Asset managers need to increase their focus on liquidity risk because there are gaps in their management which could harm investors, the UK’s conduct regulator has said. 

In a review into asset managers’ liquidity frameworks, the Financial Conduct Authority found while some firms demonstrated “very high standards”, there was a “a wide disparity” in the quality of compliance and depth of risk management expertise. 

In addition, a minority of firms in the review had inadequate frameworks to manage liquidity risk. 

In a letter to asset management bosses, the FCA said: “The methodologies we found to be flawed contemplated using solely cash and the most liquid assets first to accommodate all redemptions, without any considerations of the liquidity of selling a ‘vertical slide’”. 

Poor liquidity management can bring “serious risks for investors”, the FCA warned. 

The regulator emphasised good governance must be met.

“We expect accountabilities to be clear, and governing bodies to be composed of members with sufficient expertise who are given timely and appropriate management information about risk, including liquidity risk within your firm,” it said. 

In addition, when asset managers experience redemptions, the FCA said they must meet regulatory requirements and should ensure exiting and remaining investors are treated fairly when considering the costs of redemption. 

The watchdog also asked asset managers to work with service providers to ensure that operational systems and processes are fit for purpose, can be executed swiftly and scaled to handle additional demand when needed.   

Finally, the FCA expects firms to perform liquidity stress testing ‘diligently’, and use liquidity management tools appropriately.    

Camille Blackburn, director of wholesale buy-side at the FCA, said the review “should serve as a warning” to all asset managers, adding: “We expect boards to discuss our findings and assure themselves that their firms are not amongst the minority with serious gaps in managing liquidity risk. It’s vital the outliers take quick action. They risk regulatory intervention if they don’t take this opportunity to address weaknesses.”  

Publication of the review comes after the Bank of England announced a system-wide exploratory exercise last month to assess the risks from liquidity mismatch and leverage across the financial sector, in reaction to the liability-driven investment crisis last autumn.

The FCA’s review of 14 firms found: 

·       The building blocks and tools for effective liquidity management were usually in place at firms, but these lacked coherence when viewed as a full process and were not always embedded into daily activities. 

·       Many firms attach insufficient weight to liquidity risk management in their governance oversight arrangements, as well as insufficient challenge and escalation, particularly in volatile environments. 

·       A wide range of approaches to liquidity stress testing with some methodologies insufficient to assess actual liquidity of the portfolio, using assumptions that were not appropriately conservative. For example, some firms’ models assumed that they would always sell the most liquid assets, without ever giving regard to the liquidity of selling a ‘vertical slice’ of the portfolio.  

·       Firms typically had governance and organisational arrangements in place to meet large one-off redemptions but did not have sufficient arrangements in place to oversee cumulative or market-wide redemptions that could have a significant impact on a fund. 

·       Wide variations in the application of anti-dilution tools such as swing pricing, which could affect the price investors receive when redeeming.