Liquidity in focus. Photo: motorolka Source: AdobeStock

Liquidity buffers as preventive crisis management

Author: Dr. André Jäger, Universal-Investment

Unleashed by the coronavirus pandemic, capital market turbulence in March 2020 was a wake-up call for financial market regulators and the fund industry as a whole. Some investment funds were hit by significant outflows. Trading became increasingly illiquid in certain asset classes such as corporate bonds with lower credit ratings. New regulations on liquidity buffers (LMT – Liquidity Management Tools) for mutual funds under the UCITS framework were introduced in Germany at the end of March 2020*. However, the regulations, which are contained in the German Investment Code (KAGB), have yet to be put into practice. Discussions between the German regulator and industry representatives dragged on into 2021.

Three tools for crisis periods

The KAGB amendment in 2020 has helped Germany finally catch up on an international level. The new regulations provide investment funds with three tools to help stem the deluge of redemption requests and avert distress selling during crisis periods. These are: redemption periods, redemption “gates” and swing pricing.

BaFin has indirectly increased the pressure on the industry to improve liquidity provisions for crisis periods.

Dr. André Jäger ,
Risk Manager and Member of Universal-Investment’s Management Board

The use of liquidity tools is optional rather than mandatory, so legislators and regulators rely on the fund industry to act responsibly. “BaFin has indirectly increased the pressure on the industry to improve liquidity provisions for crisis periods,” says Dr. André Jäger, a member of Universal-Investment’s Management Board and the group’s representative in the LMT task force with the German financial regulator (BaFin), the German Investment Funds Association (BVI) and the German Banking Industry Committee (DK). "Just as cars use anti-lock braking systems, companies are equipping themselves for dangerous and extreme situations which, although rare, occur time and again on the capital markets. This is why Universal-Investment advocates the routine implementation of the tools.” Irrespective of their freedom of choice, management companies have to decide before a crisis whether and which liquidity management tool to use in funds’ sales documents. Some industry representatives regard the amendment as an infringement on investors' rights. However, the changes should in fact provide a solid standard that protects investors from further losses in crisis periods as well as averts fund suspensions and the subsequent reputational and financial damage.

The three liquidity tools vary in their complexity and ease of implementation. The redemption periods (investors may have to wait up to a month to redeem their money if they sell fund units) are defined in the minimum holding and notice periods for open-ended real estate funds that came into effect in 2013. Swing pricing - a mechanism that aims to allocate trading costs solely to investors who are subscribing or redeeming rather than spreading the costs across all the existing investors in the fund is already used in the US and Luxemburg.

Redemption gates are likely to be more challenging to implement. These depend namely on the smooth, swift interaction of the various interfaces that exist between investment companies, distribution teams, depositaries and custodians, often on a cross-border basis. Although the redemption gate mechanism has been used in Luxemburg and France for some time, it is not a template for Germany as the gates are applied manually.

The fact that members of the LMT taskforce have not always been in agreement has been widely reported in the press. In response, the BVI stressed that it is especially the ManCos who are forging ahead constructively with the implementation of the new regulation.

*1 In accordance with the "Gesetz zur Einführung von Sondervorschriften für die Sanierung und Abwicklung von zentralen Gegenparteien und zur Anpassung des Wertpapierhandelsgesetzes an die Unterrichtungs- und Nachweispflichten nach den Artikeln 4a und 10 der Verordnung (EU) Nr. 648 / 2012“, Artikel 5.” 

Author: Dr. André Jäger, Universal-Investment
Date of issue: 4/29/2021