ESMA seeks counsel from industry stakeholders on liquidity management

The European Securities and Markets Authority (ESMA) is in the process of requesting responses to its consultations on the revised AIFM Directive and UCITS Directive. It is intended that these legislative reforms will mitigate potential financial stability risks and enhance pan-European harmonisation on liquidity risk management processes in the investment funds sector, particularly with respect to open-ended AIFs and UCITS.

The adaptations of both Directives have introduced “long-awaited provisions on the availability and use of liquidity management tools” and ESMA is now seeking input on how best to apply these provisions in practice.

Draft guidelines and technical standards have already been released by ESMA for industry-wide review. Industry stakeholders are now being invited to contribute their perspectives by 8 October 2024. It is envisaged that ESMA will subsequently release its final iteration of both the guidelines and the technical standards by 16 April 2025.

The areas of focus in both the draft guidelines and the draft technical standards are summarised over the following pages.

Draft Regulatory Technical Standards on Liquidity Management Tools under the AIFMD and UCITS Directive

The draft technical standards (click here) cover the characteristics of liquidity management tools available.

The areas outlined can be summarised as follows:

• Suspensions of subscriptions, repurchases and redemptions – The revised Directives outline that suspension of subscriptions, repurchases, and redemptions is a temporary measure that fund managers can employ, in addition to other mandatory liquidity management tools, under exceptional circumstances to protect investor interests. Such suspensions must be applied to all three actions – subscriptions, repurchases, and redemptions – simultaneously and will prevent the processing of any related requests. ESMA emphasises that when a suspension is enacted, it should be accompanied by a plan for the fund's future, which could include reopening the fund, creating a side pocket, or liquidating the fund. The criteria for suspension include exceptional circumstances, investor interest, and simultaneous closure and reopening for all activities. ESMA also seeks to standardise the regulatory technical standards for suspensions across both Directives.
• Redemption gates – Redemption gates, as defined by the revised Directives, are mechanisms that temporarily limit the amount of units or shares investors can redeem from a fund, while still allowing new subscriptions. The activation of these gates is based on a predetermined threshold, expressed as a percentage of the fund's NAV, which, when exceeded, gives the fund manager or board the discretion to partially execute redemption orders, considering the fund's liquidity and investors' interests. ESMA has decided against allowing individual redemption orders to determine the activation threshold, to ensure fair treatment of all investors. The exact level of restriction applied when a gate is activated is known as the redemption gate level, which must be the same for all investors and cannot be lower than the activation threshold. Non-executed redemption orders can be carried forward or cancelled, and the fund manager or board must clarify if these carried-forward orders will have priority over new orders. ESMA intends for the technical standards on redemption gates to be consistent across both the Directives, with specific considerations for European Long Term Investment Funds (#ELTIF) as outlined in their regulations.
• Extension of notice periods – The revised Directives stipulate that funds can extend the notice period required for shareholders or unit holders to redeem their shares or units, without affecting the fund's dealing frequency or settlement period. This extension is additional to the minimum notice period already set by the fund's rules. For instance, if a fund with a two-day notice period extends it by three days, the new notice period becomes five days. This extension must be uniformly applied to all investors and, in the case of funds with multiple share classes, across all share classes. The extended notice period can be set for a specific duration, covering several consecutive dealing dates. ESMA asserts that the technical standards for extending notice periods should be consistent across both the Directives.
• Redemption fees – Redemption fees, as defined by the revised Directives, are fees charged to investors upon the redemption of fund shares or units, designed to cover the liquidity costs incurred by the fund and to protect remaining investors from being unfairly disadvantaged. These fees are predetermined and fixed, not influenced by the fund's net capital changes, and are intended to reflect the explicit and implicit costs of portfolio transactions triggered by redemptions. Redemption fees are expressed as a percentage of the redemption order and may vary within a set range to account for fluctuating transaction costs in different market conditions. They can be applied to all redemptions or only to those exceeding a specified threshold, which may be based on the fund's NAV or the number of shares/units redeemed. ESMA provides guidance on calibrating these fees, suggesting that funds may use a tiered approach where larger redemptions incur higher fees. The characteristics of redemption fees ensure uniformity among investors at the same fee level and aim to distribute the costs of redemptions fairly. ESMA recommends that the technical standards for redemption fees should be consistent across both the Directives.
• Swing pricing – Swing pricing is a mechanism outlined in the revised Directives, designed to protect investment funds from the costs associated with investor trading activity. It adjusts the fund's net asset value NAV by applying a swing factor to account for the costs of liquidity when investors subscribe to or redeem shares or units. This swing factor is applied to the NAV to create a 'swung NAV', which is the price at which all transactions occur. Fund managers can implement swing pricing on every dealing date regardless of net activity ('full swing') or only when net activity exceeds a certain threshold ('partial swing'). The direction of the NAV adjustment depends on whether there are net subscriptions or redemptions. Additionally, managers may use a single swing factor or a tiered approach with progressively increasing factors to reflect the varying costs of different levels of net capital activity. The same swing pricing rules are recommended for both alternative investment funds and UCITS funds by ESMA.
• Dual pricing – Dual pricing in the context of the Directives is a predetermined mechanism for setting investment fund prices by adjusting the Net Asset Value NAV to account for liquidity costs. ESMA concurs with the International Organization of Securities Commissions that dual pricing can be implemented by either using two NAVs – one based on assets' ask prices for subscriptions and another based on bid prices for redemptions – or by applying an adjustable spread around the fund's NAV, with separate bid and offer prices for redemptions and subscriptions, respectively. ESMA endorses these two methods for fund managers to calculate dual pricing and stipulates that the same methods should be applied across all share classes within a fund. Unlike swing pricing, which uses a single "swung NAV" for all transactions, dual pricing employs two distinct NAVs for subscribing and redeeming investors. ESMA also asserts that the regulatory technical standards on dual pricing should be uniformly applied to both the Directives.
• Anti-dilution levy – ESMA outlines the concept of an anti-dilution levy in the context of the revised Directives. This levy is a fee charged to investors at the time of subscription or redemption of fund shares to offset the costs of liquidity that the fund incurs due to large transactions, ensuring fairness among all shareholders. The levy varies based on the net capital activity of the fund, either being applied uniformly to all investors or individually based on each investor's transactions. It is designed to cover both explicit and implicit costs associated with portfolio transactions triggered by investor activity. Unlike fixed redemption fees, the anti-dilution levy is variable and may be subject to a pre-determined threshold. ESMA provides draft guidance on the calibration of this levy, advocating for uniform application across both the Directives.
• Redemptions in kind – The Directives define redemption in kind as the process of fulfilling redemption requests by transferring fund assets rather than cash to unitholders or shareholders. This mechanism is primarily reserved for professional investors and must typically reflect a pro rata distribution of the UCITS's assets. Exceptions are made when a UCITS is exclusively marketed to professional investors or aims to replicate a specific index and operates as an exchange traded fund; in such cases, a non-pro rata distribution is permissible. Redemptions in kind help to avoid large-scale asset sales, thereby protecting remaining investors from associated costs and market impacts. ESMA advocates for uniform redemption in kind technical standards across both the AIFM Directive and UCITS frameworks.
• Side pockets – The revised Directives introduce the concept of side pockets, which allow for the separation of problematic assets from the rest of a fund's portfolio due to exceptional circumstances affecting their valuation or legal status. Side pockets can be utilized by both UCITS and alternative investment funds, although they are not mandatory liquidity management tools. UCITS can exclude these separated assets from certain investment limit calculations. There are two methods for creating side pockets: physical separation, where problematic assets are either moved to a new fund or remain in the original fund while the unproblematic assets are moved; and accounting segregation, where problematic assets are allocated to a specific share class within the fund. For UCITS, physical separation must be done by transferring the unproblematic assets to a new or existing UCITS, while the problematic assets remain in the original fund, which is then closed and liquidated. Alternative investment funds, on the other hand, have more flexibility in how they can physically separate assets. Common characteristics for side pockets, regardless of the method, include being closed-ended, pro rata distribution of side pocket shares/units to investors, management with the intention of liquidation, no reinvestment of cash from asset sales, allocation of liquid assets to cover potential liabilities, and management of the remaining fund assets according to the stated investment strategy. New subscriptions and redemptions are based on the value of the fund excluding the side pocket assets. ESMA notes that aside from the process of physical separation, all other aspects of side pockets should be consistent between UCITS and alternative investment funds.