Rikard Lundgren and Håkan Karlsson: Liquidity Mismatch Risk – The Fund Treasurer’s dilemma  

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“Regulators across all major financial centers are focusing on finding structural remedies to Liquidity Mismatch Risk (LMR)” say Rikard Lundgren, Independent Director and Owner of Steendier, and Håkan Karlsson, Consultant and Advisor to the UK fund management industry. 


LMR Definition: The risk that a fund is unable to sell assets or otherwise generate sufficient cash to satisfy the Fund’s obligations, especially the settlement of Investor redemption requests. 

Why LMR matters 

Private savings, managed in collective funds, are increasingly needed to compensate for shortfalls in public pensions, education and health care. The shrinking role of banks in financing for SMEs means Corporate Bond markets need to grow. Funds are a doubbly important part of the societal contract. If funds fail to give investors access to their money as promised, confidence could be compromised. Several recent scandals illustrate this. The Woodford funds scandal in the UK has high-lighted the role (and short-comings) of fund service providers. The FCA has conducted an industry-wide review of oversight, governance and resourcing with a particular focus on the role and responsibility of third-party AFMs. The review highlighted significant shortcomings and the FCA signaled that more and tighter rules for the fund industry will follow. EU regulators have launched similar reviews. Before describing an alternative solution, we need to distinguish between two fundamentally different reasons for why a fund gets into a liquidity crisis.  


Dishonest by Design 

Some fund have a product design with liquidity mismatch built in. To attract investors, some funds promise investors easy access to their capital on short notice. Some of these funds hold investments that cannot be turned into cash until some time long into the future. But they may still promise investors quick, even daily, access to cash. In any but the most benign market such promise is clearly misleading as the main source of cash may be new investor subscriptions. Funds with such a design should be not be allowed to operate without either changing their redemption promise to reflect the liquidity of their assets or change the content of their portfolios. Swing pricing, Anti-Dilution Levies or other like mechanisms will not change the fact that some fund are dishonest in their very design.  


Screwed by markets 

Some funds are investing in assets that are mostly liquid but then turn illiquid during market disruptions. The corporate bond market is a good example of this. In the world’s second largest fund center, Luxembourg, UCITS fund governance has taken big steps to identify, reduce, measure, monitor and manage liquidity mismatches. With rules and guidance provided by the local regulator, the CSSF, based on the ESSMA recommendations, the work of turning out policies, procedures, analytical tools, reports etc. has been led by the larger local 3rd party AIFM. The methods and tools created are well suited to such highly liquid,   listed assets eligible to UCITS funds. These mechanisms are not suited to capture the more unpredictable changes in liquidity of some alternative assets, such as corporate bonds. In addition to shifts in issuer credit performance there is often idiosyncratic risk on individual bond issues and on market participant behavior. When  these all move in distressed market conditions, the consequences for the possibility to liquidate a portfolio of corporate bonds can be dramatic. In the past 40 years, every fininancial crisis has created different and unpredicted liquidity disruptions in corporate bond markets. The scenario-based liquidity risk models based on historical price data are therefore often inadequate predictors of liquidity in a future crisis. There are just too many “unknown unknowns” in corporate bond markets .  

“ In the past 40 years, every financial crisis has created different and unpredicted liquidity disruptions in corporate bond markets” – Rikard Lundgren 


The Fund Treasurer function 

When uncertainty and unpredictability is high, there is no good substitute for human experience and judgement. The investment manager is best positioned to assess the real liquidity of a portfolio. But how can investors be sure that their interest to keep the portfolio liquid enough so they can have the access to cash they have been promised is not compromised by the conflicting interest of the investment manager to keep investors’ capital in the fund?   A fund Treasurer’s primary task is to manage the balance between the actual liquidity of his assets and the promise to investors to get access to cash. If market liquidity changes, the Treasurer may need to change his portfolio. The same goes if he has reason to believe that investors will ask for more cash. Balancing the two is a dynamic process with one eye on the markets and the other on investors.  Such a Fund Treasurer needs to have sufficient competence, appropriate authority and backing by a set of rules/guidelines and reporting lines. With such a Fund Treasurer function, the problem of liquidity mismatch could in all likelihood be significantly reduced even if market liquidity behaves unpredictably. The best defense against changing market dynamics, is a human brain with good judgement and skin in the game. So how could this Fund Treasurer function be created and made to work? 

"How can investors be sure that their interest to keep the portfolio liquid enough is not compromised by the conflicting interest of the investment manager to keep investors’ capital in the fund?” - Håkan Karlsson 


The How 

By introducing a mandatory designated Fund Treasurer function, inspired by the RC/MLRO mandatory function within funds’ AML & CFT governance. A Fund Treasurer function would be a designated and regulator approved person with focus on the fund’s assets and liabilities matching. The Fund Treasurer can organisationally belong to the AIFM/AFM, be an Independent specialist or a member of staff of the Investment Manager. The individual will be responsible for the ongoing analysis of both assets and liabilities, ie investors and would ensure that there are regular and appropriate updates and reports to the Fund Board and to the regulator. In times of market disruption or deteriorating portfolio liquidity, the Fund Treasurer would give input to the Board regarding possible actions such as gating etc. As with an RC/MLRO there could also be an escalation possibility for the Fund Treasurer to the regulator for exceptional situations. The Fund Treasurer will be responsible for liquidity management policies and procedures that are adapted to the fund’s investment strategy and portfolio composition. The Fund Board may also need to be strengthened. At least one Independent Director should have adequate experience and expertise to question the Treasurer’s liquidity management proposals, policies and management. Finally, disclosure to investors need to be improved. Those marketing a fund must explain more clearly the potential impact of low liquidity in the market on an investor’s ability (and cost) to redeem fund holdings. Such information should describe any tools and mechanisms available to the fund in certain market conditions to manage liquidity, e.g. gating/suspension, swing pricing and anti-dilution levies. 


Final remarks 

For funds, such as UCITS, who are only invested in highly liquid assets, the new liquidity risk framework, as formulated by Luxembourg AIFMs, is a good approach. This could be used by other jurisdictions. Liquidity Mismatch Risk should get the same attention in professional training, regulatory guidelines, licensing processes, sanctions etc as AML/CFT has. The role of the independent Director for ensuring proper LMR management cannot be enough emphasized. The Independent Director is best placed to, together with a dedicated Fund Treasurer, raise concerns about potential mismatch risk in a portfolio and ensure that such issues are dealt with in line with certain principles such as the Prudent Person principle and the fair and equal treatment of investors, even during severe market disruptions.