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Today New City Initiative is comprised of 51 leading independent asset management firms from the UK and the Continent, managing approximately £400 billion and employing several thousand people.

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The Liquidity Conundrum

The Liquidity Conundrum

Liquidity and fund managers is now a pressing area of concern for regulators. Attempts by the Financial Stability Board (FSB), International Organisation of Securities Commissions (IOSCO) and the Financial Stability Oversight Council (FSOC) to designate certain asset managers as systemically important financial institutions (SIFIs) have so far failed to materialise. Instead, they are honing their sights on other potential risks posed by asset managers.

At present, the key focus is liquidity. One of the major fears among regulators is the impact mass withdrawals from mutual funds by investors could have on markets, particularly bonds. If a manager has a highly concentrated exposure to a specific market segment, would investor redemptions result in that manager being forced to sell underlying assets rapidly and at depressed prices to meet client withdrawals? If so, regulators are nervous about the impact this could have on capital markets.

Concerns around mutual fund liquidity were given a further impetus in December 2015 when Third Avenue, a US mutual fund, suspended redemptions to sell off its illiquid positions in the high-yield corporate debt market following withdrawal requests. Third Avenue offered clients daily liquidity despite having significant exposures to illiquid assets. One could argue that this is the exception rather than the rule, and most mutual funds will have diversified, liquid holdings and would not need to resort to such measures. Nonetheless, it represented the first mutual fund action of this kind since the Reserve Primary Fund broke the buck following its exposure to Lehman Brothers in 2008.

The Securities and Exchange Commission (SEC) is scrutinising events at Third Avenue and the mutual fund industry with a particular focus on so-called liquid alternatives. Provisions being considered by US regulators include limiting open-ended funds from having more than 15% of assets invested in illiquid instruments as well as the introduction of swing pricing. SEC Rule 18f-4 – proposed earlier in 2016 – could restrict the use of derivatives in leverage as well. This is aimed primarily at liquid alternatives. As such, the SEC recommended a hard exposure limit of 150% of fund net assets based on the notional amount of derivatives much to the chagrin of the industry.  

UCITS are also under similar scrutiny. There have been a number of complaints, particularly from traditional UCITS, that alternative UCITS offered by some hedge funds, have been stretching the rules around investing into esoteric instruments. Many of these traditional managers are concerned the UCITS brand could be tainted in the event of a high-profile blow-up whereby investor redemption requests are not met. European UCITS are of course allowed to gate. However, any suspension of redemptions by a UCITS would tarnish the brand.

The European Securities and Markets Authority (ESMA) did clamp down on this by restricting the ability of UCITS to invest in commodities. Several UCITS commodity trading advisers (CTAs) shuttered subsequently although a number of managers do gain commodity exposures through exchange traded notes.

However, it is no secret that regulators are hoping to emphasise UCITS’ retail credentials and encourage institutional inflows into AIFMs following passage of the Alternative Investment Fund Managers Directive (AIFMD). Furthermore, the introduction – should it occur – of UCITS VI could result in regulators restricting the eligibility criteria of UCITS assets. In other words, UCITS could be prevented from investing into certain esoteric or higher risk assets. Nonetheless, UCITS VI remains a long way off.

In the immediate term, there are concerns around UCITS which have China exposures. The market volatility in China has prompted the regulator to delist shares. As such, those UCITS which are invested in delisted Chinese securities could struggle to accurately value their holdings, and sell their assets to meet redemptions. However, it is assumed that most UCITS with China exposure will have diversified portfolios enabling them to meet their liquidity obligations. Nonetheless, it does raise issues around valuation and liquidity among China-focused UCITS.

Regulatory scrutiny around liquid alternatives such as alternative mutual funds and UCITS is growing. The rules are likely to become stricter and managers need to keep abreast of these developments.  Most importantly, managers must make sure they do everything they can to prevent any liquidity mismatches emerging, which could result in gating during market routs. Such a scenario would not only taint the UCITS and mutual fund brands but likely result in further, harsher regulations.