ESMA consults on leverage guidelines under AIFMD

On 27 March 2020, ESMA published a consultation paper, setting out draft guidelines for national competent authorities (NCAs) aimed at imposing greater consistency in how they use their powers under Article 25 of AIFMD.

Why is ESMA consulting and who does it affect?

In 2018, the European Systemic Risk Board (ESRB) requested ESMA to provide guidance on

• the framework for assessing how far the use of leverage in the AIF sector contributes to the build-up of systemic risk in the financial system; and
• the design, calibration and implementation of macroprudential leverage limits.

ESMA has set out its draft guidelines in Annex II to the CP and is seeking industry’s feedback.

The aim of the guidelines is to impose greater consistency on how 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 AIFMs.

The consultation period closes on 1 September 2020. This is longer than usual because of the COVID-19 pandemic.

ESMA will then consider the responses it receives before finalising the guidelines for publication.

ESMA notes, though, that its draft guidelines are “without prejudice to any further regulatory updates coming from the IOSCO work on leverage, the AIFMD review and any further calibration of the indicators that may be deemed appropriate in the future”.

What’s the background to the consultation?

Under Article 24 of AIFMD, AIFMs have to report information to their home NCA for each EU AIF they manage and for each AIF they market in the EU. (Non-EU AIFMs marketing an AIF in the EU under Article 42 of AIFMD must submit their reports to the NCA of the Member States in which the AIF is marketed.)

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 Delegated Regulation.)

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.

Article 25 of AIFMD then requires NCAs to use the information reported under Article 24 to identify how far the use of leverage contributes to:

• the build-up of systemic risk in the financial system;
• the risk of disorderly markets; or
• risks to the long-term growth of the economy.

What issues does ESMA flag?

In light of what it describes in the CP as “higher risk-taking” in the investment fund sector in a time of low interest rates, ESMA considers it to be “of utmost importance” to establish and implement a framework whereby NCAs can monitor the level of both leverage and deleveraging of highly leveraged AIFs.

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.

The draft guidelines

The guidelines proposed in the CP are based on the data reported under AIFMD, although ESMA acknowledges that this information is far from perfect, given what it has separately described as a “variety of reporting errors”, such as formatting, using monetary values instead of percentages, etc.

As a result, 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 Delegated Regulation, ie:

• the gross method (Article 7 of the Delegated Regulation); and
• the commitment method (Article 8 of the Delegated Regulation).

The guidelines follow two specific recommendations from the ESRB, which deal, respectively with (a) the assessment of leverage-related systemic risk and (b) leverage limits. Taking these in turn:

Assessment of leverage-related systemic risk (ESRB Recommendation E(1))

Through its proposed guidelines, ESMA is seeking to ensure that NCAs adopt a consistent approach when assessing whether the conditions for imposing leverage-related measures are met.

As such, the draft guidelines include:

• a set of common minimum indicators which an NCA should take into account in its assessment;
• instructions to calculate these indicators based on the reporting data under Article 24 of AIFMD; and
• qualitative and quantitative descriptions of how to interpret the indicators.

They 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 funds 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 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 funds 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.

Step 2 - Leverage-related systemic risk

NCAs should then evaluate the potential risks to financial stability posed by those AIFs which they have identified under Step 1.

These risks must include at least:

• the risk of market impact;
• the risk of fire sales;
• List item;
• the risk of direct spill over to financial institutions; and
• the risk of interruption in direct credit intermediation.

When assessing each of these, the NCA must apply various risk indicators (which can be found in Table 2 of the draft guidelines) as well as any other risk indicator it considers relevant.

A number of case studies are included in Annex 1 to help NCAs arrive at a consistent risk assessment under Step 2 across jurisdictions.

NCAs would communicate the result of their risk assessments to ESMA at least annually and whenever they identify a risk which is relevant to financial stability.

Leverage limits (ESRB Recommendation E(2))

When deciding whether leverage limits should be imposed on an AIF, which poses a risk to financial stability, an NCA should consider:

• the risks posed by the fund according to its type (hedge fund, etc) and risk profile, as defined by the two step risk assessment described above; and
• risks posed by common exposures – so, where a group of funds of the same type and similar risk profiles collectively pose leverage-related systemic risks, the NCA should apply leverage limits in a similar or identical manner to all funds in that group.

The phasing in and phasing out of any limits should be carefully implemented:

• continuous leverage limits placed on an AIF (or group of AIFs) deemed to pose a threat to financial stability should be maintained for as long as the risk posed does not decrease;
• temporary leverage limits introduced to restrict the build-up of risk, including any procyclical behaviour from an AIF, should be disapplied when the change in market conditions or fund behaviour stops being procyclical; and
• leverage limits should be implemented progressively to avoid procyclicality, especially where not doing so could trigger the risk the limits were supposed to mitigate.

In setting the level of any leverage limit, NCAs should take into account:

• when risks are directly related to size, the imposition of leverage limits should reduce the risks accordingly;
• when risks are partially size-related, but the imposition of limits may not reduce risks proportionately because AIFs can adjust their strategy to maintain the same level of risk, the NCA should consider imposing other restrictions on the management of the AIF, such as restrictions on the investment policy, redemption policy or risk policy; and
• when imposing limits may result in the risks temporarily increasing, other restrictions should be imposed on the management of the AIF, at least until the phasing in period ends. This could include setting a limit on the proportion of certain assets based on their contribution to the risk profile of the AIF.

NCAs should evaluate how efficient a leverage limit is in mitigating excessive leverage by taking into consideration:

• how proportionate the leverage limit is compared to the systemic risk posed by the use of leverage by the AIF; and
• how robust the leverage limits are in the face of arbitrage – for example, where an AIF managed by a non-EU AIFM poses leverage-related systemic risks but the NCA cannot impose leverage limits, it should look to impose other (unspecified) restrictions related to the management of the AIF. In any event, it remains unclear how effective an EU NCA might be in attempting to enforce such alternative restrictions against a non-EU AIFM.