Cyprus: Liquidity management tools in collective investment schemes

The funding fund business has grown strongly over the previous decade, each within the EU and globally. At European stage, as reported by the European Fund and Asset Administration Affiliation (EFAMA), the web gross sales of UCITS and AIFs rose to €866 billion in 2021, in comparison with €650 billion in 2020 whereas the web belongings of European funding funds grew by 17%, to succeed in €22 trillion.

Low or unfavorable rates of interest and steadiness sheet constraints within the banking sector, enhanced the position of funding funds in monetary intermediation which is anticipated to additional enhance. Whereas, such developments could strengthen the effectivity and resilience of the monetary system as an entire, there are considerations that elevated monetary intermediation by funding funds could trigger amplification of any future monetary disaster.

Notably, the complicated vary of potential behaviours of funding funds and the ensuing investor redemption requests in response to market stress, finally exacerbate the market shock and contribute to monetary instability.

The present regulatory framework governing funding fund liquidity administration within the EU consists of particular provisions on liquidity administration which have been typically enough to date. Nevertheless, the outcomes of the surveys of European Systemic Danger Board (ESRB), European Securities and Markets Authority (ESMA) and Worldwide Organisation of Securities Commissions (IOSCO) on present practices, have revealed that there are nonetheless some areas within the basic liquidity administration surroundings which might be improved.

This text concentrates principally on the liquidity administration instruments (LMTs) which may finally contribute positively to the administration of liquidity threat.

The AIFM Directive (2011/61/EU) (AIFMD), included into the nationwide regulation by the Republic of Cyprus by the adoption of ‘The Various Investments Fund Managers Legislation 56(I)/2013)’ as amended, and its implementing acts lay out the liquidity threat administration necessities, specifically within the context of the institution of a basic everlasting and impartial threat administration operate (Article 15 of the AIFMD and Article 39 of the delegated regulation (No.231/2013) to the AIFMD).

This operate shall, firstly, implement efficient threat administration insurance policies and procedures with the intention to establish, measure, handle and monitor on an ongoing foundation all dangers (together with liquidity threat) related to every AIF’s funding technique, and secondly adjust to the duty to watch compliance with the above threat limits (Article 44 and Article 48 of the delegated regulation).

Along with the overall threat administration necessities, the Article 16 of the AIFMD supplies that AIFMs shall for every fund managed which isn’t a closed-end fund make use of an acceptable liquidity administration system, together with procedures to watch the liquidity threat of the AIF and to make sure that the liquidity profile of the investments of the AIF complies with its underlying obligations. It’s additional added that the AIFMs should additionally be sure that the AIFs’ funding technique, their liquidity profile and their redemption coverage are constant.

Below Article 46(2) of the AIFMD and Article 108(3)(b) of the delegated regulation, the competent authorities and the managers respectively, have the facility to require the suspension of the repurchase or redemption of models within the curiosity of the unit-holders or of the general public by way of administration of the AIF’s liquidity. Comparable provisions are additionally included in The Various Funding Funds Legislation of 2018 L.124(I) of 2018 (Article 43).

Article 47(1) of the delegated regulation describes the precise particulars of the liquidity administration system and procedures for every AIF. In respect of the LMT, it’s particularly supplied that the AIFM shall take into account and put in force the instruments and preparations, together with particular preparations, essential to handle the liquidity threat of every AIF beneath its administration.

The AIFM shall establish the kinds of circumstances the place these instruments and preparations could also be utilized in each regular and distinctive circumstances, bearing in mind the truthful therapy of all AIF traders in relation to every AIF beneath administration. The AIFM could use such instruments and preparations solely in these circumstances and if acceptable disclosures have been made in accordance with the related provisions of the delegated regulation.

UCITS have been designed principally for the retail market as open-ended diversified and liquid merchandise.

A key precept of the UCITS Directive (2009/65/EC), carried out within the Republic of Cyprus by the adoption of the Open-Ended Undertakings for Collective Funding (UCI) Legislation 78(Ι)/2012 as amended, is the portfolio diversification based mostly on the so-called ‘5-10-40 rule’, set out in Article 52(1) and (2) which refers to most permitted exposures per issuer.

Accordingly, the overall rule as strengthened by an inventory of eligible and non-eligible belongings beneath the Article 50, requires that, a UCITS shall make investments not more than 5% of its belongings in transferable securities or cash market devices issued by the identical physique. The above 5% restrict could also be raised to a most of 10%, with an additional combination limitation of 40% of web belongings on exposures of higher than 5% to single issuers.

Other than the above precept which ensures the liquidity of the UCITS product in keeping with the overall obligation beneath Article 84(1) of the UCITS Directive, whereby a UCITS shall repurchase or redeem its models on the request of any unit-holder, the UCITS Directive consists of liquidity threat administration necessities for UCITS administration firms similar to these beneath AIFMD.

Particularly, Article 51(1) of the UCITS Directive supplies {that a} UCITS administration firm shall make use of a risk- administration course of which allows it to watch and measure the danger of the positions and their contribution to the general threat profile of the UCITS portfolio at any time.

Article 12 of the implementing Directive 2010/43/EU (as included into nationwide regulation through the ‘CySEC Directive DI78-2012-03 relating to the Circumstances for Authorization and Ongoing Obligations of a Administration Firm and the Settlement between a Depositary and a Administration Firm of UCITS)’ additional requires the administration firm, the place acceptable and proportionate in view of the character, scale and complexity of its enterprise and of the UCITS it manages, to ascertain and keep a everlasting threat administration operate which shall be hierarchically and functionally impartial from different working models of the administration firm. Amongst others, it shall moreover implement the danger administration coverage and procedures, guarantee compliance with the UCITS’ threat limits and supply related recommendation and studies to the board of administrators and the senior administration.

Moreover, Article 38(1) of the implementing Directive 2010/43/ EU supplies that administration firms shall tackle at the least the next parts within the threat administration coverage:

1. The methods, instruments and preparations that allow them to adjust to their obligations in respect of measurement and administration of threat and compliance with limits regarding world publicity and counterparty threat;

2. The allocation of obligations throughout the administration firm pertaining to threat administration.

By means of derogation from the overall obligation beneath Article 84(1) of the UCITS Directive, a UCITS could, in accordance with the relevant nationwide regulation, the fund guidelines or the devices of incorporation of the funding firm, quickly droop the repurchase or redemption of its models and its competent authorities could require the suspension of the repurchase or redemption of models within the curiosity of the unit-holders or of the general public (Article 84(2) of the UCITS Directive).

Article 39(1) of the implementing Directive 2010/43/ EU obliges UCITS administration firms to evaluate, monitor and periodically evaluate the effectiveness of their threat administration coverage, their stage of compliance with it and the adequacy of measures taken to handle any deficiencies within the efficiency of the danger administration course of.

As well as, Article 40(3) of the implementing Directive 2010/43/EU, supplies that UCITS administration firms shall make use of an acceptable liquidity threat administration course of with the intention to be sure that every UCITS they handle is ready to redeem at any time the traders’ models upon their request. Paragraph 4 additional provides that UCITS administration firms shall be sure that for every UCITS they handle the liquidity profile of the investments of the UCITS is acceptable to the redemption coverage laid down within the fund guidelines or the devices of incorporation or the prospectus.

Other than the regulatory necessities beneath the EU laws throughout the AIFM and UCITS regimes as analysed above, there are specific complimentary operational instruments recognised and utilized in many European jurisdictions by administration firms for the administration of liquidity.

The supply and implementation of LMTs for collective schemes varies considerably throughout jurisdictions. Thus, there are variations within the availability of LMTs in addition to the precise procedures governing the usage of a-LMT throughout jurisdictions as evidenced by the survey carried out by IOSCO, the Suggestion of the European Systemic Danger Board of seven December 2017 on liquidity and leverage dangers in funding funds (ESRB/2017/6) February 2018 (the ’ESBR Suggestions’) and the survey of member states carried out by ESMA.

Probably the most generally accessible instruments in member states are the next: (a) redemption charges; (b) redemption gates; (c) redemptions in variety; (d) aspect pockets; (e) suspension of redemptions; (f) anti-dilution levy; (g) swing pricing; (h) obligatory liquidity buffers; and (i) aspect letters.

LMTs, and the circumstances beneath which they can be utilized, should sometimes be listed within the constitutional paperwork of the funding fund, that are topic to approval by Cyprus Securities and Trade Fee (CySEC). These instruments are strengthened by the funds’ inner threat administration and management system, which ensures that materials dangers are correctly recognized, assessed, measured, monitored and managed.

Based on the ESBR Suggestions, the regulators aren’t typically allowed to activate instruments. The final exception to that is the suspension of redemptions, which can be imposed by the regulator whether it is deemed to be within the public curiosity. It’s additional noticed that normally the fund managers don’t want regulatory authorisation to activate a-LMT.

Nevertheless, in some jurisdictions together with Cyprus, the usage of the facility to droop redemptions is topic to earlier permission of the regulator which can require extra intensive oversight and prescriptive necessities.

In Cyprus, there’s a set of a-LMTs which might help to mitigate liquidity dangers for open-ended funds. These mechanisms embrace: (a) ex-ante instruments, akin to swing pricing and anti-dilution levies, which can be utilized to mitigate first mover benefit and systemic threat; and (b) ex-post instruments, akin to gates, aspect pockets, redemption-in-kind, discover durations and suspension of redemptions, permitting fund managers to handle funding fund liquidity by controlling or limiting outflows.

Swing pricing: The aim of this software is to guard present traders from unfavourable value results brought on by transactions executed by different traders.

In apply, a swing pricing mechanism allows a supervisor to cost, or ‘swing’, the related transaction prices attributed to the web subscriptions, or web redemptions, respectively on the incoming or outgoing traders. Successfully, the NAV of the funding fund is adjusted downwards (upwards) within the case of huge outflows (inflows) in order that the transaction prices are borne by the traders shopping for or promoting the shares somewhat than the prevailing traders.

It’s noticed that two kinds of swing pricing exist, being the ‘full’ and ‘partial’ swinging. Below full swing pricing, the relative prices are allotted and NAV is adjusted any time there are web inflows or outflows in a fund, therefore swing pricing is utilized to all subscriptions and redemptions by traders.

Below partial swing pricing, the prices are allotted and the NAV is ‘swung’ solely when web inflows or web outflows exceed a predefined threshold expressed as a proportion of a fund’s NAV, therefore swing pricing is utilized to subscriptions and redemptions past a sure threshold.

Anti-dilution levy: The anti-dilution levy is an analogous software to the swing-pricing because it goals to guard present or remaining traders in opposition to the hostile efficiency affect of recent or leaving traders. This software includes traders paying a further cost to the funding fund once they subscribe to or redeem funding fund shares, in an try to offset any potential impact on the fund’s NAV ensuing from the extra transaction prices. In comparison with the swing pricing mechanism, it doesn’t contain any adjustment to the worth of the portfolio (e.g. NAV).

Redemption gates (deferred redemptions): A mechanism that quickly defers the appropriate of shareholders to redeem their shares within the fund and provides extra time to administration firms to allow realisation of belongings in a extra orderly and managed method with the intention to lower the danger of fireplace gross sales beneath confused market situations.

This deferral could also be full, in order that traders can’t redeem their shares in any respect, or partial, in order that traders can solely redeem a sure portion of their shares.

Redemption gates will also be structured in such a way that when redemption requests attain a sure threshold, a fund administration firm can determine to satisfy on a pro-rata foundation any redemption requests and carry ahead any residual requests over that threshold to the subsequent dealing interval.

Such gates could also be imposed both on the fund-level (i.e. prohibition of redemptions if combination fund redemptions over a given interval exceed sure proportion of the fund’s belongings) or on the investor-level (i.e. prohibition from withdrawing greater than sure proportion of investor’s curiosity within the fund) with differing thresholds.

Facet pockets: This mechanism permits the segregation of the illiquid or troublesome to worth portion of a fund’s portfolio from remaining liquid investments of the funding fund through the creation of aspect pockets lessons for the previous. Whereas the rest of an investor’s shareholding could be redeemed within the regular method as described within the fund’s constitutional paperwork, shares within the aspect pocket class can’t be redeemed till such time because the underlying belongings turn out to be sufficiently liquid.

Subsequently, aspect pockets are particularly appropriate at any time when a fund has diverging investor pursuits. On this respect, traders needing liquidity can nonetheless money within the liquid a part of the funding fund’s investments at, presumably, low liquidation value whereas traders who want to stay within the funding fund are protected because the fund administration firm will not be pressured to liquidate belongings at or beneath market costs if confronted with excessive redemption demand.

Redemption-in-kind: Redemptions in-kind (or in specie) encompass non-cash funds (i.e. securities) to the redeeming investor of belongings within the fund as an alternative, in entire or partly, of money. There would due to this fact be no must liquidate giant quantities of belongings within the occasion of large-scale redemptions, thereby defending each remaining and redeeming traders from any excessive transaction prices which could in any other case come up and avoiding any market value impacts.

Resulting from its operational challenges (akin to complicated switch course of and valuation procedures) and concerned prices, this mechanism could also be appropriate for big redemption orders from institutional traders and it’s typically much less appropriate for redemptions by retail traders.

From monetary stability standpoint, such software doesn’t essentially take care of contagion points because the affect available on the market is likely to be the identical, no matter whether or not it was the funding fund itself or the investor who bought the underlying belongings right into a falling market.

Discover durations: This software supplies fund administration firms with further flexibility to handle their liquidity with out the necessity to promote belongings at discounted value.

A discover interval is stipulated within the constitutional paperwork of an funding fund and refers back to the interval of advance discover that traders should give to fund managers when redeeming their investments.

Some managers use a barely completely different type of discover interval whereby traders are topic to a redemption price (i.e. a cost {that a} fund levies to traders when exiting the fund) until the investor supplies discover of the redemption.

Suspension of redemption: A rare instrument of final resort for open-end fund constructions, which permits fund managers or regulators to droop redemptions throughout a liquidity disaster or for public curiosity or monetary stability causes, when no different possibility is accessible. As an illustration, a suspension of redemptions could also be carried out when the market buying and selling the underlying belongings is closed or throughout distinctive market occasions affecting a big proportion of the underlying belongings or the settlement system for funds (akin to TARGET2) is closed on particular public holidays.

There are numerous causes to droop redemptions. Generally reported cause as recognized by IOSCO based mostly on their report on Open-ended fund liquidity and threat administration – good practices and points for consideration, is to forestall a sudden outflow of capital, which can have further hostile impacts for the fund, akin to:

• The obligatory sale of belongings at costs that will drawback remaining traders;

• A ensuing portfolio for non-redeeming traders that’s largely concentrated in illiquid belongings and falls exterior the danger tolerance horizon of the fund; and

• A ensuing portfolio that could be too small for the supposed technique of the fund.

On November 25 2021, the European Fee has printed its legislative proposal to amend each the UCITS and AIFMD frameworks along with an Annex (collectively the ‘proposal’). The proposal consists of vital developments in respect of the LMTs.

Particularly, following the ESBR Suggestions, the European Fee has proposed the harmonisation and convergence of the supply and use of LMTs to UCITS funds and open-ended AIFs by way of safety of the worth of traders’ cash, discount of liquidity stress on funds and mitigation in opposition to broader systemic threat implications in conditions of market-wide stress.

The European Fee additional proposed that member states be sure that the LMTs listed under can be found to AIFMs managing open-ended AIFs and UCITS administration firms:

Along with having the ability to droop redemptions as explicitly supplied beneath the present regulatory framework, the administration firms would even be required to:

• Select at the least one different acceptable LMT from the factors 2 to 4 of the above listing which harmonises the minimal listing that must be accessible anyplace within the EU;

• Implement particular insurance policies and procedures for the activation and deactivation of any chosen LMT and open up to traders the precise circumstances by which the related LMT can be utilized; and

• Notify the regulator directly about activating or deactivating an LMT.

Below the proposal, ESMA is tasked with creating draft Stage 2 technical requirements (RTS): (a) to outline and specify the traits of every of the above-mentioned LMTs; and (b) on the choice and appropriate use of the LMTs.

The European Fee proposed that nationwide competent authorities be empowered to require a fund supervisor to activate or deactivate an acceptable LMT, topic to prior notification to different related authorities, ESMA and ESRB. ESMA is remitted to develop RTS indicating when the competent authority’s intervention can be warranted and by which conditions a reliable authority could train its powers in respect of LMTs.

Whereas EFAMA welcomes the choice of the European Fee to undertake a focused strategy in its evaluate of the AIFMD and UCITS Directive by together with an inventory of LMTs as a method of managing liquidity dangers and guaranteeing the truthful therapy of traders, it considers that it’s crucial that the administration of liquidity threat stays the duty of the fund supervisor.

Particularly, the administration of liquidity threat as a operate is straight linked to the funding technique of the fund, its underlying belongings and nature of its investor base. Eradicating this operate from the supervisor or introducing computerized or prescriptive triggering of comparable LMTs beneath related circumstances would give rise to pro-cyclical results, for instance by making a threat of rush for redemption the place the imposition of a selected LMT is predicted by traders out there.

Importantly, EFAMA recommends that NCAs and ESMA be granted the facility to request the supervisor to droop redemptions or impose redemption gates in distinctive circumstances the place circumstances so require, having regard to the pursuits of the unit-holders and to any monetary stability dangers, in session with the supervisor.

Equally, any specification as to the standards for the choice and use of acceptable LMTs by managers ought to undertake a principles-based strategy by reference to present steerage throughout EU jurisdictions versus setting out prescriptive guidelines as regards cases the place particular LMTs must be triggered.

On Might 16 2022, the European Parliament has issued its draft report on the European Fee’s proposals to amend the prevailing AIFMD framework after discussions and suggestions from regulators and stakeholders.

There are three essential proposed areas of enchancment associated to the liquidity administration provisions:

• The vary of LMTs from which an AIFM should choose at the least one as a part of its liquidity administration coverage are proposed to be expanded to incorporate swing pricing, anti-dilution levies and aspect pockets along with the unique listing of redemption gates, discover durations and redemption charges.

• Readability that the AIFM has major duty for choices on LMTs. On this respect, ESMA ought to permit time for the market to adapt earlier than it applies the technical requirements on choice and use of LMTs, specifically for present AIFs.

• Intervention by competent authorities in an AIF’s liquidity administration is meant to be a final resort and restricted to distinctive circumstances and after consulting with the AIFM. Importantly, the report additionally proposes utterly eradicating the power for competent authorities to require non-EU AIFMs advertising and marketing within the EU to activate or deactivate LMTs.

Though there’s nonetheless scope for change of the proposed amendments, the report is essential by way of formulating the ultimate textual content of the AIFMD II.

Liquidity threat administration has lengthy been an essential space of consideration for coverage makers and the asset administration business.

Total, fund managers shall take into account the implementation of appropriate threat administration on the prelaunch (product improvement) stage and the postlaunch (ongoing administration) stage of the product lifecycle bearing in mind the market situations and the macroeconomic surroundings.

Current regulatory frameworks have improved the functioning of markets, their transparency and finally the safety of traders. Within the context of heightened consideration for fund liquidity dangers, questions have been raised relating to the sufficiency of the prevailing regulatory regime and whether or not further guidelines are required.

Though the proposal doesn’t search to introduce in depth modifications in respect of investor safety and monetary stability, it proposes essential modifications in various areas together with the LMTs.

On this context, the affect of Covid-19 and the Ukraine battle and disaster on monetary markets are intently monitored by ESMA in coordination with nationwide competent authorities. The problem after all is to give attention to liquidity points and the usage of acceptable LMTs to make sure the orderly functioning of markets, monetary stability and investor safety.