Liquidity Stress Tests – ESMA’s Guidance for Investment Funds

What is the objective of the Guidelines?

The Guidelines set out a minimum set of standards that apply to EU fund managers when conducting LST in funds and provide guidance on how fund managers can improve their LST procedures, including by determining the appropriate use of haircuts, frequency and scenario design, and the use of historical data.

Why has ESMA adopted the Guidelines?

The Guidelines follow on from recommendations published by the European Systemic Risk Board (“ESRB”) in April 2018, on actions to address systemic risks related to liquidity mismatches and the use of leverage in investment funds. Amongst other measures, the ESRB recommended that ESMA develop guidance on how asset managers carry out liquidity stress tests.

ESMA published a consultation paper on the draft Guidelines on liquidity stress testing for UCITS and AIFs on 5 February 2019.

By way of background, the asset management industry has experienced significant growth over the last decade and regulators are increasingly concerned that distress in the funds sector could amplify risks for issuers, investors, banks and ultimately financial stability.

What is the scope of the Guidance?

The Guidelines apply to fund managers, depositaries and national competent authorities (“NCAs”) and relate to liquidity testing in UCITS and alternative investment funds (“AIFs”), including money market funds to the extent that the relevant requirements are not already covered in the MMF Regulation.

The application of the Guidelines is subject to the proportionality principle, meaning that fund managers should adapt the Guidelines to the nature, scale and complexity of the relevant fund.

What obligations do the Guidelines impose on Fund Managers?

The Guidelines impose a number of requirements on fund managers, including the requirement to:

• determine specified issues when building LST models;
• have a strong understanding of the liquidity risks arising from the assets and liabilities of the fund’s balance sheet, and its overall liquidity profile;
• ensure that LST is properly integrated and embedded in the fund’s risk management framework supporting liquidity management and that it is subject to appropriate governance and oversight;
• document LST in an LST policy within the UCITS and AIF risk management process;
• carry out LST at least annually, and where appropriate, to employ LST at all stages in the fund’s cycle – the Guidance recommends LST quarterly or more frequently;
• ensure that LST provides outcomes that meet specified requirements;
• combine the results of LST appropriately to determine the overall effect on fund liquidity, after separately testing the assets and the liabilities of the fund balance sheet; and
• aggregate LST across funds under its management where it assesses such an activity to be appropriate for those funds.

A fund manager must also ensure that LST:

• is adapted to each fund;
• employs hypothetical and historical scenarios and, where appropriate Reverse Stress Testing. LST must not overly rely on historical data;
• demonstrates that the manager is able to overcome limitations related to the availability of data;
• enables the manager to assess not only the time and/or cost to liquidate assets in the portfolio, but also whether such activity would be permissible taking into account specified factors;
• incorporates scenarios relating to the fund’s liabilities, including both redemptions and other potential sources of risk to liquidity emanating from the liability side of the fund balance sheet;
• incorporates risk factors related to investor type and concentration according to the nature, scale and complexity of the fund;
• includes other types of liabilities in normal and stressed conditions, where appropriate. All relevant items on the liability side of the fund’s balance sheet, including items other than redemptions should be subject to the LST; and
• reflects risks arising from less liquid assets and liabilities.

Is LST relevant for product development?

Yes, according to the Guidelines, a manager of a fund that requires authorisation from an NCA should:

• be able to demonstrate to the NCA that key elements of the fund, including its strategy and dealing frequency enable it to remain sufficiently liquid during normal and stressed circumstances; and
• where appropriate, undertake LST on the asset side (using a model portfolio) as well as on the liability side, incorporating the expected investor profile both from the early and late stages of the fund’s development.

What obligations do the Guidelines impose on Depositaries?

The Guidelines require depositaries to set up appropriate verification procedures to check that the fund manager has in place documented procedures for its LST programme. The depositary is not required to assess the LST’s adequacy or to replicate or challenge the LST undertaken by the fund manager.

What do the Guidelines say about interactions with national competent authorities (NCAs)?

According to the Guidelines, managers should notify NCAs of material risks and actions taken to address them. Moreover, NCAs may, at their discretion request:

• submission of a manager’s LST to help demonstrate that a fund will be likely to comply with applicable rules, including regarding the ability of the fund to meet redemption requests in normal and stressed conditions;
• managers to notify them of other information relating to the LST, including liquidity stress models and their results.

What next?

According to some estimates, referenced by ESMA in its earlier consultation paper, 93% of managers already undertake LST and these managers will need to review their existing policies and procedures to ensure that they comply with the Guidelines. The remaining 7% face a more extensive task and will need to implement their LST policies and procedures in a way that complies with the Guidelines, by September 2020.