Longer Lock-Ups Coming?

The International Organization of Securities Commissioners (IOSCO), a Madrid, Spain-based association of global organizations regulating the securities and futures markets, issued recommendations to address liquidity risk management issues recently. The recommendations coincide with recent Bank of England simulated stress tests. The result of these recommendations, according to Moody’s Investors Service, “managers are likely to shift strategies that invest in less liquid asset classes into fund structures that have longer lock-up periods or permanent capital structures.” That’s right. More extended lock-up periods were determined more appropriate investments in certain risk management schemes.

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The recommendations are expected to increase reporting and operational requirements for asset managers but also boost risk-management, transparency and resilience in times of stress, Moody’s noted in a February 13 report. But this doesn’t come without a cost, even if it is mild.

“We expect the additional costs to be marginal for the rated asset, managers because a number of regulatory initiatives already have prompted asset managers to bolster their risk and reporting processes,” Marina Cremonese and her team noted. “IOSCO’s monitoring and reporting recommendations to a great extent are an extension of risk management capabilities already in place at large asset managers, so we expect only a mild effect on large asset managers’ bottom line.”

One reason it might have a mild impact is that the recommendations are voluntary, leaving each member organization to determine their implementation. While the application is optional, or “non-prescriptive,” Moody’s expects the benefits to increase earnings stability and lower reputational risk, “a key element in assessing asset managers’ creditworthiness.”

The recommendations point to “stringent” liquidity risk management procedures but are difficult to mandate because applying a one size fits all approach over an entire market system has significant challenges. The program “should be tailored to the liquidity of collective investment schemes’ underlying assets, the investor base and the schemes’ redemption frequency.”

The recommendations were developed based on both normalized markets as well as “stressed conditions.”

Liquidity and redemptions

One area of note is about redemption frequency and considerations of the percentage of liquid assets held in the fund. While redemption levels should be considered relative to the fund’s investment objective, Moody's notes:

“Big asset-liability mismatches in open-end funds pose potential liquidity risks for fund products and potential reputational risk for fund sponsors, particularly in stressed market conditions when investor redemptions typically increase,” the report noted.

They observed that investments in less liquid assets, such as real estate, ran into issues when the market crashed, using the example of UK real estate funds just after the Brexit announcement. A “run on the bank” is a fate to be avoided.

“As a result of these recommendations, managers are likely to shift strategies that invest in less liquid asset classes into fund structures that have longer lock-up periods or permanent capital structures,” the report noted. “An increase in longer life assets under management would be positive for the stability of asset managers future cash flow generation.”

The recommendations re-iterates guidance regarding stress-testing open-ended funds with the goal to support liquidity risk management. It introduces new contingency planning recommendations to ensure that appropriate liquidity management tools can be used in a prompt and orderly manner, an event that most often occurs during market stress. “IOSCO expects that local securities regulators will now transpose the recommendations in their respective jurisdictions, and will assess those jurisdictions’ implementation over the next two to three years.” In the US, IOSCO members include the Commodity Futures Trading Commission (CFTC) as well as the Securities and Exchange Commission (SEC).