Strictly and consistently implemented liquidity management tools can help bolster the resilience of the non-bank financial sector and safeguard broader system-wide stability by preventing localised shocks from escalating into fire-sale spirals, according to analysis from the European Central Bank (ECB).

The report, prepared by Antoine Baena, Matthias Sydow and Garbrand Wiersema, highlighted that such measures are vital for managing systemic risk in the fund sector.

The analysis found that liquidity mismatches in open-ended funds present a significant risk to the financial system, particularly when redemption pressures coincide with illiquid market conditions.

The analysts noted that during episodes of financial stress, large outflows often force fund managers to sell assets rapidly at discounted prices, which can trigger destructive feedback loops.

These loops, where falling asset values lead investors to accelerate their redemptions to avoid further losses, can transmit localised stress throughout the broader financial system, the study warns.

To address these vulnerabilities, new European Union regulations under the UCITS VI and AIFMD II frameworks require investment funds to operationalise at least two liquidity management tools by April 16, 2026.

These tools are categorised into price-based and quantity-based measures designed to mitigate risks arising from liquidity mismatches.

Anti-dilution levies serve as a primary example of a price-based tool, where the costs associated with redeeming shares are transferred directly to the redeeming investors to prevent dilution of the fund’s total value.

In contrast, quantity-based tools, such as redemption gates, target pressure directly by limiting the total amount of capital that can be withdrawn over a specific period.

The European Central Bank analysis quantifies the potential impact of these measures using a system-wide agent-based model of the European financial system.

The study focuses on the first-round impact on asset valuations and the subsequent second-round liquidity dynamics during periods of extreme stress.

When all funds within the model applied a 2 per cent redemption gate, the research found that these measures significantly rebalanced redemptions across the sector.

By redistributing liquidity pressure from less resilient to more resilient funds, redemption gates effectively reduce the risk of localised shocks escalating into fire-sale spirals.

While the application of a 2 per cent gate is considered restrictive, the report explains that it mainly affects unusually severe outflows in the tail of the historical distribution.

The model suggests that total redemptions from the sector would fall by less than 5 basis points of total fund assets, meaning these tools are unlikely to create liquidity bottlenecks in other sectors like banking.

However, the authors noted that in practice, gates are calibrated by individual fund managers, which the study suggests may be suboptimal from a systemic perspective.

Anti-dilution levies also play a crucial role by offsetting losses for vulnerable funds, with the total gross amount transferred by these levies amounting to approximately 5 per cent of second-round redemptions.

These levies primarily transfer liquidity between funds, though the report finds that about 10 per cent of the total volume is paid by banks.

Both anti-dilution levies and redemption gates successfully prevent tail losses in the fund sector while maintaining a minimal impact on banks’ capital ratios.

The analysis concludes that strictly and consistently implemented liquidity management tools can help bolster the resilience of the non-bank financial sector.

These measures are instrumental in safeguarding broader system-wide stability by preventing the rapid liquidation of assets at prices below their fundamental value.

Nevertheless, the report cautions that these tools may inadvertently create new incentives for pre-emptive redemptions if investors act before gates are reached or levies are applied.

Additionally, the study points out that the activation of these tools might signal market distress, potentially triggering further outflows in other fund classes.

While these potential downsides remain, the analysts observe that the overall impact of liquidity management tools on systemic liquidity risk appears to be positive.

The findings highlight the importance of careful calibration to ensure that these tools remain effective during future financial crises.

Ultimately, the study confirms that these regulatory changes provide a necessary buffer against the risks of forced asset sales in the European market.