8 - Investment Funds

CSA Staff Notice 81-333 Guidance on Effective Liquidity Risk Management for Investment Funds September 18, 2020 A. Introduction The Purpose of this CSA Staff Notice (the Notice) is to provide guidance to investment fund managers (IFMs) on developing and maintaining an effective liquidity risk management (LRM) framework for investment funds. While this guidance is aimed at investment funds that are subject to NI 81-102 Investment Funds (NI 81-102), many of the LRM practices and examples outlined below may also be relevant for other investment funds when IFMs consider how to effectively manage their funds’ specific liquidity risks. The guidance provided in this Notice is based on existing securities regulatory requirements and does not create any new legal requirements or modify existing ones. Further, the guidance outlined below is meant to be flexible and scalable; it is not meant to suggest a “one-size fits all” approach since LRM is inherently fund-specific and multi-dimensional. IFMs may tailor their liquidity practices to manage and mitigate material liquidity risks specific to each fund’s unique characteristics. For purposes of this Notice, liquidity risk refers to the risk that a fund is unable to satisfy redemption requests without having a material impact on the remaining securityholders of a fund. A fund must be able to sell the underlying portfolio assets within a reasonable amount of time, in an orderly manner to satisfy redemption requests. If a fund does not manage liquidity risk properly, there could be adverse outcomes for the fund and its investors. Concerns may arise where there is a potential mismatch between the liquidity of the underlying portfolio assets of investment funds and the redemption terms and conditions offered to investors. The management of potential liquidity mismatch is a key focus for regulators. Internationally, the Financial Stability Board (FSB) has expressed concerns over certain structural vulnerabilities from asset management activities and specifically identified the liquidity mismatch as a potential source of systemic risk. 1 In Canada, the Bank of Canada (BoC) recently noted funds’ liquidity/redemptions mismatch as a potential area of structural concern, 2 though they also noted that asset managers appear to be taking measures to mitigate the impact of a decline in liquidity on the financial system. 3 1 FSB “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities” https://www.fsb.org/2017/01/policy-recommendations-to-address-structural-vulnerabilities-from-asset-management- activities/ 2 Bank of Canada “2019 – Financial System Review” https://www.bankofcanada.ca/wp-content/uploads/2019/05/Financial- System-Review%E2%80%942019-Bank-of-Canada.pdf 3 The BoC noted that: Open-ended mutual funds that have large holdings of corporate bonds have grown significantly in the past Page 1 of 15

Considering these global developments and heightened awareness around LRM in the asset management sector generally, staff of the Canadian Securities Administrators (Staff or We) are providing guidance in this Notice regarding effective LRM practices for investment funds. We encourage investment funds, IFMs and portfolio managers to review this Notice. Purpose This Notice:  briefly summarizes certain key international securities regulatory developments and the Canadian securities regulatory framework in this area, and  provides relevant and practical guidance for Canadian investment funds and their managers to support development and maintenance of a robust, effective LRM framework that considers normal and stressed market conditions. Investment funds vary in terms of size, structure, investment objectives and strategies, investor base, underlying portfolio assets and other fund characteristics, all of which may impact the specific liquidity risks facing the fund. What may be considered a material liquidity risk for one fund, may not be material for another fund. Accordingly, there are different approaches to effectively manage liquidity risk, according to each fund’s characteristics. The guidance provided in this Notice is not meant to suggest or endorse a “one size fits all” approach to LRM. Any examples provided herein are for illustrative purposes only and not meant to be exhaustive of all potential scenarios or approaches to LRM. B. Key international securities regulatory developments and the Canadian framework International regulatory landscape In recent years, both the FSB and the International Organization of Securities Commissions (IOSCO) have published policy recommendations and guidance pertaining to LRM in the asset management sector. In January 2017, the FSB published “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities” (the 2017 FSB Policy Recommendations). 4 As noted above, the 2017 FSB Policy Recommendations identified a “liquidity mismatch between fund investments and redemption terms and conditions…” as a potential source of structural vulnerability arising from asset management activities and asked IOSCO to review its existing guidance in this area and, as appropriate, enhance it. In February 2018, following an extensive public consultation exercise, IOSCO issued a report entitled “Recommendations for Liquidity Risk Management for Collective Investment Schemes - Final Report” (the 2018 IOSCO LRM Recommendations). 5 The 2018 IOSCO LRM Recommendations emphasize that decade and that such funds offer daily redemptions to investors but hold assets that may be difficult to sell on short notice. If many investors were to withdraw simultaneously, these funds might be forced to quickly sell bonds to honor their commitments, potentially decreasing liquidity in the bond market. A decrease in liquidity could have negative consequences for both bondholders and bond issuers, which could amplify the effect of an adverse shock on the financial system. The BoC also noted that asset managers are, however, aware that market liquidity may be less reliable than in the past and have indicated that they are altering their portfolio management strategies to prepare for periods of low liquidity, which should mitigate the impact of a decline in liquidity on the financial system. 4 See footnote 2. 5 https://www.iosco.org/library/pubdocs/pdf/IOSCOPD590.pdf. The 2018 IOSCO LRM Recommendations were followed by a Page 2 of 15

throughout the entire lifecycle of the fund, there should be an appropriate alignment between underlying portfolio assets and redemption terms. IOSCO noted that these recommendations are directed at preventing liquidity and redemption mismatches from arising in the first place, rather than just mitigating problems as they crystallize. Domestic regulatory landscape Under the Canadian securities regulatory regime, IFMs have a general statutory obligation to:  exercise the powers and discharge the duties of their office honestly, in good faith and in the best interests of the investment fund, and  exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in the circumstances. 6 (the IFM Statutory Conduct Standard). In exercising their duties under the IFM Statutory Conduct Standard, it is both in the best interest of the fund and prudent for IFMs to consider investor redemptions and fund liquidity when designing the fund’s operation and managing the fund’s assets. Both NI 81-102 and NI 31-103 Registration Requirements, Exemptions and Ongoing Registrant Obligations (NI 31-103) also contain provisions which are relevant to LRM and the roles and responsibilities of IFMs in managing liquidity risk. 7 As a fund’s liquidity risk is a risk associated with the business of the fund, section 11.1 of NI 31-103 requires a registered firm to have policies and procedures, that establish a system of controls and supervision sufficient to address such risk. In addition, Part 3.3.1 of Companion Policy 81-102CP states that the CSA expects an IFM to establish an effective LRM policy that considers the liquidity of the types of assets in which the investment fund will be invested and the fund’s obligations and other liabilities. It also states our view that the IFMs should regularly measure, monitor and manage the liquidity of the investment fund’s underlying portfolio assets, keeping in mind the time to liquidate each underlying portfolio asset, the price the asset may be sold at and the pattern of redemption requests. Lastly, in Ontario, Ontario Securities Commission staff (OSC Staff) have conducted continuous disclosure reviews of fund practices relating to portfolio liquidity and have provided certain LRM guidance and recommendations based on staff’s observations from these reviews. 8 C. Elements of an Effective LRM Framework The LRM process forms a critical part of the broader total risk management process for investment second Final Report entitled “Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration”, which provides a list of market best practices to address LRM (see: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD591.pdf). IOSCO also issued a July 2019 statement on its 2018 IOSCO LRM Recommendations, noting why they provide a comprehensive framework for addressing liquidity risk (see: https://www.iosco.org/news/pdf/IOSCONEWS539.pdf). 6 For example, see s.116 of the Securities Act (Ontario) (the OSA), s. 159.3 of the Securities Act (Quebec), s.125 of the Securities Act (British Columbia), s.54(3) of the Securities Act (New Brunswick), s. 33.1(1) of the Securities Act (Saskatchewan), and s.75.2(3) of the Securities Act (Alberta). 7 See for example, s. 2.4 of NI 81-102 for restrictions concerning illiquid assets, s. 2.18 of NI 81-102 for money market funds and s.11.1 of NI 31-103 for compliance systems of registered firms. 8 See OSC Staff Notice 81-727 Report on Staff’s Continuous Disclosure Review of Mutual Fund Practices Relating to Portfolio Liquidity (OSC SN 81-727). This review was undertaken based on OSC Staff’s observations that, while the mutual fund industry consists largely of funds focused on traditional asset classes, such as equities and investment grade debt, there was an increase in fund offerings with asset classes that may have higher liquidity risk. OSC SN 81-727 provided a summary of the results of the continuous disclosure review and also contained a number of recommendations based on OSC Staff’s observations at that time. Page 3 of 15

funds. The following guidance is intended to identify key elements of an effective LRM framework and further discusses how each of these elements is relevant to developing and maintaining an effective LRM framework for investment funds. A robust and effective LRM framework should include the following key areas (see also Figure 1):  Strong and effective governance  Creation and ongoing maintenance  Stress testing  Disclosure of liquidity risks  Use of LRM tools to manage potential and actual liquidity issues Governance Creation & ongoing Disclosure of Stress testing Use of LRM tools maintenance liquidity risk Figure 1. 1. Strong and Effective Governance Page 4 of 15 Align with fund liquidity profile of assets

Governance is an essential element for an effective LRM process and provides oversight of the liquidity management of a fund that is independent of the portfolio management function. Since securities legislation does not prescribe detailed requirements pertaining to all aspects of fund governance, in practice, IFMs have the discretion to determine effective LRM governance, which may include separate governance structures for purposes of general fund management and specific risk oversight. In maintaining an effective LRM framework, an IFM’s investment committee, governance committee or other group charged with risk oversight may be formed and have primary responsibility for dealing with material LRM matters. In fulfilling their oversight function, such committee should consider:  the assessment, monitoring and review of liquidity risk within the LRM framework,  the effectiveness of the policies and procedures relating to LRM controls, and  the development and oversight of policies and procedures which set out escalation procedures in the event of a liquidity event. IFMs should assess whether an existing governance body or new committee needs to be established to provide adequate oversight over the LRM function, independent of the portfolio management function and for the ongoing management and monitoring of liquidity. Page 5 of 15

The expertise of the committee members or other working group could be diverse across functions, such as product development, risk management, compliance, portfolio management and fund management. While we understand that funds may vary in size, operations and organizational structure, the following examples reflect potential responsibilities of an oversight committee as it relates to LRM:  establishing reporting and escalation procedures for material liquidity events, portfolio valuation issues and deficiencies in internal controls as they relate to LRM,  considering those circumstances where a liquidity issue may cause a conflict of interest between the fund and the IFM, and whether such situations require escalation or other internal approvals,  on-going review of LRM policies and procedures, and  reviewing of all material exception reports for stress testing and working with the portfolio managers to ensure appropriate remedial steps have been taken. In considering whether the funds they manage have a robust, effective and well-maintained LRM framework in place, IFMs may also need to:  obtain and assess information from various sources across functions, and  if not already in place, consider whether new or enhanced reporting and other compliance mechanisms need to be implemented to ensure that the necessary information is being shared with relevant parties within the IFM. The collection and dissemination of relevant and timely liquidity information will enable IFMs and portfolio managers to better anticipate and deal with liquidity risks in a proactive and orderly manner. 2. Creation and Ongoing Maintenance The CSA expect IFMs to have LRM processes, policies and procedures in place that are consistent with the IFM Statutory Conduct Standard which applies to them under local securities legislation, 9 as well as with their obligations as registered firms under NI 31-103 and the obligation of the funds under their management to comply with NI 81-102. 10 A proper LRM process should begin with the design phase of products to ensure alignment of redemption terms and investment strategy, and from there will continue to take into consideration the lifecycle of the fund, recognizing that the fund’s liquidity risk characteristics may change over time, and that LRM needs to remain effective in varied market conditions. An effective LRM process may include:  documented policies and procedures that address the fund’s key liquidity risks, which could include a description of how these risks are identified, monitored and measured, and the techniques used to manage and mitigate these risks,  a regular assessment of the liquidity profile of the fund’s assets and liabilities taking into consideration current market conditions, redemption activity, and investor behavior, and 9 See footnote 7. 10 See CSA Consultation Paper 33-403 for further details. Page 6 of 15

 communication and review by senior management and/or relevant personnel on a periodic basis. The following six principles, and related practical implementation strategies for each, support creating and maintaining an effective LRM framework (see also Figure 2): 1. Align the investment objectives, strategy, and redemption policy of the fund with the liquidity profile of the fund’s underlying portfolio assets and the redemption demands of the investor base at the design stage and on an ongoing basis.  Consider whether investments are aligned with redemption features and investor base of the fund throughout its lifecycle and monitored on a regular basis.  For example, if a fund holds a substantial amount of investments that are thinly traded, have longer clearing periods or are in emerging markets, the IFM may elect to offer less frequent redemptions. 2. Create and adhere to robust policies and procedures that integrate LRM considerations.  An effective LRM framework includes comprehensive policies and procedures that fully integrate LRM into investment decisions, including portfolio trading activities.  Consider whether the stated policies and procedures are aligned with the liquidity profile of the fund and support the overall ability of the fund to meet investor redemption requests and its other obligations. 3. Perform active, ongoing portfolio monitoring using qualitative and quantitative metrics to ensure adequate levels of liquidity exist to meet redemption needs and other obligations. All relevant data should be used to actively manage liquidity risks.  A fund may regularly review the composition of underlying portfolio assets, including cash and short-term securities with consideration of past redemption activity, distribution channels, investor base, fund performance, fund ownership, and any other special considerations (for example, changing market or other economic factors).  An effective liquidity assessment may also incorporate identification and monitoring of large redemptions by investors.  Examples of quantitative metrics used in arriving at a liquidity assessment may include volume metrics, market depth, reasonably anticipated size of trade, as well as third party assessments of liquidity of the underlying portfolio assets. o for fixed income funds, examples of quantitative metrics used in arriving at a liquidity assessment may include volume metrics provided by third party trading platforms, broker-dealer quotes, volatility, bid-ask spreads, fund holdings relative to outstanding issue size, and other internal estimates such as market depth.  Examples of qualitative metrics used in a liquidity assessment may include the credit quality of underlying portfolio assets, investor concentration in the fund, investor profile, industry risk, geographic risk and the specific terms and conditions of underlying portfolio securities. 4. Set internal liquidity thresholds and targets that management of the fund can use to assess the liquidity profile of a fund and make any necessary adjustments. Page 7 of 15

 Establish effective internal liquidity thresholds that are proportionate to the redemption obligations and liabilities of the fund.  For example, in addition to ensuring compliance with the illiquid asset restrictions under NI 81- 102, a fund may elect to impose an internal limit (min/max) of underlying portfolio assets that could be convertible to cash in a certain number of days and classify those assets accordingly. These internal liquidity thresholds would be monitored on a regular basis. 5. Report material liquidity events in a timely manner for consideration by relevant personnel of the IFM.  Internal LRM reports contain sufficient information to understand the liquidity issues, actions taken and whether any further actions or approvals are necessary.  Funds may implement early and timely identification of significant redemption requests in their reporting framework for further consideration and potential action. 6. Where possible, identify emerging liquidity concerns and potential liquidity shortages.  Although funds may not predict or foresee all liquidity events, monitoring market conditions and early identification of the resulting impact on a fund’s portfolio, including potential liquidity shortages, will support effective management of a fund’s liquidity risks.  A firm’s LRM policies and procedures may also outline procedures before and after a liquidity shortage occurs, and also identify when the use of LRM tools may be appropriate. 3. Stress Testing Stress test Scenario Frequency Analyze Risk identification Mitigation thresholds analysis of testing results • Plan for heightened • Market risk Proportional to the Illustrate and • Historical Based on specific liquidity risks • Liquidity risk liquidity risk profile • Hypothetical attributes of the quantify • Modify fund • Redemption of the fund fund vulnerabilities of a strategies to risk fund address identified LRM risks Figure 3. While conducting stress testing is not specifically required under securities legislation, the guidance in this section identifies some of the key factors to consider when conducting stress testing. Stress tests are important validation tools that enable a fund to assess the liquidity of its underlying portfolio assets, relative to the redemption flows under various market conditions and may be included as part of an effective LRM process to ensure that funds are prepared to respond appropriately to liquidity risks. Stress testing simulates stressed events and market conditions and liquidity events in order to understand their implications on the fund’s ability to meet redemption requests. While effective stress testing will likely be independent from the portfolio management function, it is acknowledged that this may not be possible in a smaller fund. An effective stress test will depend on the ability to Page 8 of 15

create meaningful and relevant stress scenarios based on the use of reliable, relevant and current data. Funds that adopt stress testing may benefit from written stress testing policies that are reviewed and approved regularly. There may be different ways to incorporate stress testing or scenario testing into the LRM framework. Stand-alone stress testing processes may be included as part of the overall LRM compliance function to measure the effect of significant one-off transactions. Certain historical stress or scenario data points may also be directly built into establishing operational liquidity thresholds and/or targets, such as largest redemptions (historic stress test) or largest client redemptions (scenario stress test). The stress testing process is summarized in Figure 3 and described in more detail below. Identification of Risks The identification of key risks includes but is not limited to, market and redemption risk. Market risk reflects the potential loss due to factors that affect the overall performance of the financial markets, such as movements in interest rates, recessions or geopolitical events. Redemption risk reflects the potential for an unusual amount of redemptions to occur in a limited period of time. While not an exhaustive list, a fund may also choose to incorporate one or more of the following events or risks in their stress testing, which may affect the fund or underlying portfolio assets held by the fund:  general market stress or disruption 11  market stress affecting a class or subclass of assets  interest rate risk  credit risk  reputational risk  redemption risk  geopolitical risk  other sources of liquidity risk Stress tests that anticipate reasonably foreseeable stressed market conditions and include relevant risk factors to which the fund could be exposed, may be most useful. Effective stress testing would also be proportionate to the liquidity risk profile of the fund. Scenario Analysis Stress tests can cover a range of scenarios that reflect a spectrum of events and severity levels. The complexity can range from a simple sensitivity test (using a single factor) to complex stress tests (using multiple factors), which aim to assess the impact of severe events. While stress test scenarios can take on a variety of forms, it is important that they are diverse and reflect material risks relevant to the fund. IFMs should incorporate reliable and up-to-date market information and may take into account the behavior of other market participants, whose actions may separately or collectively have an effect on the liquidity of the fund and/or its underlying portfolio assets. When conducting a scenario analysis, IFMs may consider a number of factors including:  downgrade of credit rating of an underlying portfolio asset or of the issuer of the 11 For example, with the recent COVID-19 pandemic, we experienced reduced market trading, significant market volatility and other market disruptions. Page 9 of 15