ESMA publishes Final Guidelines on Liquidity Stress Testing in UCITS and AIFs

On 02 September 2019, the European Securities and Markets Authority (ESMA) published its Final Report, “Guidelines on liquidity stress testing in UCITS and AIFs” (the Report).

The report sets out 16 guidelines which are addressed to fund managers, one to depositaries and one to national competent authorities (NCAs).

The Guidelines will apply from 30 September 2020.

This note looks at the application of the Guidelines to managers and depositaries, reviews the key aspects contained in the Guidelines and considers industry reaction to their development and publication.

Application of the Guidelines

In respect of funds, the Guidelines apply in respect of UCITS and AIFs, including ETFs (whether they operate as UCITS or AIFs) and leveraged closed ended AIFs.

In respect of managers, the Guidelines apply primarily in relation to Article 16(1) of the AIFMD, Article 51 of the UCITS Directive and Article 28 of the Money Market Funds (MMF) Regulation, together with the relevant Level 2 measures made under those provisions.

In respect of depositaries, the Guidelines apply primarily in relation to Article 21 of the AIFMD and Article 22(3) of the UCITS Directive, again along with the associated Level 2 measures.

Overview of the Guidelines

The aim of the Guidelines is to “increase the standard, consistency and, in some cases, frequency of liquidity stress testing (LST) already undertaken and promote convergent supervision of LST by NCAs”.

The Guidelines should be adapted to the nature, scale and complexity of the fund in question but are not intended to provide comprehensive guidance regarding liquidity management issues outside the scope of LST.

Looking at some of the key issues raised by the Guidelines, it should be noted that they require:

• a manager to have a strong understanding of the liquidity risks arising from the assets and liabilities on the fund’s balance sheet so the LST employed is appropriate for the fund it manages
• a manager to document LST in an LST policy within the UCITS’s Risk Management Process or the AIF's Risk Management Policy (RMP) – the Guidelines set out a series of matters which should be included in the policy
• LST to be properly integrated and embedded within a fund's risk management framework and subject to appropriate governance and oversight
• LST to be carried out at least annually, though the Guidelines recommend that it be done quarterly
• a manager of a fund which seeks authorisation from an NCA to be able to demonstrate that the fund can remain sufficiently liquid during normal and stressed conditions
• depositaries to have appropriate verification procedures to check that a manager has documented LST procedures in place.

The Guidelines in more detail

Looking at the guidelines that apply to managers or to depositaries, the following points should be noted:

A. Guidelines applicable to managers

1. The design of the LST models

In building its LST model, a manager should

• determine a number of factors specified in the Guidelines (including the risk factors that might impact the fund’s liquidity, the types of scenarios to use, their severity, and how the results of the LST are to be used by risk management, portfolio management and by senior management), and
• ensure that LST provides information that enables follow-up action.

2. Understanding liquidity risks

A manager should 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, in order to employ LST that is appropriate for the fund it manages”

The manager should also strike a balance by using LST that is focused, specific to the fund and highlights the key liquidity risk factors but, at the same time, uses a range of scenarios sufficiently wide to adequately represent the diversity of the fund’s risks.

3. Governance principles for LST

The manager should ensure that LST is properly integrated within the fund’s risk management framework and is subject to appropriate governance and oversight.

4. The LST policy

LST should be documented in an LST policy within the UCITS and AIF RMP, and this should require the manager to periodically review the LST and adapt, if necessary, it.

The Guidelines set out a list of minimum content requirements for an LST policy. These include:

• clear definition of the role of senior management in the process
• internal ownership and which management function(s) is/are responsible for its performance
• periodic review, documentation of the results and a procedure for amending the policy
• the circumstances requiring escalation
• the funds subject to LST
• the types and severity of stress test scenarios used and the reasons for selecting those scenarios, and
• the frequency at which LST is carried out (see Guideline 5 below) and the reasons for selecting that frequency.

5. Frequency of LST

The Guidelines state that LST should be carried out at least annually, at all stages of a fund’s lifecycle, but recommend quarterly (or more frequently), depending on the fund’s nature, scale and complexity and liquidity profile.

The reasons for determination of frequency used should be recorded in the LST policy. Flexibility is allowed for on this issue.

The Guidelines include a number of factors which ESMA considers might increase the frequency of regular LST. These include:

• higher unit dealing frequency
• a concentrated investor base
• complex investment strategy (eg extensive use of derivatives)
• a less liquid asset base

On the other hand, a highly liquid asset base and/or less frequent dealing in the fund’s units are noted as factors which might decrease regular LST frequency for a fund.

6. The use of LST outcomes

The Guidelines state that LST should provide outcomes which, among other things, help ensure the fund is sufficiently liquid, strengthen the manager’s ability to manage fund liquidity in the best interests of investors, and help identify the potential liquidity weaknesses of an investment strategy.

As a result, LST should assist a manager in its broader contingency planning (including preparing a fund for a crisis).

7. Adapting the LST to each fund

LST should be adapted appropriately to each fund in respect of:

• the frequency of LST
• the types and severity of scenarios to employ to create stressed conditions (these should always be sufficiently severe but plausible)
• the assumptions regarding investor behaviour and asset liquidation
• the complexity of the LST model (including the complexity of the fund’s investment strategy, portfolio composition and use of EPM techniques)

8. LST scenarios

The Guidelines indicate that LST should employ hypothetical and historical scenarios - as well as Reverse Stress Testing, where this is appropriate - while avoiding over-reliance on historical data, not least because “future stresses may differ from previous ones”.

9. Data availability

LST should show that the manager is able to overcome limitations arising out of the availability of data - this would include the manager avoiding optimistic assumptions, justifying reliance on third party LST models and exercising expert qualitative judgement.

10. Product development

During product development, a manager of a fund which requires authorisation from an NCA should:

• be able to demonstrate that key elements of the fund - including its strategy and dealing frequency - would enable it to remain sufficiently liquid during normal and stressed circumstances, and
• where appropriate, undertake LST on the asset, as well as the liability, side.

11. Stress testing fund assets to determine the effect on fund liquidity

LST should enable a manager to assess

• the time and/or cost to liquidate assets in a portfolio, and
• whether liquidation would be permissible taking into account (among other things) the fund’s objectives and investment policy and the manager’s obligation to manage the fund in the interests of investors.

12. Stress testing fund liabilities to determine the effect on fund liquidity

The Guidelines require that LST incorporate scenarios relating to the liabilities of the fund, including redemptions and other potential sources of liquidity arising from the liability side of the fund’s balance sheet.

Risk factors related to investor type and concentration according to the fund’s nature, scale and complexity should be incorporated into the LST - the Guidelines set out examples of investor behaviour which might be included in the LST model

13. LST on other types of liabilities

Where appropriate, a manager should include other types of liabilities in its LST in normal and stressed conditions. All relevant items on the liability side of the fund’s balance sheet, including items other than redemptions, should be subject to LST.

The Guidelines set out a number of factors which might affect liquidity risk in respect of the following types of liability:

• Derivatives
• Committed capital
• Securities Financing Transactions / Efficient Portfolio Management
• Interest/credit payments

14. Funds investing in less liquid assets

The LST should reflect risks arising from less liquid assets and liabilities risks. Managers should pay particular regard to the appropriateness of the frequency of LST for funds which invest in less liquid assets.

15. Combined asset and liability LST

The manager should separately stress test the assets and the liabilities of the fund balance sheet, then combine these results to determine the overall effect on fund liquidity. So doing can help assess which funds present the largest liquidity risk at a given moment, which can, in turn, have a material role in a manager’s contingency planning for a crisis, for example, planning for the impact of crystallised liquidity risk in one or more funds at firm-level.

16. Aggregating LST across funds

The Guidelines require a manager to aggregate LST across funds under its management where it assesses such an activity to be appropriate for those funds - this involves utilising the same liquidity stress test on more than one fund with similar strategies or exposures.

B. Guidelines applicable to depositaries

The Guidelines require a depositary to establish appropriate verification procedures to check that the manager of a fund has documented procedures in place for its LST programme. This, though, does not require the depositary to assess the adequacy of the LST. Nor does the depositary have to replicate or challenge the LST undertaken by a manager.

A depositary which is not satisfied that LST is in place should take action such as (depending on the national regime) informing the applicable NCA of the manager’s failure to comply with applicable rules (or requiring the manager to inform the NCA).

Industry reaction

Industry response to ESMA’s consultation paper (CP) of 05 February 2019, in which it set out its proposed LST guidelines, was not wholly favourable.

While "most" respondents agreed that LST is an important management tool for fund managers and all were in favour of a principles-based approach which allows flexibility, significant concerns were raised about a number of issues – in light of these, ESMA’s response has been to make little practical change to its proposals.

(a) Cost

Many respondents were worried that the costs would outweigh any benefit and warned that carrying out the liquidity stress tests would increase costs significantly. Some respondents noted the likely need to build additional operations in order to comply with ESMA’s proposals.

Others argued that the rules would mean “designing additional systems and accessing additional data points that are not necessarily easily obtainable”.

In response, ESMA noted that the fact that managers were already required to perform annual LST on in-scope funds would reduce the cost impact of its Guidelines, while it felt that “a consistent application of LSTs will enhance financial stability and investor protection in the asset management sector”, thereby justifying the implementation cost.

(b) Date of implementation

Although ESMA accepts that a 'significant majority' of respondents to its CP (which closed on 01 April 2019) suggested an implementation period ranging from 18 to 24 months, ESMA’s final report states that an application date of 30 September 2020 allows a 'sufficient' implementation period, bearing in mind the importance of ensuring convergence on how LSTs are performed by the asset management industry.

(c) Obtaining relevant and high-quality data

'Numerous concerns' were raised regarding the difficulty of obtaining relevant and high-quality data, with the UK’s Investment Association warning that “it is not yet clear whether data vendors are able to provide comprehensive and reliable asset liquidity data across the full range of assets invested in”.

In response, ESMA states, in its Final Report:

“ESMA is aware of the challenges regarding availability of data, which was already reflected in Guideline 9 in the CP. The wording of Guideline 9 has been retained in the final Guidelines” (see Guidelines 9, "Data availability" above).

(d) The exclusion of MMFs

Respondents were almost unanimously of the view that MMFs should be excluded from the Guidelines, not least since the MMF Regulation already includes more stringent provisions around liquidity. There was, therefore, little rationale in applying two sets of rules to MMFs, which could create the risk of conflicting regulation and operational issues for firms.

Taking this feedback partly into account, ESMA has decided to narrow the scope of applicable provisions to MMFs, focusing on those parts of the Guidelines not already covered in the rules under the MMF Regulation. ESMA has also kept the provision that in case of conflict, the MMF Regulation rules apply.

Next steps

The Guidelines will now be translated into the official languages of the EU and will then be formally published on the ESMA website.

On publication, NCAs will have two-months in which to notify ESMA whether they (a) already comply with the Guidelines, (b) do not yet comply with them but intend to do so or (c) do not intend to comply.

The Guidelines will apply from 30 September 2020.