Publication of the CSSF working paper “An Assessment of Investment Funds’ Liquidity Management Tools”

The CSSF presents in this joint work with two co-authors from the BIS an empirical assessment of the effectiveness of liquidity management tools used by Luxembourg-domiciled open-ended funds (UCITS) during the COVID-19 crisis and the years before.

The analysis focuses on the following tools:

1. the funds’ portfolio management, including cash and other liquid assets;
2. the use of swing pricing; and
3. the temporary suspension of redemptions.

The main findings are the following:

• For most funds, the liquid asset ratio generally exceeds the maximum daily redemptions, suggesting that these funds have sufficient liquidity buffers to meet elevated redemptions. However, funds increase cash positions in periods of high volatility, such as the March 2020 market turmoil, and thereby contribute to pro-cyclical selling of assets.
• Fund managers’ estimates of how the liquidity of the fund portfolio would be affected in a stress scenario vary considerably across funds. Some assessments may underestimate the potential impact of concerted sales of the same, or highly correlated, assets by other funds.
• Funds frequently use swing pricing to pass on the trading costs to transacting investors. Swing pricing mitigates dilution of the fund value. It also dampens fund outflows during episodes of elevated market volatility, except during episodes of systemic stress, such as the March 2020 turmoil.
• Funds rarely suspend redemptions. Suspensions often precede the permanent closure and liquidation of the fund. They may also lead to higher outflows from funds with similar portfolios. Lower survival rates and adverse signaling effects may imply that funds wait too long before suspending redemptions.

Overall, these results generally confirm the relevance and effectiveness of these tools in contributing to the overall liquidity risk management of open-ended funds, especially in supporting open-ended funds in managing large outflows. However, they also call for further guidance to support fund managers in assessing the liquidity of their portfolio to better reflect a macroprudential perspective and internalise the risk of concerted selling of assets by funds in a stress scenario. Further guidance could also be given to the calibration of swing pricing to make it more responsive to deteriorating market conditions. Finally, additional guidance on the use and timing of suspensions could make these more effective and enhance market stability.

The authors therefore trust that this paper will contribute to the current work being carried out on the regulatory framework for open-ended funds in international fora, such as by FSB, IOSCO and international securities regulators, particularly on additional conclusions to be drawn from the recent COVID-19 crisis. It should also encourage fund managers to critically consider the above findings with a view to assess the appropriateness of their liquidity management processes for their managed products.