How S&P Data and Analytics Support New Mandatory Liquidity Management Tools for Open-Ended Funds

The upcoming introduction of a harmonized framework for liquidity management tools has been a key topic of discussion within the European fund management industry this year. The recently adopted Regulatory Technical Standards aim to enhance the ability of investment professionals to manage fund liquidity and promote fair treatment of investors by aligning the liquidity profiles of collective funds with redemption demands.

These new regulatory requirements were developed to address vulnerabilities in UCITS and open-ended alternative investment products that may arise from significant investment withdrawals. Investors can experience net redemptions or subscriptions, necessitating trades that incur transaction costs. Without appropriate mitigants, these costs can erode the net asset value (NAV) and ultimately affect all shareholders. In stressed market conditions, substantial investor outflows may even trigger a fund run if sudden redemption requests cannot be met in an orderly manner.

In response to these concerns, the European Securities and Markets Authority (ESMA) has mandated the adoption of liquidity management tools designed to mitigate potential issues. S&P Global addresses this challenge by providing advanced quote-based liquidity metrics, which include transaction costs and market impact across a wide range of instruments. This data is critical for the successful adoption of the required tools and is essential for compliance with the Regulatory Technical Standards.

To ensure fairness among investors and prevent excessive redemptions in both normal and stressed market conditions, the ESMA has proposed the implementation of at least one quantitative tool and one anti-dilution tool. By April 2026, fund managers in the European Union will be required to implement at least two mitigants from the following list:*

*  The list does not include side pockets which manage liquidity by removing the illiquid assets from the main pool and as such are neither quantitative nor anti-dilution tools.

Quantitative liquidity tools are designed to manage the volume or timing of redemptions, helping to control the pace of outflows and avoid forced asset sales. These tools are activated based on predetermined, objective thresholds, such as a specific percentage of net redemptions, a monetary value, or a proportion of fund assets.

In contrast, dilution mitigants aim to ensure fairness and stability by allocating the costs associated with liquidity to the investors who trigger them. While quantitative tools focus on volume-based restrictions and do not require extensive market data input, anti-dilution tools utilize transaction cost information to mitigate the first-mover advantage. To differentiate between charges attributable to third parties and fees dictated by market liquidity, transaction costs can be categorized into explicit costs (such as brokerage fees or taxes) and implicit costs (including bid-ask spread effects and market impact effects).

Why is the transparency of implicit transaction costs critical for anti-dilution tools?

The generally accepted definition of implicit costs is the difference between the mid-price and the actual execution price. These costs can be substantial, particularly for funds holding less liquid assets or during stressed market conditions. Accurately incorporating these costs into liquidity management tools ensures that the price at which investors transact reflects the true cost of underlying liquidity.

It is important to note that typical collective funds do not react to every redemption or subscription with distinct order executions. Instead, the implied transaction costs relate to daily net redemptions or net subscriptions, which are mutually exclusive on any given day. When redemptions and subscriptions are balanced, the net flows are usually insignificant, making the entrance and exit fees a small fraction of the weighted average bid-ask spread.

However, exceptionally large redemptions or subscriptions can lead to additional transaction costs and a subsequent drop in NAV. This additional cost, known as market impact, must be accounted for over the bid-ask spread when executing large trades quickly. Unlike pure bid-ask spreads, market impact is often very visible, especially for less liquid investments. The mandated dilution mitigants aim to protect invested shareholders from significant losses in the event that a large redemption encounters thin or no liquidity in the underlying market.

The following overview illustrates the impact of implicit costs on the proposed anti-dilution tools:

• Redemption fees: These fees are intended to discourage frequent withdrawals and prevent short-term investments. Capital charges can be applied to the redemption of shares, reflecting both explicit and implicit costs. These charges can be expressed as a percentage or a fixed monetary amount and are deducted from gross redemptions.
• Swing pricing: This mechanism adjusts the fund’s NAV upward or downward by a preset swing factor that reflects the transaction costs associated with buying or selling shares, including any significant market impact. The swing occurs on days with net inflows or outflows exceeding a certain threshold, making it similar to contingent redemption fees. A key advantage of swing pricing is that it allows the transfer of transaction costs to subscribers or redeemers in single-priced funds without imposing explicit fees, which is less discouraging for investors.
• Dual pricing: This approach creates separate bid/ask price adjustments that reflect the implied transaction costs. Similar to swing pricing, it emphasizes cost transparency, with calibration contingent on net capital flows. This tool is ideal for funds with frequent trades but may be less suitable for less liquid assets.
• Anti-dilution levies: These contingent fees are designed to be charged directly to investors entering or leaving the fund. By imposing transaction charges on withdrawing investors, anti-dilution levies protect the remaining shareholders from costs incurred by large inflows or outflows of capital. Since crowded redemptions may cause significant NAV drops, the regulator requires that spread and market impact effects are used for estimating levies in both normal and stressed market conditions.

How can S&P help?

S&P Global offers comprehensive quote-based liquidity metrics across various instruments, obtained through advanced parsing techniques. We determine transaction costs and market impact effects for millions of fixed income  assets by combining extracted liquidity parameters such as quote volumes, quote ranges, and bid-ask spreads. For equities we apply a cost curve model that defines transaction cost as a function of trading strategy and stock-specific metrics, including country and exchange-level data. By simulating the asset liquidation in the cost computation process, we ensure that the data is well suited for feeding any anti-dilution tool mandated by ESMA. We invite you to contact us and explore the benefits of our solutions.