UCITS liquidity risk management - ESMA reports findings of its CSA

As we reported at the time, in January last year, ESMA and the EU’s National Competent Authorities (NCAs) launched a Common Supervisory Approach (CSA) into the supervision of how UCITS' managers (ManCos) perform liquidity risk management (LRM) across the EU.

What did the CSA cover?

The CSA, which was in two stages, assessed whether (and how far) UCITS ManCos comply with LRM obligations and what implications this had on possible supervisory risks and market practice.

The first stage of the CSA involved each NCA requesting the large majority of the UCITS ManCos in its jurisdiction to supply quantitative data in order to get an overview of the supervisory risks faced.

The second stage focussed on a sample of UCITS ManCos and UCITS and will entail more in-depth supervisory analyses.

What has ESMA found?

a) High level

On 24 March 2021, ESMA published a Public Statement (the Statement) which sets out its findings from the CSA.

Overall, most UCITS ManCos were able to demonstrate that they have implemented and applied sufficiently sound LRM processes, with NCAs identifying only a small number of cases where there were significant liquidity risks, which could jeopardise the UCITS's capacity to meet redemption requests or honour other liabilities.

For a "very limited number of UCITS", ESMA reports that liquidity profiles pointed to potential asset/liability mismatch risks and these were only sometimes mitigated by the use of liquidity management tools (LMTs).

The exercise also identified the need for improvements in certain key areas (see below). As a result, NCAs are following up with market participants to address the supervisory findings identified by the CSA.

b) Going into more detail - areas where improvement can be made

NCAs reported the following 11 areas where specific failings were found

1. Documentation of LRM arrangements, processes and techniques

   In some cases, there was a lack of clarity in key areas (eg, pre-investment liquidity analyses and forecasts, escalation processes and verification of data reliability) despite regulatory requirements for relevant activities to be documented

2. LRM procedures

   There were issues with the quality of the written LRM procedures - in some cases, procedures did not provide for the LRM arrangements, processes and techniques to be documented or failed to cover all asset types or the use of LMTs

3. Quality of LRM mechanisms and methodology

   In some instances, the methodology was not always appropriate, not forward-looking and, more frequently, not justified and back-tested. In some particularly worrying cases, margin calls were not considered at all.

4. Overreliance on liquidity presumption with regard to listed securities

   In some cases, the UCITS ManCo placed an overreliance on the presumption of liquidity referred to in Article 2(1) of the UCITS Eligible Assets Directive (EAD) where they invested in listed securities.

5. Application of liquidity presumption to financial instruments not admitted to or dealt in on a regulated market in violation of Article 2(1) of the EAD

   The findings revealed that "a few specific supervised entities" had applied the presumption of liquidity to all assets - including financial instruments not admitted to or dealt in on a regulated market under Article 50(1) of the UCITS Directive, where overall portfolio liquidity was deemed sufficient. In these cases, no liquidity analysis and forecasts were performed for investments subject to Article 50(2)(a) of the UCITS Directive, which allows for up to 10% investment in unlisted securities. The failure to perform pre-investment liquidity analyses and forecasts for these financial instruments is in breach of the UCITS framework

6. Delegation

   In some cases where the portfolio management function was delegated to an entity which effectively also performed the LRM functions, there was an insufficient involvement of the internal risk management function and insufficient delegation monitoring and due diligence. More to the point, ESMA's statement makes clear that the simultaneous delegation of portfolio and risk management functions to the delegate contravenes UCITS delegation and substance rules and 'should not be allowed'

7. Data reliability

   There were some examples of a widespread lack of data quality checks with overreliance on very few data providers, with UCITS ManCos not implementing robust and documented control processes with cross-checks and back-tests

8. Disclosures

   The Statement notes some cases of missing, inaccurate, or unclear disclosures on liquidity risks and LMTs to investors in the UCITS KIID and/or prospectus

9. Governance

   There as some evidence of insufficient - and, more rarely, an absence of - reporting to senior management. Questions were also raised about documentation of the decision-making process, especially in respect of the escalation process and the lack of formalisation of the criteria that trigger this

10. Internal control framework

    In some cases, NCAs identified a "strong need" to strengthen the overall control framework as both compliance and internal audit functions were not performing sufficient controls with respect to LRM processes

11. External controls

    External controls by the UCITS's ManCo, depositary and external auditors were not always performed. In respect of controls by external auditors, divergent national rules and practices regarding the scope of audit may be a factor.

What else?

More broadly, the COVID-19 crisis revealed cases where there had been a lack of reactivity or adaption of the LRM assessment, such as adapting risk analyses and forecasts or understanding of the limits of the models employed to the changed market conditions. NCAs intend to address these in their follow-up supervisory actions.

ESMA notes that the results of the CSA should be read in conjunction with its November 2020 Report 'Recommendation of the European Systemic Risk Board (ESRB) on liquidity risks in investment funds', in which it defined five priority areas for consideration:

1. Ongoing supervision of the alignment of the funds' investment strategy, liquidity profile and redemption policy;

2. Ongoing supervision of liquidity risk assessment;

3. Fund liquidity profiles;

4. Increase of the availability and use of liquidity management tools; and

5. Supervision of valuation processes in a context of valuation uncertainty.

Next steps

The Statement sets out what happens next

• Market participants should "critically review" their LRM frameworks to ensure that their frameworks (a) are free of any of the adverse supervisory findings above and (b) allow ongoing compliance with all relevant UCITS regulatory requirements, associated EU and national guidance.
• NCAs will undertake follow-up actions on individual cases to ensure that regulatory breaches and identified weaknesses are remedied. Some NCAs will also be looking to follow up with some UCITS ManCos, through on-site visits and/or desk-based reviews of the latest documents provided, in order to complete their supervisory analysis.
• ESMA will look to conduct further work to promote convergence in the way NCAs follow-up on the supervisory findings made during the CSA, including enforcement actions where appropriate.