Investment funds: Dealing with liquidity risks (2024)

In order to gain a better understanding of these risks, BaFin investigated companies’ own requirements in open-ended funds for liquidity management and liquidity stress testing more closely; in BaFin's view, sound risk management at fund level is the first line of defence against the threat of contagion in the financial system. This article focuses primarily on liquidity risk management. The detailed results in the area of liquidity stress testing can be found in a report that BaFin published recently (only available in German). This also includes guidelines for asset management companies.

The key takeaway from the guidelines regarding liquidity risk management is that the business model of the specific asset management company and the funds managed by it will be significant in determining the most sensible way of managing liquidity risk. However, reporting channels and responsibilities must always be clearly defined. The assessment of liquidity risks in particular should be based on the company's own deliberations and assessments. There is therefore no one-size-fits-all solution for liquidity risk management – and for good reason. This makes asset management companies themselves responsible for developing the most suitable tools for risk management.

Definition of liquidity risk

The meaning of liquidity risk in investment funds is different from how liquidity risk is defined in other parts of the financial industry. Customers of banks, for example, expect their institutions to be able to return their deposits in full at any time, subject to the maturity date. Investment funds, on the other hand, invest their investors' money in assets that fluctuate in value. An investment fund is liquid while it can guarantee that it is able to meet investors' redemption requests and other payment obligations at any time.

A fund's assets are subject to a range of risks that influence yields and thus the redemption value of fund units. The asset management companies manage these risks in the investors' best interests, with their risk management being subject to legal and other regulatory requirements.

Liquidity risks in the financial sector

The principle of liquidity management for investment funds therefore involves bringing the liquidity of the investment fund into line with its payment obligations (see Figure 1). To achieve this, primarily the market liquidity risk on the asset side and the expected and actual payment obligations on the liabilities side need to be monitored. The main challenge here is that the funds' obligations are usually short-term, but they primarily invest in long-term and in some cases potentially illiquid assets.

The principle of liquidity risk management

Figure: The principle of liquidity risk management; © BaFin

In Germany, the provisions restricting liquidity risks in open-ended funds are set out in the Investment Code (Kapitalanlagegesetzbuch – KAGB) and are principle-based. Compliance with these provisions is subject to BaFin's ongoing supervision. Every asset management company must have an appropriate liquidity risk management system and ensure that the investment strategy, the liquidity profile and the redemption policy are in line with each other. They also have to conduct regular stress tests for all open-ended funds. These are to be conducted using both normal and exceptional liquidity conditions.

Liquidity risk on the asset side

Market liquidity risk on the asset side (see Figure 2) primarily lies in an inability to generate sufficient cash to cover payment obligations at short notice and on time, in particular in the case of an unexpectedly high level of redemption requests. A challenge for risk managers here is that there is not always a clear line between whether an asset is categorised as liquid or illiquid, and this categorisation varies over time. For example, assets that are initially categorised as liquid can become illiquid, or vice versa, depending on the market situation.

For this reason, processes and procedures need to be established as part of liquidity risk management to enable the asset management company to identify liquidity risks at an early stage, assess their consequences and, if necessary, take measures to counter them. A more in-depth analysis should be carried out in the key investment areas. For example, for an equity fund focusing on selected countries it is very useful to gain a good understanding of market practice in that location and to call on the expertise of specialist dealers. For bonds used as collateral for derivative transactions, however, such an in-depth analysis is not absolutely necessary.

It is therefore particularly important for the assessment of liquidity risks that the risk management structure suits the respective asset management company. In order to be able to assess the liquidity of assets on the asset side, it is important that the company regularly checks the liquidity of assets on the asset side and reassesses their liquidity. In doing so, the company can develop an overview and is able to follow changes in the liquidity status closely.

Liquidity risk on the asset side

Figure: Liquidity risk on the asset side; © BaFin

Liquidity risk on the liabilities side

The liquidity risk on the liabilities side of the investment fund (see Figure 3) primarily lies in the fund not, or not sufficiently, being able to deal with high outflows of funds, resulting from investors redeeming unit certificates, without impacting portfolio allocation. Here the challenge lies in predicting the redemption behaviour of investors. This can vary hugely due to the different types of investors, their investment horizons and their individual portfolio or tax situations. However, in certain market phases, in particular when there are extreme fluctuations in prices, they can be unexpectedly similar. The delivery and payment obligations of the fund arising from derivatives, securities loans and repurchase agreements are another important aspect.

The liabilities side can vary considerably. Some companies are part of a group financing structure, while others specialise in retail or special funds. The level of knowledge about the investors in a retail fund also differs to varying degrees depending on how the funds are distributed. It is higher if the company can access the securities account data and lower if the distribution is carried out by third parties. Independently of that, however, liquidity management is particularly challenging for retail funds where the retail fund includes a large tranche for institutional investors. These investors generally react more quickly to market developments and business trends than retail investors, and with much higher sums and percentages of the fund. Asset management companies should therefore communicate closely with the institutional investors so that they can react in good time. Analysing the investor structure, looking at the historical data and evaluating the predictions that can be derived from these are measures that should be a matter of course for companies in order to increase awareness of outflows of funds. For this to be possible, the companies need to have enough historical data available.

Liquidity risk on the liabilities side

Figure: Liquidity risk on the liabilities side; © BaFin

Quantifying liquidity risk

Comparing the two sides – the liquidity on the asset side and the expected payment obligations on the liabilities side – shows whether the liquidity profile of the investments of the investment fund at least matches, in principle, the underlying liabilities such as the actual and expected redemptions, as well as other payment obligations. This relationship can be represented by means of liquidity measures.

Quantifying liquidity risk

Figure: Quantifying liquidity risk; © BaFin

Ultimately, companies use measures to obtain a concise visualisation of liquidity risk (see Figure 4). The measures that are used include, for example, liquidity and illiquidity ratios, liquidity measures and liquidity points systems. Comparing liquid assets with expected liabilities allows the undertaking to assess the liquidity of the fund. Internal thresholds reveal excess liquidity and liquidity shortfalls, which allows the company to take appropriate countermeasures.