In response to recommendations which were issued by the European Systemic Risk Board (the "ESRB") in April 2018 to address liquidity and leverage risk in investment funds, ESMA has launched a public consultation on its draft guidelines pursuant to Article 25 of the Alternative Investment Fund Managers Directive ("AIFMD") (the "CP"). The aim of the guidelines is to harmonise approaches to leverage within alternative investment funds ("AIFs") across the EU by imposing greater consistency on how national competent authorities ("NCAs") (a) assess the systemic risk of the use of leverage; and (b) set limits on the amount of leverage an AIF can employ. Accordingly, the outcome of the consultation could have a significant impact on alternative investment fund managers ("AIFMs") and will be of interest to the board of directors of AIFMs and AIFs, with the CP suggesting NCAs could impose leverage limits on certain categories of AIFs that pose a risk to financial stability.
Background to the CP
The ESRB requested that ESMA provide guidance on Article 25 of AIFMD. This provision (Article 25(1)) states that EU member states shall "ensure that the competent authorities of the home member state of the AIFM use the information to be gathered under Article 24 for the purposes of identifying the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system, risks of disorderly markets or risks to the long-term growth of the economy".
As set out in Article 6 of Commission Delegated Regulation 231/2013 (the "AIFMD Level 2 Regulation"), the leverage of an AIF must be expressed as the ratio between the exposure of the AIF and its net asset value. The exposure of the AIF must be calculated using two different methods – the gross method and the commitment method – as set out in detail in the AIFMD Level 2 Regulation (Articles 7 and 8). An AIFM must demonstrate that the leverage limits it sets for each AIF it manages are reasonable and that it complies with these at all times. In specified circumstances, an NCA has the power to restrict the level of leverage that an AIFM can employ in order to limit the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks of disorderly markets. Although AIFMs are able to set leverage limits based upon what they deem to be reasonable, NCAs have typically stopped short of imposing limits since AIFMD was introduced.
Currently, AIFs can employ both financial leverage, which includes securities financing transactions and borrowing, and synthetic leverage through the use of derivatives. Unlike financial leverage, synthetic leverage cannot be observed from balance sheets as derivatives are accounted for at market value – thus making it difficult for NCAs to assess systemic risk within financial markets. The information on both types of leverage is included in the mandatory reporting for each leveraged fund under Article 24 of AIFMD.
An AIFM which manages AIFs that employ leverage "on a substantial basis" must also report information about the overall level of leverage employed by each AIF. The phrase "on a substantial basis" is defined in Article 111 of the AIFMD Level 2 Regulation to mean an AIF with a leverage ratio calculated in accordance with the commitment method which exceeds three times its net asset value.
The assessment proposed under the guidelines in the CP is based on the data reported under AIFMD, ESMA suggests that, when assessing leverage-related risks, NCAs should rely on the indicators available and relevant in their jurisdictions, using both leverage measures set out in the AIFMD Level 2 Regulation.
Risks Associated with Leverage
In relation to assessing the risks associated with leverage, ESMA notes in the CP:
"Given the rapid expansion of the investment fund sector and the higher risk-taking, in a context of low interest rates, it is of utmost importance to implement a framework for NCAs to monitor the level of leverage and deleveraging process of highly leveraged alternative investment funds,"
The CP notes that:
- deleveraging can amplify systemic risks during a financial crisis, especially where a fund has short redemption periods;
- during a financial crisis, spill-over effects resulting from the fund deleveraging (such as amplification of the price impact of adverse market movements on the fund's assets or fire sales) can be further amplified by leverage since, with the same value of outflows, leveraged funds are likely to liquidate a greater amount of assets; and
- leverage can amplify the impact of negative market movements during stressed times given the need to obtain more liquidity to cover margin calls and higher haircuts on leveraged positions. This increases the fund's liquidity risk.
Proposals - The draft guidelines
There are two main sections of the draft guidelines – 1) guidelines on the assessment of leverage-related systemic risk; and 2) guidelines on leverage limits which are based on the two separate parts of an ESRB recommendation to ESMA.
1. Assessment of leverage-related systemic risk
In order to ensure that NCAs take a consistent approach in the assessment of leverage-related systemic risk, when assessing whether the conditions for imposing leverage-related measures are met the draft guidelines include:
- a common minimum set of indicators to be taken into account by NCAs during their assessment;
- the instructions to calculate such indicators based on the reporting data under Article 24 of the AIFMD; and
- qualitative and quantitative descriptions of the interpretation of the indicators.
The guidelines set out a two-step risk assessment, which NCAs should perform quarterly, following the receipt of Article 24 data from AIFMs.
Step 1 - Level, source and different usages of leverage
The assessment under Step 1 is to determine which AIFs pose risks to financial stability and to select those for which it is deemed appropriate to set a leverage limit. Accordingly, NCAs would have to identify:
- AIFs which employ leverage on a substantial basis;
- AIFs which employ leverage (though not on a substantial basis) and have assets under management ("AuM") of €500m or more; and
- other AIFs whose "unusually high use of leverage" (as measured using the indicators set out in Table 1 of the draft guidelines) may pose risks to financial stability.
In this context, an "unusually high use of leverage" is one that differs significantly from that of other AIFs when compared with:
- the average value of leverage of AIFs of the same type (for example: hedge funds or funds of funds); and
- the AIF's historical average leverage value.
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