Liquidity mismatches in open-ended funds, such as that seen in the property sector and in the case of the Woodford Equity Income fund, poses a threat to financial stability and could “amplify shocks in the financial system”, the Bank of England (BoE) has warned.
In its annual Financial Stability Report, published on Monday (16 December), the BoE said such mismatches, which is not unique to "any single market or fund type", could lead to forced sales which may also impact the provision of finance to the economy.
The Bank's report noted the risk in relation to the suspension of the Woodford Equity Income fund in June, as well as the more recent M&G Property Portfolio gating and those seen in the open-ended property fund sector in the wake of the 2016 Brexit referendum.
It also noted there have been "several" similar examples internationally in recent years where funds experienced large redemption requests, citing those seen in Third Avenue funds in 2015, GAM in 2018, H2O in 2019 and some mutual funds in India in 2018 to 2019.
The BoE said: "Large-scale redemptions from funds could result in them selling less liquid assets below their fundamental value.
"This can amplify shocks to the wider financial system, such as sudden price falls, rather than absorb them, and lead to higher market volatility.
"These effects can be further amplified by other vulnerabilities in market-based finance, including possible reduced willingness of dealers to intermediate in the corporate bond markets at times of stress."
It added that asset price falls as a result of such events may increase the cost of finance for companies by "raising the cost of issuing finance in capital markets and by reducing the value of collateral used by businesses and thus their ability to borrow".
The bank also said that asset price falls can "transmit" to other parts of the financial system, including banks and insurers, via their "common asset holdings with funds and a broader impact on market sentiment".
It explained: "This could further reduce the supply of finance to the real economy. Funds could also be affiliated to banks, which can result in reputational risks to these banks from fund stress and thus affect provision of finance."
Notably, the bank warned that the extent to which fire sales in open-ended funds, particularly those which are highly leveraged, can amplify market shocks depends on asset type.
It explained: "Bond funds have grown in size and have increased their exposures to corporate bonds, their asset sales would have a much larger impact on market liquidity during stress now than they had in the past.
"Fund flows affect bond prices, with the impact being larger for outflows than inflows and greater where a higher proportion of a specific bond is held by funds.
"The majority of UK corporate bonds held in funds are rated BBB or below, so fund outflows may have a particularly high impact on these bonds".
Governor of the BoE Mark Carney said there was no desire to stop open-ended funds investing in illiquid assets, which "can be very attractive assets, but… are not commensurate with daily liquidity".
He added the liquidity mismatch "should not be something that retail investors find out about in a gating situation, it's something that they should know in advance and have an expectation of how long it should take to get their money out".
To that end, the report suggested that "there should be greater consistency between the liquidity of a fund's assets and its redemption terms".
It explained: "Redeeming investors should receive a price for their units in the fund that reflects the discount needed to sell the required portion of a fund's assets in the specified redemption notice period.
"[And] redemption notice periods should reflect the time needed to sell the required portion of a fund's assets without discounts beyond those captured in the price received by redeeming investors."
Carney also pointed to new rules brought in by the US Securities Exchange and Commission should be followed in the UK that require funds to separate their holdings into liquidity buckets.
"The funds should make judgements about the liquidity of their assets. Normally that is a spectrum of liquidity; it is not just one type of asset. They should put their assets into liquidity buckets," said Carney.
"And liquidity in that regard shouldn't be about whether something is listed or not, or has certain technical characteristics; it should be about how truly liquid they are. How long would it take under reasonable circumstances to sell the underlying asset?"
Commenting on the report, chief executive of the Investment Association Chris Cummings said: "Events this year have raised important questions about how liquidity is managed in the fund management industry, particularly with investments in assets that cannot be sold quickly to meet investors' withdrawals.
"This industry has been successfully tested through very challenging market conditions and continues to generate good returns for its customers in the UK and around the world. However, we also need to ensure that the fund regime is as robust as possible for the future.
"We have a shared interest alongside the FCA and the Bank of England in market resilience, customer choice and ensuring the economy receives the investment it needs for long-term growth. We look forward to working with both organisations to review liquidity management processes."
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