AIFMD – managing liquidity risks

The Alternative Investment Fund Managers Directive (AIFMD) places a requirement on fund managers to estimate their liquidity and report it to the various regulatory bodies that affect them. Fund managers are also affected by the SEC’s Rule 22e-4, which was introduced in October 2016. While it mainly affects funds domiciled in the US, such as ETFs and OEMFs, fund managers in the UK and Europe should still note its stringent requirements for the reporting of liquidity.

Under Rule 22e-4, investment managers and advisers must have a risk-management process in place to measure their liquidity and define not just how they report it, but how they also report problems such as breaches, as well as determine their thresholds.

Rule 22e-4 defines four categories of liquidity:

• Highly liquid – this is defined as all positions that can be sold and settled within three working days
• Moderately liquid – positions that can be sold in three to seven calendar days, plus disposal positions that can be sold within the timeframe but maybe not settled if market conditions trigger a delay
• Less liquid – positions that can be sold with seven calendars, but are expected to take longer than seven days to settle
• Illiquid – all positions that will longer than seven calendar days to sell.

Note that only highly liquid positions are affected by business days – the other three are affected by calendar days. Rule 22e-4 states the liquidity level should be selected according to whether the sale and settlement window can be achieved without a position’s market value changing significantly in that period and whether it can also be achieved under “foreseeably stressed market conditions”. This means AIF managers will have to calculate how much financial hit they are able to absorb to liquidate positions. Daily monitoring of liquidity is essential to minimise risk.

From the SEC’s point of view, Rule 22e-4 isn’t intend to increase the reporting burden, but rather to encourage fund managers to integrate all their risk management processes so that liquidity risk management becomes as normal as managing operational risk, market risk, credit risk, etc, and there is greater consistency in the detail, quality and frequency of reporting by fund managers.

Fund managers should aim to have best practice protocols – if they can adhere to Rule 22e-4, they should then also be compliant with other regulatory reporting directives such as the AIFMD. Defining maximum capacities for each category and having strategies in place to manage the liquidity risks even under stressful conditions. One such strategy could be the use of a capital asset pricing model to adjust prices according to liquidity.

AIFMD – fund’s liquidity

The starting approach for measuring a fund’s liquidity should be quantitative, based on a high quality database with more than adequate records on historical flows and their exact circumstances. This data can be used to extrapolate the optimum levels of liquidity required for each category across the entire AIF and ultimately create a liquidity profile that will enable fund managers to liquidate when stressful conditions require cash.