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Name emergency tools that regulators can let funds use when redemption demands are unforeseen, and explain the circumstances in which each is permitted.

FRM® Part II · Risk Management and Investment Management · Liquidity Risk Management · FRM2.IM.16.d

The idea

When redemption requests are unforeseen, regulators can allow funds to use emergency tools, each with its own conditions. A suspension halts dealing altogether and is reserved for exceptional circumstances, such as a market closure or the impossibility of valuing the portfolio, where it serves investors as a whole. The regulator is normally informed. A gate caps redemptions on a dealing date, usually as a percentage of NAV, and scales requests back pro rata or carries the excess forward. A side pocket segregates illiquid or hard-to-value assets so the rest of the fund can continue to deal. Redemption in kind pays investors in securities, and liquidity fees or swing pricing make redeemers bear the cost of their exit. All need support in the fund documents. The usual mistake is confusing a gate, which limits, with a suspension, which stops dealing.

A practice question

From the question bank, with the reason each wrong option is wrong.

A side pocket is used by an investment fund to:

  1. pay redeeming investors in securities rather than cash, so no assets must be soldWhy not: Describes redemption in kind, which transfers assets rather than isolating them.
  2. segregate illiquid or hard-to-value assets from the liquid portfolio - correct
  3. adjust the dealing price by a swing factor when net outflows exceed a thresholdWhy not: Describes swing pricing, an anti-dilution mechanism.
  4. borrow cash from outside lenders to meet redemption requestsWhy not: Describes a credit line or borrowing facility, which is funding rather than segregation of assets.

A side pocket ring-fences assets that cannot be sold or valued reliably. Existing investors keep a pro rata claim on them, and the remaining portfolio can continue to meet redemptions at a fair NAV.

A harder one

A major exchange on which much of a fund's portfolio trades closes unexpectedly, and the fund cannot determine a reliable NAV. Which regulator-permitted emergency tool is the appropriate response?

  1. A gate, because gates are the only tool allowed when a NAV cannot be computedWhy not: Gates assume a valid NAV and merely limit the amount redeemed; they are not the only permitted tool.
  2. Redemption in kind to all investors using the last stale prices, since this needs no valuationWhy not: In-kind redemptions still require valuation, and using stale prices would treat investors unfairly.
  3. No tool is available, because an open-ended fund must always pay at the last published NAVWhy not: Ignores that regulators permit suspension in exceptional circumstances such as market closure or inability to value.
  4. Temporary suspension of dealing, used only in exceptional circumstances - correct

Inability to value assets reliably is the classic exceptional circumstance where a suspension is allowed. A gate presupposes a valid NAV, and paying in kind or at stale prices would be unfair to remaining or redeeming investors.

The hardest tier

Which statement about the conditions under which regulators allow funds to use emergency liquidity tools is most accurate?

  1. Gates may only be used once the regulator has taken control of the fund and removed the managerWhy not: Too restrictive: managers can apply gates under their fund rules without the regulator taking over.
  2. Managers may create side pockets whenever they wish, without provision in the fund documents or disclosure to investorsWhy not: Side pockets require authority in the documents and transparency to investors; unilateral use would be unfair.
  3. Suspensions and gates need a basis in the fund rules, exceptional circumstances and regulator notification - correct
  4. Regulators ban any tool that treats redeeming investors differently, so swing pricing and in-kind payments are prohibitedWhy not: Anti-dilution and in-kind tools are accepted precisely to treat investors fairly; they are not prohibited.

Emergency tools must be provided for in the fund's documents, justified by exceptional conditions, and serve the interests of investors as a whole, typically with regulator notification. They are not discretionary or banned.

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