SFC Liquidity Risk Management for Asset Managers: Redemption Stress in Open-Ended Funds

The SFC published its long-awaited Consultation Conclusions on Liquidity Risk Management Requirements for Open-Ended Funds in October 2024, with the new rules taking effect from 1 January 2025 for new funds and a phased compliance deadline of 1 July 2025 for existing funds. The trigger was not a single market crash but a pattern: the March 2020 dollar-fund stress, the 2022 UK gilt crisis, and multiple gating events in Hong Kong’s own retail fund space since 2021. The SFC observed that over 40 per cent of authorised open-ended funds in Hong Kong hold assets that are less liquid than the redemption terms offered to investors — a structural mismatch that the new Code on Unit Trusts and Mutual Funds (UT Code) amendments directly address. This article sets out the new liquidity classification framework, the mandatory stress-testing regime, and the reporting obligations that asset managers must operationalise before the July 2025 deadline.

The New Liquidity Classification Framework

The SFC has replaced the old binary “liquid/illiquid” distinction with a three-tier classification system under the revised UT Code paragraph 4.7A. Every asset in an open-ended fund must now be categorised as “Highly Liquid”, “Liquid”, or “Less Liquid” based on a standardised methodology that considers both the asset’s secondary-market depth and its settlement timeline in normal market conditions.

Step 1: Define the classification criteria for each tier. The SFC’s guidance paper of December 2024 sets out the default thresholds. A “Highly Liquid” asset must be capable of being converted to cash within one business day at a cost not exceeding 0.5 per cent of its net asset value. “Liquid” assets have a conversion window of up to seven business days with a cost cap of 2 per cent. “Less Liquid” assets are those that cannot meet either test — typically private credit, unlisted real estate, or structured products with lock-up periods exceeding 30 days.

Step 2: Map every portfolio holding to the classification grid. The manager must assign a classification to each position at least monthly, and within one business day of any material change in the asset’s trading profile. The SFC’s Frequently Asked Questions on Liquidity Risk Management (January 2025) clarifies that a manager cannot rely solely on an external pricing vendor’s liquidity score. The manager must overlay its own redemption profile — a fund with daily dealing but holding 15 per cent in assets classified as “Less Liquid” fails the new liquidity coverage requirement automatically.

Step 3: Maintain the liquidity buffer. The UT Code now requires that at least 80 per cent of a fund’s portfolio be held in “Highly Liquid” or “Liquid” assets at all times, with the “Highly Liquid” component alone constituting no less than 30 per cent of the fund’s net asset value. The SFC’s own market-wide data from the 2024 Annual Liquidity Review showed that 28 per cent of authorised funds would have breached the 30-per-cent threshold on at least one dealing day in the preceding 12 months.

Mandatory Stress-Testing: The SFC’s Four-Scenario Minimum

The new paragraph 4.7B of the UT Code introduces a statutory stress-testing obligation that goes beyond the industry’s previous best-practice standards. The manager must conduct stress tests at least quarterly, using four prescribed baseline scenarios and any additional scenarios that reflect the fund’s specific risk profile.

Scenario 1: Redemption shock at fund level. The test must assume that 20 per cent of the fund’s outstanding units are redeemed within a single dealing day. The manager must demonstrate that the fund can meet this redemption demand without gating or suspending dealing, and without selling assets at a discount exceeding 3 per cent of their last available NAV. The SFC’s Consultation Conclusions recorded that 34 per cent of respondents had not tested this specific scenario before the new rules were proposed.

Scenario 2: Market-wide liquidity freeze. The second scenario models a simultaneous 15 per cent decline in the fund’s primary market indices and a widening of bid-offer spreads to 200 per cent of their 12-month average. This scenario is designed to capture the correlation risk that the 2020 dollar-fund stress revealed — when liquidity dries up across asset classes simultaneously, diversification offers little protection.

Scenario 3: Sector-specific dislocation. The manager must identify the fund’s three largest sector or geographic exposures and stress each one individually. For a Hong Kong-focused equity fund, this means testing a 30 per cent decline in the Hang Seng Index with a simultaneous suspension of trading in the fund’s top five holdings. The SFC’s Thematic Review of Liquidity Risk Management (March 2024) found that 22 per cent of fund managers had not stress-tested sector-specific shocks at all.

Scenario 4: Manager-level operational failure. The final prescribed scenario tests the fund’s ability to process redemptions when the manager’s own dealing, settlement, or valuation systems are unavailable for three consecutive business days. This scenario was added after the SFC identified, in its 2023 Manager Oversight Report, that 15 per cent of authorised fund managers had no business continuity plan that specifically addressed redemption processing during a systems outage.

Reporting and Disclosure Obligations

The new liquidity risk management framework imposes three distinct reporting layers: internal board reporting, regulatory filing to the SFC, and investor-facing disclosure.

Internal board reporting. The manager’s board of directors (or equivalent governing body) must receive a liquidity risk report at each quarterly meeting. The report must include the fund’s current liquidity classification breakdown, the results of the most recent stress tests, and any breach of the 80/30 liquidity buffer that occurred during the quarter. The SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (Cap. 571, subsidiary legislation) paragraph 5.3 now explicitly requires that the board confirm in writing that the liquidity risk management framework is adequate and effectively implemented.

Regulatory filing to the SFC. The manager must submit a Liquidity Risk Management Return (Form LR-1) to the SFC within 15 business days of each calendar quarter-end. The form requires the manager to report the fund’s actual liquidity classification at quarter-end, the results of the four stress-test scenarios, and any instance where the fund gated or suspended redemptions during the quarter. The SFC’s Guidance Note on Form LR-1 (December 2024) specifies that the data must be reported at the individual fund level, not aggregated by manager.

Investor-facing disclosure. The offering document of each authorised fund must now include a liquidity risk disclosure section that states the fund’s target liquidity profile, the maximum expected redemption period under normal and stressed conditions, and a summary of the stress-testing methodology. The SFC requires this disclosure to be in plain language — the Consultation Conclusions explicitly rejected industry proposals to allow the disclosure to be satisfied by cross-referencing the UT Code requirements. The new disclosure obligation applies to all offering documents filed on or after 1 July 2025.

Practical Implementation Steps for Managers

The compliance timeline is fixed, but the SFC has indicated in its Frequently Asked Questions that it will take into account a manager’s good-faith efforts if the July 2025 deadline is missed by a narrow margin. The following steps are derived from the SFC’s published guidance and the new UT Code provisions.

Step 1: Audit the current portfolio against the new classification grid. The manager should run a one-time liquidity classification of every holding as at the fund’s most recent valuation date. Any position that falls into the “Less Liquid” category must be flagged for immediate review. The SFC’s Guidance Note recommends that managers complete this audit by 31 March 2025 at the latest.

Step 2: Build or upgrade the stress-testing model. The four prescribed scenarios require a model that can handle simultaneous shocks across asset classes and settlement systems. The manager must document the model’s assumptions, data sources, and calibration methodology. The SFC’s Thematic Review found that 40 per cent of managers were still using spreadsheet-based stress testing as of June 2024 — the new rules require a system that can produce results within five business days of any material portfolio change.

Step 3: Update the offering document and investor communications. The new liquidity risk disclosure must be drafted, reviewed by the fund’s legal counsel, and filed with the SFC as part of the post-authorisation filing process. The SFC has stated that it will reject filings that simply repeat the UT Code language without fund-specific disclosure.

Step 4: Train the dealing and operations teams. The redemption processing workflow must now include a liquidity check before any redemption is processed. If the redemption would cause the fund to breach the 80/30 buffer, the manager must escalate to the designated liquidity risk officer. The SFC’s Manager Oversight Report (2023) recorded that 18 per cent of redemption failures were caused by operational errors rather than market conditions.

Actionable Takeaways

1. Complete the portfolio liquidity audit by 31 March 2025 — the SFC will expect to see a documented classification methodology and a remediation plan for any positions that fall into the “Less Liquid” category.
2. Implement a quarterly stress-testing process covering all four prescribed scenarios, with results documented in a format that can be submitted as Form LR-1 within 15 business days of each quarter-end.
3. Update the fund’s offering document to include a fund-specific liquidity risk disclosure section in plain language, filed with the SFC before the 1 July 2025 deadline for existing funds.
4. Ensure the board of directors receives a quarterly liquidity risk report that includes the classification breakdown, stress-test results, and any buffer breaches, with a written confirmation of adequacy.
5. Train the dealing team to perform a liquidity check before processing any redemption that would bring the fund below the 80/30 buffer threshold, with escalation to the designated liquidity risk officer.

This does not constitute legal advice. Consult a solicitor for your specific case.