ICE Fixed Income Monthly

Fund liquidity management: the case for a proven approach

Liquidity: when you need it most, it’s often in short supply. In fixed income, the vast range of liquidity profiles is a defining feature of the asset class. Timely and accurate data on asset prices for fixed income securities can thus be difficult to obtain, particularly during times of market upheaval. This dynamic is the crux of growing regulatory focus on fund liquidity management.

Earlier this month, Britain's financial regulator published a review that found most firms fell short in some aspects of their liquidity frameworks. This follows a report from the European Securities and Markets Authority (ESMA) in May on valuation practices, which noted that the outcome of liquidity stress tests were not systematically applied by funds, and strongly encouraged firms to consider lessons from recent market events — such as the COVID-19 pandemic — when setting liquidation costs. For regulators, creating a backdrop that offers greater protection for retail investors is also central to their approach.

Globally, a few frameworks are emerging. The FCA in the UK has required that firms abide by ESMA’s stress testing guidelines, which were issued in 2020. Its recent review notes that many firms still fail to meet these guidelines, with a wide range of stress testing methodologies used, from highly sophisticated to more simple approaches. The ESMA guidelines require funds to quantitatively assess the liquidity impact to their portfolios of both historical simulations and hypothetical scenarios. For example, firms may be required to apply analytics to stress test portfolios through simulations that replicate aspects of the 2008 credit crisis, as well as hypothetical stress levels. At ICE, we are advocates of this approach, given the broad range of factors that can impact the liquidity of financial instruments and the universal desire to ensure appropriate guardrails remain in place to protect market participants.

To date, the SEC proposals for fund liquidity management are the most prescriptive and far-reaching. Its November 2022 proposal includes requirements that attempt to conflate a normal baseline scenario with stressed inputs — for example, defining the daily classifications based on “current market conditions,” while also requiring the use of a stressed 10% liquidation volume. This approach could produce outputs that are neither baseline nor stressed. Instead, in our view, keeping these factors as separate outputs would offer greater visibility into a funds’ liquidity profile.

For global regulators, choosing the right frameworks for liquidity management is crucial. From our perspective, it means applying proven analytics to help reduce systemic risk, boost investor transparency and give funds a more accurate gauge of their position when markets get shaky, as they inevitably do from time to time.

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