Two solutions proposed to solve open-ended fund liquidity problems

The FCA’s proposals indicate that more drastic measures, such as barring open-ended funds from holding illiquid assets, will not be introduced. 

The Financial Conduct Authority (FCA) has proposed two measures to address the liquidity problems faced by open-ended funds that hold illiquid investments: the introduction of swing pricing, or notice periods.

The potential solutions surfaced in a speech given last week by Edwin Schooling Latter, director of markets and wholesale policy at the FCA, to members of the Investment Association.

The speech was made just days after several open-ended property funds barred investors from accessing their money by putting suspensions in place. The suspensions stem from uncertainty over the valuation of UK commercial property, in light of the steep stock market falls in recent weeks following the intensification of the coronavirus outbreak. 

The first proposal – swing pricing – aims to reduce redemptions during periods of market stress by putting a penalty in place for those investors who wish to exit the fund. The price ‘swings’, with the penalty rising when the number of investors wanting to exit the fund at the same time increases.

According to Schooling Latter, some investors may consider it the best way to remove a ‘first mover’ advantage without restricting redemptions.

He explains: “It is intended to help avoid remaining investors bearing an unfair proportion of costs, risks, or loss of value, as the fund’s most liquid assets are sold to meet redemptions by exiting investors.

“But fairness also means not discounting redemption value so severely that it is unfair on those exiting the fund. It should not be used as an attempt to gate or suspend redemptions ‘by other means’.”

The other idea proposed – notice periods – is a less complex tool for investors to get their heads around. A notice period refers to the gap (for instance weeks or months) between the point at which an investor submits a redemption request and the subsequent pricing and execution of that transaction. 

Schooling Latter says as well as being “arguably a simpler and therefore more effective way of promoting investor understanding of the risks associated with investing in less liquid assets through an open-ended structure”, notice periods would in theory reduce the likelihood of redemption requests at times of market stress.

He adds: “As when redeeming daily-dealing funds, the actual sale value is only determined at the point when the transaction is priced and executed. But with a notice period, the gap between the last published net asset value (NAV) before receiving the redemption request and the NAV determined at execution of the transaction would be longer.

“Trying to sell at a time of stress would mean the investor accepting significantly greater uncertainty about the value they would achieve than if they gave notice in a period of more 'normal' market volatility.”

Schooling Latter also points out that the risk of a firesale is also reduced. He continues:  “If the fund could, for example, sell its relatively less liquid bonds over a two-week or one-month period, rather than having to sell on a single day when markets may be most stressed, this could both be better for investors and reduce amplification of price moves affecting the remainder of the financial system.”

The FCA’s proposals indicate that more drastic measures, such as barring open-ended funds from holding illiquid assets, will not be introduced.