The Bank of England considers the liquidity mismatch in open-ended funds a potential “systemic risk.”

After the recent debacles in the Woodford Equity Income Fund and  M&G Investments property fund, the Bank of England may change redemption rules for open-ended funds.

The Bank of England may impose delayed payouts for investors in open-ended funds that hold hard-to-liquidate assets. Alternatively, it may impose a haircut on investors demanding immediate redemptions in such funds.

The bank made these proposals in its latest Financial Stability Report.

Bank of England: Open-ended funds a “systemic risk”

The bank observed that funds holdings of assets take longer to liquidate in an orderly way. This is especially apparent during a period of market stress.

Globally, more than US$ 30 trillion of assets are now held in open-ended funds. These funds offer short-term redemptions while investing in longer-dated and potentially illiquid assets.

“The FPC judges that the mismatch between redemption terms and the liquidity of some funds assets means there is an advantage to investors to redeem ahead of others, particularly in stress,” the Bank said in its report. “This has the potential to become a systemic risk.”

The Bank cited instances of liquidity mismatch in open-ended funds such as M&G Investments Property Fund, LF Woodford Equity Income Fund, and the UK CRE funds in June 2016.

It observed that the sensitivity of fund flows to their performance is higher when funds hold less liquid assets. Further, large-scale redemptions from funds could cause the forced sale of assets amplifying the shocks to the system. The situation gets worse if these funds hold a greater proportion of the total assets of that market. The risk is higher if the funds use leverage.

Some investors more equal than others?

In a redemption situation, an open-end fund may need to sell its less liquid assets at a discount. It could possibly realize a higher amount if it had more time to undertake the sale.

“If redeeming investors received a price that did not reflect the discount, they could benefit at the expense of the remaining investors, contrary to the collective nature of the investment scheme,” the report said.

Therefore, it is desired to establish “greater consistency” between the liquidity of a fund’s assets and its redemption terms. Accordingly, the Bank, together with the FCA, is considering certain proposals.

Principles for fund design delivering greater consistency

These are:

• The liquidity of funds assets should be assessed as the price discount needed for a quick sale of a representative sample (or “vertical slice”) of those assets. Alternatively, the time needed for sale to avoid a material price discount.
• Redeeming investors should receive a price for the units in the fund that reflects the discount needed to sell the required portion of the fund’s assets in the specified redemption notice period.
• Redemption notice periods should reflect the time needed to sell the required portion of the fund’s assets without discounts beyond those captured in the price received by redeeming investors.

“Conceptually, funds should apply a pricing tool, a notice period, or a combination of both, that reflects the liquidity of the underlying assets held in the fund,” the Bank said.

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