In an industry letter issued 7 August 2019, the Central Bank highlighted the importance of liquidity risk management and liquidity stress testing in investment funds and at EU level, ESMA has published its final guidelines on liquidity stress testing ("Guidelines") in UCITS and AIFs.
The Guidelines apply to fund managers and provide guidance on how they should carry out liquidity stress tests on the individual funds that they manage and how depositaries should fulfil their obligations regarding these stress tests. The Guidelines, are supplementary to the requirements on liquidity stress testing ("LST") in the AIFM and UCITS Directives and may be applied proportionately, having regard to the nature, scale and complexity of each fund. The Guidelines apply to all UCITS and AIFs, with ESMA clarifying that this includes those funds established as money market funds, ETFs, and leveraged closed-ended AIFs1 .
The Guidelines require fund managers to stress test the assets and liabilities of the funds they manage, which includes redemption requests by investors. Managers should be aware of the liquidity risk of the funds they manage and use stress testing as a tool to mitigate this risk. Under the Guidelines, fund managers must:
- integrate LST into a fund's risk management framework and LST should be subject to appropriate governance and oversight;
- have a strong understanding of liquidity risks and a fund's overall liquidity profile;
- develop LST models, ensuring that the LST provides information enabling follow-up action;
- adapt the LST to each fund;
- include an LST policy in the UCITS and/or AIF risk management process. This policy should be kept under review and the LST adapted as appropriate. This policy should include at a minimum:
- a statement of ownership of the policy and the management function responsible for its performance;
- a clear definition of the role of senior management in the LST process;
- the interaction of the LST policy with other liquidity risk management procedures, including the fund manager's contingency plans and the portfolio management function;
- a requirement for regular internal reporting of LST results specifying the frequency and recipients of the report;
- provision for periodic review, documentation of the results and a procedure for amending the policy where required by the review;
- the funds subject to LST;
- initial validation of the LST models and assumptions underpinning them, which should be performed independently from portfolio management (though not necessarily by an entity/person external to the manager);
- the types and severity of stress test scenarios used and the reasons for selecting those scenarios;
- the assumptions used relating to data availability for the scenarios, their rationale and how frequently they are revisited; and
- the methods for liquidating assets, including the limitations and assumptions used.
- carry out LST at least annually,
although ESMA recommends that it is conducted quarterly, unless a
higher or lower frequency is justified by the characteristics of
the fund. This explanation should be noted in the LST policy.
Ad-hoc LST should be undertaken as soon as practicable if a
material risk to fund liquidity is identified by the manager and
requires being addressed in a timely manner. ESMA has included
examples of factors that fund managers should take into account in
deciding on the appropriate LST frequency to apply. These include:
- the liquidity of the fund and any change in the liquidity of the assets;
- whether the fund is open-ended or closed-ended; and
- the redemption policy and use of liquidity management tools.
- notify national regulators of material risks and the actions taken to address them; and
- during product development be able to demonstrate to their regulator that the fund will remain sufficiently liquid during normal and stressed circumstances.
The Guidelines also require depositaries to verify that a fund has documented procedures for its LST programme, which could include reviewing the UCITS and/or AIF risk management process to confirm that the manager carries out LST on the fund. However, a depositary does not need to replicate or challenge the LST performed by a manager.
Further, regulators may request submission of the fund manager's LST in order to demonstrate that the fund is likely to comply with applicable rules, including those regarding the fund's ability to meet redemption requests in normal and stressed conditions. Regulators will also have the discretion to request information from fund managers regarding their LST models and the results of their stress tests. Therefore, fund managers should now be reviewing their overall liquidity management processes and preparing to comply with the Guidelines in advance of their application on 30 September 2020.
Additionally, ESMA has developed a stress simulation framework for the investment funds sector. ESMA will use this stress simulation framework as part of its regular risk monitoring to identify risk and assess possible adverse scenarios that might impact the EU fund industry. Regulators can use this methodology to simulate stress situations for different segments of the funds industry.
Commenting on the framework, ESMA Chair, Steven Maijoor stated that:
"The stress simulation framework is a key element of ESMA's stress testing strategy, which also includes guidelines on liquidity stress testing and on money market fund stress testing. The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU financial system.
This framework will be an important tool for supervisors to assess risks in the asset management industry, as the methodology developed by ESMA can be applied across the industry's different sectors."
1 In the case of money market funds, the scope is limited to those aspects of the Guidelines that are not already covered by the Money Market Funds Regulation (namely; the design of LST models, the LST policy, governance principles for LST, understanding liquidity risk and the depositary requirement). For ETFs, the Guidelines apply in addition to ESMA's Guidelines on ETFs and other UCITS Issues. However, in the case of ETFs LST should be adapted to take into account the specificities of ETFs such as the role of authorised participants, redemption models and replication models.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.