China’s regulator learns from illiquid fund panic

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Reacting to “liquidity risk management in overseas markets”, the CSRC has proposed a tool to counteract illiquid mutual fund investments.

Over the past 12 months, two separate incidents over funds holding some illiquid assets caused investor panic and the scramble for redemptions. The funds, from European fund managers Neil Woodford and Natixis-owned H20, raised global concern over the risks in holding illiquid investments.

Managers were also punished. Woodford’s Equity Income Fund has been suspended and he is under investigation by the UK regulator. Natixis-owned affiliate, H20, reported second quarter net outflows of $6.64bn (€6bn), which were linked to holding some illiquid assets.

In response, the China Securities Regulatory Commission (CSRC) said that a guideline has been drafted for a sidepocket mechanism in mutual funds and it is seeking public consultation.

The regulator said it was “learning from liquidity risk management in overseas markets” according to a report from state-run Xinhua.

“This move aims to further enrich the liquidity risk management tools of security investment funds, regulate the business operation process of security investment funds, and protect the legitimate rights and interests of fund shareholders,” the CSRC said in a statement.

The sidepocket mechanism in a mutual fund keeps illiquid and often highly risky assets separated from the fund’s other liquid investments. Once put in the sidepocket, the assets will be closed for subscription, but investors can continue to subscribe to or redeem their investment in the rest of the fund holding liquid assets.

CSRC guidelines noted that the mechanism should be used when potentially toxic assets are over 5% of the portfolio.

When the weight is under 5%, the sidepocket could still be used if redemptions from minority shareholders reach a certain level, the regulator said.

The draft also sets clear requirements for the relevant parties. For example, fund managers need to inform the fund distributors of related matters after the mechanism starts.

Because ETFs have specific characteristics, they don’t need a mechanism to counter illiquid risk, the regulator added.

Last year, India’s regulator also moved to allow some funds to have sidepockets after domestic defaults on bonds that were held by mutual funds, according to local reports.

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