnecessaryovertimeto meet regulatory requirements and market developments.Theyshouldhaveanadequateunderstandingoffundingliquidityconstraints,and of the approaches and tools that can alleviaterelatedliquidityrisks.Lastly,theyshouldbeabletounderstandwhattodoincaseofnullliquidityandcontinuouslydevelopeffectivedocumentation on LRM.

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Annex: Managing fund liquidity in the time of COVID(excerptedwithpermissionfromtheDecember2020SS&CWhitepaperofthesamename)


Introduction

Measuring and managing portfolio liquidity is a critical issue for alternative asset managers. Investorsunderstandthatfundmanagerstypicallyhavewidelatitudeinassetselectionandthatlessliquidorilliquidassetscancomprisesignificantpercentagesoftheholdings.Moreover,thesepercentagescanshiftquicklyanddramaticallyasmanagersanticipateandadapttochangingmarketconditions.Bothmanagersandinvestorswanttoknowthefundcanmeetliquiditydemandswithoutdisruptiontotheportfoliostrategy.Interestinliquidity,ofcourse,isheightenedintimesofuncertaintyandsystemicstress,asiscertainlythecasetodayworld-wideduetotheoutbreakofCOVID-19.

ThispaperwillanalyzetheimpactofCOVID-19onalternativefundliquidity,drawingonSS&C’sproprietaryindicesforredemptions,overallcapitalmovements,andperformance.IndicesarecompiledsolelywithactualclientdatacollectedacrossallSS&Cclients,i.e.,thereisnobootstrappingorextrapolationofdataandnoselectionorsurvivorbias.Wewillalsodetailhowfund liquidity is presented to investors and other externalparties,includingregulatorsandriskaggregators.

Liquidity data in the age of COVID-19RedemptionsWidespreadrecognitionoftheCOVID-19outbreak probably dates back to February 2020,whenmarketsfirstbegantoreflectthe shockingly rapid spread and health consequencesofthevirus.Therefore,wedonothaveevenasingleyearofCOVID-19databehindus,soanyanalysisofthetrendsmustincludethis caveat.

However,thedatathathasemergedthusfarspeaksquiteclearly.Belowisagraphofthetime series of redemption notices received by SS&Cfundadministrationclientsdatingbacktothefinancialcrisisof2008-09.ThisdataisencapsulatedinSS&C’sForwardRedemptionIndicator,amonthlycalculationofredemptionnotices as a percentage of assets under management.

https://www.globeopindex.com/home.go

https://www.globeopindex.com/home.go

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Several points are clear from the graph:

1. Redemptionnoticesthroughout2020arerunningsteadilyinthelowsingledigits.ThemostrecentreadingforNovemberof3.63%continues this trend.

2. Theredemptionexperiencein2020isentirelyconsistentwithpre-outbreaklevelsfrom2019 and other recent years.

3. Asacorollarytothesefirsttwopoints,the2020redemptionlevelsinnowayresemblethoseofthelastsystemiccrisis,thefinancialcrisisof2008-09,whenredemptionsapproached20%.

Figure 1: SS&C GlobeOp Forward Redemption Indicator Chart – November 2020


Capital movementsSS&CalsocalculatesaCapitalMovementsIndex,whichmeasurestheactualmonthlychangeincapitalbytrackinginflowsandoutflows.Theseoutflowsdifferfromredemptionnoticesinthatthelatterincludesredemptionsscheduledwellintothefuture.Capitaloutflows,ontheotherhand,areamountsthathavebeenwithdrawninthecurrentmonth.Thenetinflowsandoutflows,withoutgainsandlossesfromperformance,are presented as percentages of assets under management.

TheCapitalMovementsIndextellsasimilarstorytotheForwardRedemptionIndicatordiscussedabove.

1.Netflowsofcapitalhaveremainedremarkablysteadyin2020andareconsistentwithrecentyears’ data.

2.Thetwoindividualcomponentsofthismeasure,inflowsandoutflows,aresteadyintheirownright.

3.Thecurrentflowsindicatenothinglikethemassiveoutflowsthatoccurredinthefinancialcrisis.

Figure 2: SS&C GlobeOp Capital Movement Index Chart- November 2020

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Performance and other factors influencingliquidityIf liquidity demands are a function of market disruption,whataccountsforthesteadytrend lines in redemptions and capital movements?Thestartingpointforthisanswerisperformance.ThegraphicbelowpresentsSS&Caggregated alternative asset fund performance. Investors allocate capital to alternatives to improvetheirrisk-rewardpositionandtheperformancerecordfor2020indicatesthatmanagersarefulfillingthismission.

Figure 3: SS&C GlobeOp Hedge Fund Performance Chart – October 2020


Yet,itmustbenotedthattheprospectofthisstrongperformancewasnotimmediatelyobviouswhenCOVID-19firstroiledmarketsearlierin2020.Webelieveadditionalfactorsexplaintheconfidencethatinvestorsshowedin alternative managers during those turbulent months.

1.Thereturnofvolatilitytothemarketswasseen as playing into alternative managers’ strengths,bothintermsofavailablelong/shortstrategiesandproficiencyinactivetrading.

2.Themacro-policyreactionstotheCOVID-19crisiswereswiftanddecisiveforbothfiscaland monetary policy.

3.Thesespeedyreactionshelpedkeepanemerging public health crisis from becoming an immediate market crisis so that markets never“seizedup”thewaytheyhadin2008-09

4.Manyinvestorsof2020hadlivedthroughthe2008-09crisis,understoodtheimplicationsof policy responses and remembered the V-shapedrecoveryofthatcrisis.Panicsellingtookplace,butnotonthescaleof2008-09.

Therelativecalminredemptionshascreatedopportunities,aswell.Forexample,severalfund launches have focused on deep credit anddistressedassets,strategiesthatnaturallyencompasslessliquidassets.Thesefundscanmoveforwardmoreconfidently,giventheconsiderations discussed.

Again,weareonlypartwaythroughtheCOVID-19outbreakandthenewsisfilledwithnewsurgesandhopefulsignsfordevelopingeffectivetherapiesandvaccines.Therefore,marketsremainvolatile,butwithconfidenceseeming to remain high in alternative asset managers’abilitytocreateattractiverisk-adjustedreturns,liquiditydemandsare runninginlinewithpre-COVID-19levels.…

5555

Conclusion

Alternative asset funds have proven remarkably resilientandeffectiveinnavigatingthefinancialimpactoftheCOVID-19crisis,and,todate,investorshaveshownstrongconfidenceintheirability to continue to do so in the aggregate. Still,themarketturbulencehasremindedallinvestment stakeholders of the importance of measuring,monitoring,andmanagingliquidityrisk.…Weexpectthiswillcontinuetobetheforeseeablecasefutureamongmanagers,investors and regulators.

Endnotes


1 See section 2.3 of this paper.

2 Centralbanks,securitiesregulators,systemicrisk bodies and other international bodies are collectively referred to in this paper as “authorities”.

3 AIMA,theAlternativeInvestmentManagementAssociation,istheglobalrepresentative of the alternative investment industry,withmorethan2,000corporatemembersinover60countries.AIMA’sfundmanager members collectively manage more than $2 trillion in assets. AIMA drawsupontheexpertiseanddiversityofits membership to provide leadership in industryinitiativessuchasadvocacy,policyandregulatoryengagement,educationalprogrammes and sound practice guides. AIMAworkstoraisemediaandpublicawarenessofthevalueoftheindustry.AIMAset up the Alternative Credit Council (ACC) tohelpfirmsfocusedontheprivatecreditanddirectlendingspace.TheACCcurrentlyrepresentsover170membersthatmanage$400billionofprivatecreditassetsglobally.AIMA is committed to developing skills and educationstandardsandisaco-founderof the Chartered Alternative Investment Analystdesignation(CAIA)–thefirstandonly specialised educational standard for alternative investment specialists. AIMA is governedbyitsCouncil(BoardofDirectors).Forfurtherinformation,pleasevisitAIMA’swebsite,www.aima.org.

4 Article4(1)(b)ofDirective2011/61/EUoftheEuropean Parliament and the Council of 8 June2011onAlternativeInvestmentFundManagers,asamended(the‘AIFMD’)definesthe term ”AIFs” as “collective investment undertakings,includinginvestmentcompartmentsthereof,which:(i)raisecapitalfromanumberofinvestors,withaviewtoinvestingitinaccordancewithadefinedinvestmentpolicyforthebenefitof those investors; and (ii) do not require

authorisationpursuanttoArticle5ofDirective2009/65/EC[(theUCITSDirective)].“TheAIFMDsetsouttheconditionsunderwhichalternativeinvestmentfundmanagers(or ‘AIFMs’) are able to market the AIFs they manage in the EU to “professional investors” (asdefinedinArticle4(1)(ag)oftheAIFMD).AIFMs may only market an AIF to an investor thatisnota“professionalinvestor”(i.e.,retailinvestors) if the AIFM does so in compliance withthenationallawoftheMemberStateoftheinvestor.“ProfessionalinvestorsownmostofthesharesofAIFs,yetretailinvestorshareissignificantat16%oftheNAV[oftheEUAIFuniverseasoftheendof2018],withmoreparticipationin[fundsoffunds]and[realestate]funds.“EuropeanSecuritiesandMarketsAuthority(ESMA),“EU Alternative InvestmentFunds-2020AnnualStatisticalReport”(10January2020)(‘ESMA2020StatisticalReport’),atpage4.

5 Section2(a)(29)oftheU.S.InvestmentCompanyActof1940,asamended(the‘InvestmentCompanyAct’),definesa“privatefund”as“anissuerthatwouldbeaninvestmentcompany,asdefinedinsection3oftheInvestmentCompanyAct,but for section 3(c)(1) or 3(c)(7) of that Act.” Asageneralmatter,eachinvestorinaprivatefundrelyingonSection3(c)(1)oftheInvestment Company Act is required to be an“accreditedinvestor”asdefinedinRule501(a)undertheU.S.SecuritiesActof1933,asamended(the‘SecuritiesAct’).Similarly,each investor in a private fund relying on Section3(c)(7)oftheInvestmentCompanyActisrequiredtobea“qualifiedpurchaser”asdefinedinRule2a-51underInvestmentCompany Act.

http://www.aima.org

https://www.esma.europa.eu/press-news/esma-news/esma-report-values-eu-alternative-investment-funds-€58-trillion



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6 Althoughthesedefinitionsdifferinsomeofthedetailsfromthedefinitionof“professional investor” used in connection withmarketingAIFs,theyaregenerallycovering the same types of sophisticated professionalinvestors.Forthisreason,therestofthispaperwillrefertoAIFsandprivatefunds collectively as “professional investor funds“.

7 See, e.g.,theimpactoftheEuropeanCentralBank’s2016/17corporatesectorpurchaseprogramme on corporate bonds’ yield spreads,EuropeanCentralBank(ECB),“HowECB purchases of corporate bonds helped reducefirms’borrowingcosts?”,ResearchBulletin(January2020),(‘ECB2020ResearchBulletin’).

8 Policymakershavealsobeenreviewingtheeventsof1H2020andconsideringtheirimplications for liquidity risk management and margin requirements. See, e.g.,DanielBarthandJayKahn,“BasisTradesandTreasuryMarketIlliquidity”,OfficeofFinancialResearch(OFR)BriefSeries20-01(16July2020);andL.Rousová,etal.,“Derivatives-relatedliquidityriskfacinginvestment funds”(May2020)(‘ESRB2020StaffPaper’),publishedaspartoftheECB“FinancialStabilityReview”(May2020),(‘ECB2020Report’).See alsoFinancialStabilityBoard(FSB),“HolisticReviewoftheMarchMarketTurmoil”(17November2020)(‘FSB2020HolisticReview’).

9 SeeFSB2020HolisticReview,supranote8,atpages24-26.See alsoEuropeanSystemicRiskBoard(ESRB),“Liquidity risks arising from margin calls”(June2020)(‘ESRBMarginCalls’),at page 8.

10 SeeECB2020Report,supranote8,atparagraph4.1. See alsoESRB,“Financial stability implications of support measures to protecttherealeconomyfromtheCOVID-19pandemic”(February2021),atpage14.

11 BankofEngland,FinancialPolicyCommittee,“FinancialStabilityReport”(December2019)(‘BoE2019Report’),atpage76.

12 SeeECB2020ResearchBulletin,supra note 7 (“reducing yields in the targeted bond market segment,theprogrammeencouragedinvestorstoshifttheirinvestmentstowardssimilarbutsomewhatriskierbonds”).See also ECB,“FinancialStabilityReview” (November 2019)(‘ECB2019Report’),atpage7(“Thesearchforyieldhasintensifiedsincethestartoftheyear,withlessthan10%ofthebondsoutstandinggloballyofferingyieldsof3%”)andpage46(“Institutionalinvestorshave recently increased their holdings of illiquid assets since they are often associated withhigherandpositivereturns”);andInternational Monetary Fund (‘IMF’) “GlobalFinancialStabilityReport:LowerforLonger” (October2019)(‘IMF2019Report’),atpage40(Figure 3.1. Institutional Investors’ Increased Risk-TakinginaPersistentlyLow-Interest-Rate Environment).

13 SeeBoE2019Report,supranote11,atpage 76 (“Funds’ holdings of assets that take longer to liquidate in an orderly way,especiallyduringaperiodofmarketstress,areincreasing.Globally,morethanUS$30trillionofassetsarenowheldinopen-endedfundsthatoffershort-termredemptionswhileinvestinginlonger-datedandpotentiallyilliquidassets,suchascorporatebonds.Thathasmorethantripledsince2006.“).AccordingtoBankofEngland,theseestimatesarebasedon“FSBGlobalMonitoringReportonNon-BankFinancialIntermediation2018” (February 2019),atpage5(notablyregarding“collectiveinvestmentvehicles(CIVs)withfeaturesthatmake them susceptible to runs”).

14 IMF2019Report,supranote12,atpage39.

https://www.ecb.europa.eu/pub/economic-research/resbull/2020/html/ecb.rb200128~00e0298211.en.html



https://www.financialresearch.gov/briefs/files/OFRBr_2020_01_Basis-Trades.pdf

https://www.financialresearch.gov/briefs/files/OFRBr_2020_01_Basis-Trades.pdf

https://www.fsb.org/2020/11/holistic-review-of-the-march-market-turmoil/

https://www.fsb.org/2020/11/holistic-review-of-the-march-market-turmoil/

https://www.esrb.europa.eu/pub/pdf/reports/esrb.report200608_on_Liquidity_risks_arising_from_margin_calls_3~08542993cf.en.pdf?8380a2a90041200ca6e5c008138a127e

https://www.esrb.europa.eu/pub/pdf/reports/esrb.report200608_on_Liquidity_risks_arising_from_margin_calls_3~08542993cf.en.pdf?8380a2a90041200ca6e5c008138a127e

https://www.esrb.europa.eu/pub/pdf/reports/esrb.reports210216_FSI_covid19~cf3d32ae66.en.pdf




https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2019/december-2019.pdf?la=en&hash=4A650CF0FB871B5094C614C99689D9AD930CAA01

https://www.ecb.europa.eu/pub/pdf/fsr/ecb.fsr201911~facad0251f.en.pdf

https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019

https://www.imf.org/en/Publications/GFSR/Issues/2019/10/01/global-financial-stability-report-october-2019

https://www.fsb.org/wp-content/uploads/P040219.pdf




15 “Liquiditystressscenariosconfirmthatfixed-incomefundsarevulnerabletoliquidityshocks”.IMF2019Report,supranote12,atBox3.1atpages48and49.

16 ESRB,“Recommendation on liquidity risks in investment funds”,(ESRB/2020/4)(6May2020)(‘ESRB2020Recommendations’),atpage 2.

17 ESRB,“Recommendation on liquidity and leverage risks in investment funds”,(ESRB/2017/6)(7December2017)(‘ESRB2017Recommendations’),atpage1.

18 ECB2020Report,supranote8,atOverview.

19 See, e.g.,ESMA,“ESMAReportonTrends,Risks and Vulnerabilities”(17March2021),atpage 31.

20 IOSCOhaspublishedalistofrecommendations aimed at reinforcing the LRM processes of investment funds and ensuring “proper alignment of fund assets and redemption terms” throughout the life ofthefund.IOSCObelievesthat“thebestline of defence against a liquidity mismatch remainswiththe[collectiveinvestmentschemes]andtheresponsibleentity”andexpectsresponsibleentities“toexercisetheirsoundprofessionaljudgementinthebestinterestofinvestors[…],inbothstressed and normal market conditions”. IOSCO,“Recommendations for Liquidity Risk Management for Collective Investment Schemes”,FinalReport(February2018)(‘IOSCO2018Recommendations’),atpages2and 23.

21 TheIOSCOrecommendationsstatethatthe LRM of investment funds “must also takeaccountof[…]deliveryandpaymentobligationssuchasmargincalls,obligationstocounterpartiesandothercreditors”.IOSCO2018Recommendations,supranote20,atpage 12.

22 Someruleshavebeenimplementedtoreinforce the quality of the LRM reporting to authorities.Forexample,theU.S.SecuritiesandExchangeCommission(SEC)introducednewliquidityrulesthatrequireU.S.registeredopen-endinvestmentcompanies(‘mutualfunds’)ofmorethanUSDonebillionto classify their portfolio holdings into four liquiditybuckets.SeeRule22e-4(b)(1)(ii) under the Investment Company Act. Under theserequirements,thesemutualfundsareexpectedtoclassifyeachinvestmentintooneoffourliquiditycategories,dependingonhowmanybusinessdaysareneededtosellapositionwithoutsignificantchangeinitsvalue.Investmentscanbehighlyliquid,moderatelyliquid,lessliquidorilliquid.Thereare clear numerical values for each of this category: less than three business days for thefirst,betweenthreeandsevendaysforthesecond,lessthansevendaysforthethirdandmorethansevendaysforthefourth.SeeRule22e-4(a)(6),(8),(10)and(12) under the Investment Company Act.

23 IMF2019Report,supranote12,atpage47.Also,inSeptember2019,theUKFinancialConductAuthority(FCA)adoptednewrequirementsforopen-endednon-UCITSretailschemes(‘NURSs’)whichinvestin‘inherently illiquid assets’ such as property. See Illiquidassetsandopen-endedfundsandfeedbacktoConsultationPaperCP18/27,FCAPolicyStatementPS19/24(September2019).Thesenewrulesimposedrequirementsforstandardriskwarningsandotherinvestordisclosures.Managersofthesefundswillalso have to “produce [and disclose to investors]contingencyplansfordealingwithliquidityrisks”.See id.,atpage7.Amongotherthings,thisplanwoulddescribe“howthefundmanagerwillrespondtoaliquidityriskcrystallising”,thetypeofliquiditytoolsthey“maydeployinsuchexceptionalcircumstances[…]andtheconsequencesforinvestors”,etc.See id.,atpage20.

https://www.esrb.europa.eu/pub/pdf/recommendations/esrb.recommendation180214_ESRB_2017_6.en.pdf?c8d7003d2f6d7609c348f4a93ced0add




https://www.esma.europa.eu/sites/default/files/library/esma50-165-1524_trv_1_2021.pdf

https://www.esma.europa.eu/sites/default/files/library/esma50-165-1524_trv_1_2021.pdf

https://www.iosco.org/library/pubdocs/pdf/IOSCOPD590.pdf



https://www.ecfr.gov/cgi-bin/text-idx?SID=130db38c2051384a98c86437c1d53a11&mc=true&node=se17.4.270_122e_64&rgn=div8

https://www.ecfr.gov/cgi-bin/text-idx?SID=130db38c2051384a98c86437c1d53a11&mc=true&node=se17.4.270_122e_64&rgn=div8

https://www.fca.org.uk/publication/policy/ps19-24.pdf

https://www.fca.org.uk/publication/policy/ps19-24.pdf

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24 In2019,theESRBrecommendedthatESMAdevelop “guidance on the practice to be followedbymanagersforthestresstestingof liquidity risk for individual AIFs and UCITS[…]inordertopromotesupervisoryconvergence.”ESRB2017Recommendations,supranote17,atpage4.FurthertothisESRBrecommendation,inSeptember2019,ESMApublished guidance on liquidity stress testing (‘LST’)thatappliestobothAIFsandUCITS.SeeESMA,“FinalReportGuidelinesonLSTinUCITSandAIFs”(2September2019)(‘ESMALSTGuidance’).FromSeptember2020,AIFMsandUCITSmanagementcompaniesarerequired to regularly stress test the liabilities andassetsofthefundstheymanage,andtouseLSTtomitigatepotential(liquidity)risks,inaccordancewiththeESMALSTGuidance,regardlessofhowtheywereundertakingLSTpreviously.ECBstaffmembershavenotedthat“[g]oingforward,furtherextrememarketshocksmayoccur,whichcallsfortheconductofforwardlookingsimulationsofmargincallsunderstressscenarios.”ESRB2020StaffPaper,supra note 8.

25 IOSCOhasstatedthat“itwouldbeimpracticaltopursue,assomehavesuggested,“aglobal‘onesizefitsall’”prescriptiveapproachwhichtriestomatchdifferentassetclasses,fundinvestmentstrategies and redemption periods according to universally applicable standards”. As such,the2018recommendationsofIOSCO“containpractical,actionableprincipleswhichsupportthosedomesticregulatorswhomaywishorneedtopursueaprescriptive approach responsive to the natureofparticular[open-endfunds]theysupervisedirectlyand/orspecificcharacteristicsofthelocalmarketsinwhichthey operate.“ “StatementonIOSCOliquidityrisk management recommendations for investment funds”(18July2019),atpage2.

26 TheIMFhasemphasisedthat“minimumeligibility criteria (based on credit quality and liquidity)fortheinclusionofassetsinfixed-income funds’ portfolios could be introduced to help lessen credit risks and liquidity mismatches”. SeeIMF2019Report,supra note12,atpage47.

27 IntheUK,NURSsthatinvestininherentlyliquidassetswillberequiredtosuspenddealing if a standing independent valuer has expressedmaterialuncertaintyregardingatleast20%ofthefund’sassets’value,orifthatfundinvestsatleast20%ofitsassets’valueinunitsoffund(s)forwhichdealingsin units have been temporarily suspended. Seeid.,Appendix1,atpage16.TheFCAcanauthorise fund managers “to continue to dealwheretheyhaveagreedwiththefund’sdepositary that this is in the fund investors’ best interests.” See id.,atpages4and5.

28 See IOSCO“Open-endedFundLiquidityandRiskManagement-GoodPracticesand Issues for Consideration”,FinalReport(February2018)(‘IOSCOGoodPracticesReport’).

29 BIS-BCBS,“GuidanceforSupervisorsonMarket-BasedIndicatorsofLiquidity” (January2014),atpage5,(Table2–Liquiditycharacteristics,criteriaandmetrics).

30 AIMAandCAIAAssociation,“Efficientflows:Understanding liquidity in alternative investment funds”,TrusteeSeries,Paper4(2018)(‘AIMAEfficientFlows’),atpage9.

31 Activismoccurswhenaninvestorpurchasesa large number of a public company’s shares and/ortriestoobtainseatsonthecompany’sboardinordertoeffectasignificantchangewithinthecompany.

32 SeeESRBMarginCalls,supranote9,at page 8.

https://www.esma.europa.eu/sites/default/files/library/esma34-39-882_final_report_guidelines_on_lst_in_ucits_and_aifs.pdf

https://www.esma.europa.eu/sites/default/files/library/esma34-39-882_final_report_guidelines_on_lst_in_ucits_and_aifs.pdf

https://www.iosco.org/news/pdf/IOSCONEWS539.pdf






https://www.bis.org/publ/bcbs273.pdf

https://www.bis.org/publ/bcbs273.pdf

https://www.aima.org/uploads/assets/uploaded/7656e745-4db1-4bf9-a09924216e53225c.pdf




33 Thisriskwasoneofseveralmargin-relatedrisksremarkeduponbytheESRBinaJanuary2020paper.“[M]arketparticipantsinderivatives transactions can change collateral requirementsatshortnotice,forexamplebyincreasing haircuts or by rendering certain collateral ineligible. Introducing notice periodswouldprovidegreatertransparencyand planning certainty to market participants and could thereby reduce liquidity risk andthelikelihoodoffiresales.”ESRBExpertGroupontheMacroprudentialUseofMarginsandHaircuts,“Mitigating the procyclicality of margins and haircuts in derivativesmarketsandsecuritiesfinancingtransactions”(January2020),atpage56.

34 Lowleverageentailshigherfundingliquidity,giventhelowerfundingconstraints.

35 Retail funds can be used by institutional investors but are primarily designed for retailinvestors.ESMAhasestimatedthatin2017,65%ofUCITSwereidentifiedasmarketed to retail investors and the share ofUCITStargetedatinstitutionalinvestorshadreached35%.SeeESMA,“ESMAAnnualStatisticalReport:PerformanceandcostsofretailinvestmentproductsintheEU2019” (10January2019),atpage10.

36 Astheydonotredeeminvestorshares,closed-endregisteredinvestmentcompaniesare not covered.

37 Forinstance,afundwithUSD100millioninassetsmayborrowuptoUSD50millionfroma bank.

38 AIFMsalsohavetodisclosecashborrowingonthetemplatesetinAnnexIVb)of EUDelegatedRegulation(No.231/2013) (19December2012)(the‘AIFMDLevel2Regulation’).

39 U.S.registeredinvestmentadvisersarerequiredtoreportdifferentsortsofmeasures in the Form PF (Paper version)(‘FormPFTemplate’).Thisinformationprovides balance sheet leverage measures by using regulatory assets under management or NAV.

40 SeeArticle76ofDirective2009/65/EC(theUCITSDirective)(“[T]hecompetentauthoritiesmay,however,permitaUCITSto reduce the frequency to once a month on condition that such derogation does not prejudicetheinterestsoftheunit-holders”).InDecember2017,theESRBhighlightedthat“this option has not been transposed into nationallawbyallMemberStates”.ESRB2017Recommendations,supranote17,atpage15,footnote3.Despitetheflexibilityofferedforlessfrequentredemptions,manyUCITSofferdailyinvestorliquidity.ThisisnotablythecaseofLuxembourgwhere“themajorityofUCITSofferdailyliquidity.“SeeIMF,“Luxembourg:FinancialSectorAssessmentProgram:TechnicalNote–FundManagement:Regulation,Supervision,andSystemicRiskMonitoring”,IMFCountryReportNo.17/257(28August2017),atpage12.

41 TheInvestmentCompanyActgovernstheoperationsofU.S.registeredinvestmentcompanies,whethertheyareoftheopen-endorclosed-endtype.Rule22c-1underthe Investment Company Act requires open-endregisteredinvestmentcompanies(collectively,‘mutualfunds’),theirprincipalunderwritersanddealersinmutualfundshares to sell and redeem mutual fund shares at a price determined at least daily basedonthecurrentnetassetvaluenextcomputed after receipt of an order to buy or redeem.

https://www.esrb.europa.eu/pub/pdf/reports/esrb.report_200109_mitigating_procyclicality_margins_haricuts~0f3e9f9e48.en.pdf




https://www.esma.europa.eu/sites/default/files/library/esma50-165-731-asr-performance_and_costs_of_retail_investments_products_in_the_eu.pdf



https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:083:0001:0095:EN:PDF

https://www.sec.gov/files/formpf.pdf

https://www.imf.org/en/Publications/CR/Issues/2017/08/28/Luxembourg-Financial-Sector-Assessment-Program-Technical-Note-Fund-Management-Regulation-45205




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42 IOSCOGoodPracticesReport,supranote28,atpage50.

43 Forfurtherdetails,seeAIMA,“GuidetoLiquidAlternativeFunds”(2015)(‘AIMAGuidetoLiquid Alts’) (available to members at www.aima.org and to regulators upon request to [email protected]).

44 See id.,atpage16(“A‘diversified’fundisrequiredtohaveatleast75%ofthevalueofitstotalassetsincashandcashitems,governmentsecurities,securitiesofotherinvestmentcompanies,andothersecurities.Thesecuritiesofasingleissuerthataccountformorethan5%ofthediversifiedAMF’sassetsorthatconstitutemorethan10%oftheissuer’svotingsecuritiesareexcludedfromthe75%bucket.A‘non-diversified’AMF(afundthatdoesnotmeetthedefinitionof“diversified”fund)isnotrequiredtocomplywiththistest.”).

45 Mutual funds could adopt such strategies iftheybuiltsignificantliquiditybufferstoensure they could meet daily redemptions in most circumstances.

46 Forfurtherdetailsontheserules,see AIMA GuidetoLiquidAlts,supranote43,atpage17.

47 Forfurtherdetailsontheserules,see AIMA GuidetoLiquidAlts,supranote43,atpages17-18.

48 See“UseofDerivativesbyRegisteredInvestment Companies and Business DevelopmentCompanies”,85FR83162 (21 December2020).Thesenewrequirementsbecameeffective19February2021,however,thecompliancedateis19August2022.

49 Theunderlyingliquidityisthecombinedliquidity of the three other attributes: asset liquidity,fundingliquidityandstrategyliquidity.

50 ESMA2020StatisticalReport,supranote4.

[NB:Thereferencetoprivateequity’sweeklyto monthly redemption frequency may not befullyrepresentativeofthewiderEUopen-end private equity fund population as there is typically no redemption in a broader private equitycontext.]

51 SeeSEC,“PrivateFundsStatistics,SecondCalendarQuarter2019”(29January2020)(‘SEC2019StatisticalReport’),atpage35.



54 Foradefinitionof“activism”,see supra note 31.

55 SeeAIMAEfficientFlows,supranote30.

56 A large amount of liquidity related information has to be disclosed by AIFMs on thetemplatesetinAnnexIVofthe‘AIFMDLevel2Regulation’,see supranote38.U.S.registered investment advisers are required toreportsimilarinformationontheSEC’sForm PF. See FormPFTemplate,supra note 39.

57 SeeBIS,“Establishing viable capital markets”,CGFSPapers,No62(January2019).

58 SeeIMFandWorldBank,“DevelopingGovernmentBondMarkets:AHandbook” (July2001),atpage17.

59 Styledriftoccurswhenaninvestmentfund’smanager changes the original strategies and goalsofthefund.Disappointingreturnscanforexamplepersuadeamanagertoadoptnewtypesofstrategiesthathaveachievedhigherreturns.Thedriftcanalsooccurunintentionally,shouldthecharacteristicsof the underlying investments change (for instanceamid-sizefirmcandevelopintoalargeone,withdifferentfinancialneedsanddynamics).Thefrontierbetweenwhatisstyledriftandwhatisnotcansometimesbethin.Theclausesofsomeprofessionalinvestorfundsinvolveextensiveparameters

http://www.aima.org

https://www.govinfo.gov/content/pkg/FR-2020-12-21/pdf/2020-24781.pdf?utm_campaign=subscription+mailing+list&utm_source=federalregister.gov&utm_medium=email

https://www.sec.gov/divisions/investment/private-funds-statistics/private-funds-statistics-2019-q2-accessible.pdf

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http://documents.worldbank.org/curated/en/334621468740683230/pdf/multi0page.pdf


thatallowmanagersforexampletoinvestin the entire investable universe of bonds orstocks.Somehow,styledriftcanthenbepracticedwithinthepre-definedprovisions.Whatevertheformofthestyledriftmaybe,such practice often increases liquidity risks. Itremainschallengingtopre-defineLRMprocesses that can automatically adapt to newstrategies,assetsandformsofrisks.

60 Inlargerfunds,thiskindofinformationisrarely available. Managers act in the best interest of all investors and that might not alwaysbetokeepalargeliquidityreserve.Modelling typically considers investor concentrationaspects(typeofinvestor,largestinvestors…),combinedwithqualitativeinformation gathered from the commercial relationshipsthatmanagershavewithclientsand the redemption mechanism outlined in the fund’s constitutional documentation.

61 SeeAIMAandS3Partners,“Accessing the financialpowergrid,hedgefundfinancingchallenges under Basel III and beyond” (January2016)(‘AIMABaselIII’)forfurtherdetailsontherelationshipbetweenprimebrokersandhedgefunds.SeealsoAIMAandCAIA,“Understanding the use of leverage in alternative investment funds”,TrusteeSeries,Paper3:Madetomeasure(2018),forfurtherdetails on funding liquidity.

62 Thesebankingruleshavesignificantlyraisedtheconstraintsonbanksfinancingprofessionalinvestorfunds,notably“bankinternal funding costs”. SeeAIMABaselIII,supranote61,atpage10.

63 SeeSEC,“InformationforNewly-RegisteredInvestment Advisers”(23November2010).

64 See supranote38,Articles46to49ofthe‘AIFMDLevel2Regulation’foramoredetailed analysis of liquidity rules applicable undertheAIFMD.

65 See ESMALSTGuidance,supranote24.

66 Forfurtherdetailsonarrangements,see the analyseson“investorliquidity”inSection2.1.

67 KPMG,“ReportontheOperationoftheAlternative Investment Fund Managers Directive(AIFMD)–Directive2011/61/EUFISMA/2016/105(02)/C”,submittedtotheEuropeanCommissionon10December2018,atpages221-222.

68 Forfurtherdetails,seetheTable1ofTurnerJ.,D.Vaughan,C.GardnerandR.Fenwick(2014),“A Practical Comparison of Reporting UnderAIFMDversusFormPF”,TheHedgeFundLawReport,Vol.7,Number41,AdviseTechnologies,LLC,Dechert,LLP.

69 Forthatpurpose,authoritiescanadvisetouse a number of buckets ranging from highly liquid to illiquid.

70 Thetwoformsusedifferentcategoriesfortheclassificationofinvestors.

71 Forexample,thefields178-185ofthetemplatesetoutinAnnex4ofthe‘AIFMDLevel 2 Regulation’ (See supra note 38) require the AIFM to report the percentage of the AIF’s portfolio that is capable of being liquidated withineachoftheliquidityperiodsspecified.Thisrequirement,however,diminishestheusefulness of the data reported because it causes AIFMs to report that certain AIFs are less liquid than they actually are. For example,apositionmightbeabletobepartiallyliquidatedbetween1and30days,butitmighttakeupto90daystocompletelyliquidatetheposition.Currently,anAIFMmustshowthatallinthe90-daycategory.AllowingAIFMstospreadthelikelyliquidityintothevariouscategorieswillprovideamoreaccurateviewofAIFs’liquidity.Therequirements that each investment must be assigned to only one period must therefore be reconsidered.

https://www.aima.org/article/accessing-the-financial-power-grid-hedge-fund-financing-challenges-under-basel-iii-and-beyond-report-by-aima-and-s3-partners.html



https://www.aima.org/article/made-to-measure-understanding-the-use-of-leverage-in-alternative-investment-funds.html

https://www.aima.org/article/made-to-measure-understanding-the-use-of-leverage-in-alternative-investment-funds.html

https://www.sec.gov/divisions/investment/advoverview.htm

https://www.sec.gov/divisions/investment/advoverview.htm

https://ec.europa.eu/info/sites/info/files/business_economy_euro/banking_and_finance/documents/190110-aifmd-operation-report_en.pdf




https://www.dechert.com/knowledge/publication/2014/10/a-practical-comparison-of-reporting-under-aifmd-versus-form-pf.html

https://www.dechert.com/knowledge/publication/2014/10/a-practical-comparison-of-reporting-under-aifmd-versus-form-pf.html

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72 AIMA has published a Position Paper on Improving Regulatory Reporting under theAIFMDonpotentialwaysregulatoryreportingintheformsetoutasAnnexIVofCommissionDelegatedRegulation(EU)No.231/2013couldbeimproved,see https://www.aima.org/resource/aima-position-paper-on-improving-systemic-regulatory-reporting-under-the-aifmd.html.

73 Severalreportshaveshownthatinrecentyears the aggregate underlying portfolio liquidityofhedgefundshasbyfarexceededtheliquidityofferedtoinvestorsacrossthedifferenttimeperiods.See, e.g.,IOSCO,“ReportontheFourthIOSCOHedgeFundsSurvey”,FinalReportFR22/2017(November2017),atpage25,Figure11.Followingthemarketvolatilityin1Q2020,theECBhassuggestedthat“[m]inimumliquiditybuffersshouldalsobeconsidered,tomanageincreasedliquidityneedsfromoutflowsormargincallsinastressperiod.”ECB2020Report,supranote8.Whileliquiditybuffersare sound practice for professional investor funds,minimumliquiditybuffersarenotappropriateinthiscontextduetothesubstantial diversity of investment strategies anddiversityofliquidityprofilesintheprofessional investor fund space.

74 SeeESRB,“Issues note on liquidity in the corporate bond and commercial papermarkets,theprocyclicalimpactofdowngradesandimplicationsforassetmanagers and insurers”(May2020),atpage 4.

75 SeeIOSCOGoodPracticesReport,supra note 28(columnsthatconcernexclusivelyretailfundsand/ornon-EUcountrieshavebeenremoved).

76 RegulatorysandboxwasfirstintroducedbytheFCAintheUKatend-2015andbroadlysimilarframeworkshavesincethenbeenadoptedamongothersbyAustralia(ASIC,2016),theNetherlands(AFM-DNB,2016),Switzerland(FINMA,2016),Singapore(MAS,2016b),Thailand(Finextra,2016)andHongKong(PinsentMasons,2016).

77 Tradingoflessliquidassetsislimited,thusgenerating little data.

78 SeeSEC2019StatisticalReport,supra note 51,andESMA2020StatisticalReport,supra note 4.

https://www.aima.org/resource/aima-position-paper-on-improving-systemic-regulatory-reporting-under-the-aifmd.html





https://www.esrb.europa.eu/pub/pdf/reports/esrb.report200514_issues_note~ff7df26b93.en.pdf?c5c05e93a8491ce6a232463954a3e3d8






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