EU: ESMA liquidity management tools standards and guidelines for UCITS and AIFs

Why should I read this?

The European Securities and Markets Authority (ESMA) has set out a detailed framework for managers to use when selecting, activating, calibrating and monitoring liquidity management tools (LMTs), in its final draft Regulatory Technical Standards (RTS) and Guidelines.

LMTs introduced by AIFMD II require AIFMs and Management Companies to select and apply at least two LMTs from the list included in AIFMD II in respect to each open-ended AIF and UCITS they manage.

ESMA prepared the RTS and Guidelines on the basis of the mandate granted by AIFMD II.  These require the RTS to specify the liquidity management systems and procedures AIFMs and Management Companies should employ so the operation of LMTs is consistent with the investment strategy, liquidity profile and redemption policy of each fund in scope.

ESMA believes that by following this framework asset managers will be able to better manage the liquidity of their funds, especially in times of market stress. The RTS and Guidelines aim to harmonise industry practice across the EU to ensure all fund managers have access to the same tools and methodologies and promote market stability and investor protection.

Non-EU firms may be indirectly affected by the RTS and guidelines if they have subsidiaries or branches in the EU, market their UCITS or AIFs into the EU, or simply because of cross-pollination of ideas and processes.

See our previous client briefing:

• EU: AIFMD II – the key aspects of which asset managers should be aware

What is required?

Suspension of subscriptions, repurchases and redemptions

The RTS confirm that suspension is an all or nothing tool.  If used, a manager must simultaneously suspend subscriptions, repurchases and redemptions of all share classes.

The Guidelines flag that suspensions should only be considered in exceptional circumstances, including:

• difficulties with asset valuation
• severe liquidity issues (e.g. due to margin calls or significant withdrawals)
• critical cyber incidents
• unforeseen market closures
• trading restrictions
• closure of trading venue
• severe financial or political crisis
• identification of significant fraud
• natural disasters

We note that the guidelines do not provide for suspensions in anticipation of corporate actions such as mergers or liquidations, circumstances in which suspensions are often used, absent further exceptional circumstances in which liquidity issues may harm the interests of creditors.  For example, a fund manager may temporarily suspend while deciding whether or not to liquidate in response to a liquidity crisis, but suspension to facilitate a merger is not expressly accounted for.  This seems to be a missed opportunity since it may be harder to argue that these are ‘exceptional circumstances’ due to the long list of examples now provided.  Of course such circumstances may be accommodated at a national level.

Redemption gates

Redemption gates (a temporary and partial restriction of the right to redeem shares) must be accompanied by a statement of a clear quantifiable minimum threshold on which they will be activated.  The threshold must be based on the total net or gross redemption orders for a given dealing day, and will either be expressed as proportion of the fund’s NAV, or as a monetary value (or a combination of both), or as a percentage of the fund’s liquid assets.

The Guidelines suggest that the use of redemption gates should be considered by: fund managers who manage funds with a concentrated investor base (which are thus vulnerable to liquidity issues on a significant redemption); and managers of funds whose assets tend to be less liquid, including inherently illiquid assets.

Extension of notice periods

An extension of the notice period is a period of time added to the minimum notice period investors must give when seeking to redeem their shares.  Such an extension will not have any impact on the fund’s redemption frequency.

The Guidelines suggest that the use of extended notice periods should be considered by managers of funds with a liquidity profile which is particularly susceptible to deterioration in times of market stress and AIFs invested in less liquid assets (in particular, real estate and private equity assets).

Redemption fees

Redemption fees are fees paid by unitholders to account for the cost of liquidity (a recurring concept: in summary, a measure of all explicit and implicit costs involved in dealing), to ensure those unitholders remaining in the fund are not disadvantaged.

The RTS require redemption fees be charged within in a predetermined range, taking into account the estimated costs of redeeming units, including the estimated market impact of asset sales undertaken in order to meet those redemptions (which may be most useful for funds with foreseeable transaction costs or which are less illiquid). These fees may be expressed as a percentage of the redemption orders or as a monetary value, and may be applied proportionately in accordance with the quantity of redemption orders received.

Swing pricing

Under AIFMD II, swing pricing is a pre-determined mechanism through which the NAV of a fund is adjusted by the application of a “swing factor” reflecting the cost of liquidity. The RTS provides that the swing factor should include estimated costs of subscriptions or redemptions as well as the estimated market impact of asset purchases or sales to meet those subscriptions or redemptions, which must be expressed as a percentage of the fund’s NAV.

Swing pricing may be applied when there is a difference in the value of redemption orders and subscription orders.  If there are more redemptions than subscriptions, the swing factor can be deducted from the NAV; if there are more subscriptions than redemptions, the swing factor can be added to the NAV. The swing factor can include different swing factors corresponding to various activation thresholds.

The Guidelines suggest swing pricing is suited to funds invested in:

• assets with fixed, transparent and/or foreseeable transaction costs
• less-liquid assets where other LMTs, such as swing pricing, may be challenging or impossible to implement due to infrequent and limited pricing sources

Dual pricing

Dual pricing is a pre-determined mechanism where the subscription and repurchase/ redemption prices of units are set to reflect the cost of liquidity; while the RTS clarifies that dual pricing must be calculated in accordance with one of the following:

• an open-ended AIF or a UCITS has two NAVs; one for subscribing investors calculated using ask prices of the assets in which the fund is invested, and one NAV for redeeming investors calculated using the bid prices of the assets in which the AIF is invested; or
• an open-ended AIF or a UCITS has one mid-market NAV for both subscribing and redeeming investors with an adjustable spread representing bid and offer on either side.

Guidance characterises this LMT as potentially appropriate for funds invested mainly in assets whose liquidity costs are primarily reflected by a bid-ask spread.

Anti-dilution levy

An anti-dilution levy is described in Annex V as a fee paid by a unitholder to the fund at the time of subscription, repurchase or redemption to compensate the fund for the liquidity costs incurred by virtue of the size of that transaction.  The intention of the levy is to ensure that other unitholders are not unfairly disadvantaged by another’s transactions. 

The RTS provides that an anti-dilution levy must include the costs of subscriptions/redemptions and the estimated significant market impact of asset purchases or sales to meet those requests (if any). The levy can be expressed as a percentage of redemption/subscription orders, or as a cash value. A levy may be applied if the difference between redemption and subscription orders exceeds a predefined activation threshold. As for swing pricing, when the activation threshold is exceeded and the difference results in net redemptions, the levy is deducted from the amount paid to redeeming investors. Conversely if the threshold is exceeded and there are net subscriptions, the levy is charged to subscribing investors.

Redemptions in kind/in-specie redemptions

AIFMD II describes redemptions in kind as the meeting of redemption requests by the transfer of assets instead of cash.

The RTS sets out that the LMT can be used if a sale of sizeable blocks of securities held by the fund would likely create significant transaction costs and market price impacts to unitholders.  There is a carve-out for ETFs such that delivery of underlying securities to authorised participants or to market-makers to satisfy dealing requests are not be considered to be activation of a redemptions in kind LMT.

Guidance on the point advises that managers thinking of choosing a redemption in kind LMT should consider the structure of the fund, the investor concentration and the asset types when doing so. In kind redemptions can only be made to professional investors.  This raises a question of whether a fund with mixed investor types (retail and professional) can count a redemption in kind mechanism as one of its two minimum LMTs.

Side pockets

A side pocket is described in AIFMD II as the separation from the other assets of the fund of assets whose economic/legal features have changed significantly or become uncertain due to exceptional circumstances.

Side pockets can only take the following forms:

• accounting segregation, in which a specific share class is created for those assets
  • for accounting segregation, new subscriptions, redemptions and repurchases must be executed on the basis of the fund’s NAV from which the assets of the side pockets are excluded
• physical separation, in which a separate fund is created to separate those assets from the other assets (for AIFs) or in which all other assets are transferred to another UCITS (for UCITS)
  • for physical separation, the separate fund may comprise either the affected assets, or the unaffected assets

Investors receive shares or units in the side pocket pro rata to their holdings in the fund from which the side pocket is spun out.  All side pockets must be close-ended, with no subscriptions being accepted.

What should I do to prepare?

Fund managers should identify which liquidity management tools are most appropriate for their funds and set activation thresholds.  They should prepare to align their current liquidity management policies and procedures with the new requirements, in particular putting in place processes to ensure liquidity monitoring.

Under the Guidelines, this exercise involves assessing the suitability of the fund’s selected LMTs against all relevant factors, including:

• the fund’s legal structure and any specific features associated with that structure (e.g. ETFs, master-feeder structures)
• the fund’s investment strategy and policy
• the dealing terms of the fund (minimum duration of notice period, lock-up period, settlement period, redemption policy, dealing frequency)
• liquidity profile of the fund and its underlying assets
• results of liquidity stress testing
• characteristics of the fund’s investor-base
• the fund’s distribution policy

Next steps

The RTS are subject to review and adoption by the European Commission.  If adopted, the RTS and accompanying Guidelines will enter into force on the 20^th day following the publication in the  Official Journal.

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