Leverage – ESMA publishes Guidelines on Article 25 of AIFMD

On 23 June 2021, ESMA formally published Guidelines on how national competent authorities (NCAs) should use their powers under Article 25 of AIFMD to:

• assess the systemic risk of the use of leverage; and
• set limits on the amount of leverage an AIF can employ.

The Guidelines apply two months after their publication - ie, from 23 August 2021.

What does Article 25 of AIFMD say?

Article 24 of AIFMD requires AIFMs 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.)

Where an AIFM manages AIFs that employ leverage "on a substantial basis" (as defined in Article 111 of the AIFMD Level 2 Delegated Regulation), it must also report information about the overall level of leverage employed by each AIF.

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 can 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's the background to the Guidelines?

ESMA's proposals for the Guidelines were originally set out in a consultation paper (the CP), published on 27 March 2020. The aim was to impose greater consistency in how NCAs use their powers under Article 25 of AIFMD.

The CP followed a request made in 2018 by the European Systemic Risk Board (ESRB) for 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.

For our summary of the CP, see here.

ESMA's Final Report, containing its proposed Guidelines was published on 17 December 2020 - these have now been translated into the official languages of the EU and formally published on the ESMA website, starting the two month implementation clock.

What do the Guidelines say?

The Guidelines are based on the data reported under AIFMD, although ESMA has previously acknowledged that this information is far from perfect (highlighting what it describes as a "variety of reporting errors", such as formatting, using monetary values instead of percentages, etc).

The guidelines are intended to ensure that NCAs adopt a consistent approach when assessing whether the conditions for imposing leverage-related measures are met.

They set out a two-step risk assessment, which NCAs should perform quarterly:

Step 1 - Level, source and different usages of leverage

The purpose of the Step 1 assessment 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.

As such, NCAs should 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 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 median or average value of leverage of AIFs of the same type (for example: hedge funds or funds of funds); and
• the AIF's historical median or average leverage value.

Step 2 - Leverage-related systemic risk

NCAs should then evaluate the leverage-related potential risks to financial stability posed by AIFs 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 2 of the Guidelines to help NCAs arrive at a consistent risk assessment under Step 2 across jurisdictions.

NCAs should communicate the result of their risk assessments to ESMA at least annually and whenever they identify a risk which is relevant to financial stability. In addition, they should inform other EU NCAs where an AIFM's operations or arrangements in other EU jurisdictions "may pose risks relevant to financial stability and integrity of the financial system".

Leverage limits

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 AIF 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 AIFs 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 of AIFs.

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 aim to 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 AIFM; and
• how robust the leverage limits are in the face of gaming and arbitrage.