Shaping Financial Stability: A Perspective on the Latest Macroeconomic Policy Developments

Declan Tannam (IQ-EQ) and Ruth Fairclough (Irish Funds) delve into the recent Macroprudential policy outreaches by FSB, IOSCO and the Central Bank of Ireland for Open ended Funds and address Irish Funds’ response to this important topic.

Over the last number of years, the Central Bank of Ireland (CBI) has highlighted macroprudential policy as a key area of focus regarding wider macro financial stability, and in November 2022, Ireland became the first country to activate the leverage limits provided for under Article 25 of AIFMD post its consultation on property funds (CP 145).

In July 2023, the CBI hosted a joint event of the Financial Stability Board (FSB) and the International Organization of Securities Commission's (IOSCO) where they launched two significant consultation papers, both of which substantially revolved around the subject of liquidity risk management and the utilization of tools for liquidity management in Open-ended Funds (OEFs). These papers, namely "Addressing Structural Vulnerabilities from Liquidity Mismatch in Open-Ended Funds" by the FSB (referred to as "The FSB Paper") and "Anti-dilution Liquidity Management Tools – Guidance for Effective Implementation of the Recommendations for Liquidity Risk Management for Collective Investment Schemes" by IOSCO (referred to as "The IOSCO Paper") were required to be read together and had an overarching objective to enhance the resilience of the Non-Bank Financial Intermediation (NBFI) sector while preserving its benefits.

This article delves into an analysis of the primary insights extracted from these papers, as well as the responses and feedback provided by Irish Funds in response to these documents.

FSB

FSB background to paper

In 2022, the FSB assessed the effectiveness of its 2017 Policy recommendations to address structural vulnerabilities from asset management activities in relation to liquidity mismatch in OEFs. The assessment concluded that the FSB Recommendations remain broadly appropriate, but that enhancing clarity and specificity on the policy outcomes they seek to achieve would make them more effective from a financial stability perspective.

Summary of FSB guidance

The main amendments to the 2017 FSB Recommendations involve enhancing the clarity of redemption terms for Open-End Funds (OEFs) based on their asset liquidity, grouping OEFs into categories with specific redemption expectations. These changes also aim to ensure a broader range of anti-dilution and quantity-based LMTs for OEF managers in various market conditions, promoting their use in OEF constitutional documents to address liquidity mismatch concerns. Additionally, OEF managers are required to provide clearer public disclosures on the availability and use of LMTs in both normal and stressed market conditions to improve investor awareness. These amendments intend to address potential liquidity issues in OEFs and protect investor interests.

Summary of Irish Funds response to FSB guidance

The Irish Fund’s response broadly welcomes the overarching objective to enhance the resilience of the sector while preserving the benefits and supported a principles-based approach whereby all liquidity management tools are at the disposal and discretion of responsible entities. However, the response did urge caution against the adoption of single definitions e.g. “normal” or “stressed” and outlined reservations against the categorisation of assets as liquid, less liquid and illiquid and therefore opposed the proposed “bucketing” approach. Irish Funds also reiterated support for the improvement of access to data for all stakeholders and pointed to the existing well established AIF and UCITS liquidity management framework.  

IOSCO

IOSCO background to paper

In response to the liquidity pressures encountered by open ended funds (“OEFs”) in March 2020, IOSCO undertook a Thematic Review on Liquidity Risk Management. The final recommendations were published in November 2022, and this latest IOSCO Paper aims to support effective implementation of these recommendations. The focus of this paper is on the use of anti-dilution LMTs by OEFs to mitigate investor dilution and potential first-mover advantage arising from structural liquidity mismatches in OEFs.

Summary of IOSCO guidance

The IOSCO Paper’s proposed guidance notes that a fund should be capable of implementing anti-dilution LMTs as part of the everyday liquidity risk management of their OEFs. This should be supported by a liquidity risk management framework and adequate and appropriate governance arrangements.

The IOSCO Paper further notes that the fund should consider and use at least one appropriate anti-dilution LMT for each OEF under management and anti-dilution LMTs should impose the estimated cost of liquidity on subscribing and redeeming investors. This cost of liquidity should include the explicit and implicit transaction costs of subscriptions or redemptions, including any significant market impact of asset purchases or sales to meet those subscriptions or redemptions. Furthermore, this should be capable of being achieved in both normal and stressed market conditions.

The IOSCO Paper also considers activation thresholds for anti-dilution LMTs as well as LMT related disclosure requirements in constitutional documents, on an ex-ante and ex-post basis.

Summary of Irish Funds response to IOSCO guidance

The Irish Fund’s response broadly welcomes the regulatory outcomes that IOSCO are seeking to achieve. The response recognises the important role that LMTs can play as part of a wider robust liquidity risk management framework and that LMTs should be subject to a strong governance process.

The Irish Funds’ response notes the wide range of asset classes, fund types, and liquidity scenarios that could be captured by the IOSCO Paper and stresses the importance of principles-based guidance that affords sufficient discretion and flexibility. The response notes that autonomy should be given to the fund manager in choosing the appropriate LMT and that LMTs should only become applicable upon material dilution.

The Irish Funds’ response also seeks to highlight the practical challenges in implementing LMTs in certain scenarios. These challenges are both operational and quantitative and are likely to come with a cost to implement. The operational challenge extends to practical implementation - timing, communications, and coordination across parties and time zones. The quantitative challenge relates to the complexity around estimating the market impact, even in instances of normal market conditions, particularly for securities not traded on an exchange. In stresses market conditions decisions may be better driven by a governance process rather than a pre-defined data driven process.

Finally, the Irish Funds response pushes back on the proposal to extend the oversight duties of external third parties (e.g. depositaries) to include the effectiveness of anti-dilution LMTs. The response suggests the alternative of the depositary checking that appropriate documented procedures are in place for the anti-dilution LMT programme (which would mirror the process in place for depositaries under the ESMA liquidity stress testing guidelines).

The future focus for LMTs

Both IOSCO and the FSB are set to release the final reports from their consultation papers in late 2023. The content and the degree of flexibility to implement aspects of the guidance is eagerly awaited.

In Europe we would highlight the European Commission’s (EC) legislative proposals on amending the AIFMD, UCITS Directive, and the recent report on the adequacy of on money market funds regulation. The proposals to revise the AIFMD and UCITS Directive aim to expand and harmonise the range of LMTs available for use by funds in the EU, which Irish Funds supports. The EC also believes that EU MMFs will benefit from the AIFMD/UCITS review, whereby asset managers would be allowed to select the most appropriate liquidity management tools from a dedicated list.

The future focus for Macro Pru

The FSB and IOSCO papers are just one part of our ongoing commitment to macroprudential policy engagement, with the Irish Funds Investment Risk and MacroPru groups now shifting their attention to the CBI’s latest discussion paper (DP11) - An approach to macroprudential policy for investment funds which is due for submission on November 15th.

In 2024, we are expecting an increased focus on leverage, with the FSB expected to undertake work in this space, and both the Irish Funds Investment Risk and MacroPru groups continue their commitment to engage with macroprudential policymakers.