During times of crisis, investors become particularly risk-averse. In March, during the height of the pandemic, investors were quick to pull their money out of investment funds worldwide, with the S&P falling by around 34%, according to Bloomberg. Additionally, mutual funds faced a liquidity crisis as they received redemption requests and were unable to sell some of their investments in the debt market due to poor liquidity.
However, before COVID-19, the European Securities and Markets Authority (ESMA) initiated the writing and research of a new regulation aimed at fostering financial stability by mitigating liquidity risk and promoting supervisory convergence across EU-domiciled funds and fund managers by setting a minimum standard for liquidity stress testing (LST). While this new liquidity stress testing regulation was formulated before the crisis, the recent market disruptions have further highlighted its importance.
The new regulation is due to come into force on September 30th, 2020. Hannes Helenius – Chairman of the Board, FA Solutions explains what you need to know before it kicks in.
What is liquidity stress testing?
ESMA defines liquidity stress testing as a risk management tool within the overall liquidity risk management framework of a manager, which simulates a range of normal and stress conditions to assess the potential impact on the funding assets, overall liquidity of a fund, and the necessary follow-up actions.
The goal of liquidity stress testing is to analyze if a fund has enough funding sources to withstand unexpected market disruptions and make sure they have enough liquid assets to meet a surge in redemption requests.
What is the new regulation?
ESMA will require fund managers to stress test the assets and liabilities of the funds they manage from September 30th, 2020, according to its final guidance for liquidity stress tests of investment funds. The new guidelines will apply to Alternative Investment Funds (AIFs) and UCITS (Undertakings for the Collective Investment in Transferable Securities) funds as well as Exchange-Traded Funds (ETF) since they are traditionally run following UCITS regulations. However, policymakers are now asking tough questions about the daily liquidity of all fund types.
The new legal framework sets a minimum standard for LST to improve fund managers’ operational capacity and sharpen up contingency planning in case of a liquidity crisis. It focuses on four key points:
- Ensuring funds have sufficient liquidity levels
- Allowing asset managers to manage this liquidity in the best interest of the investors
- Identifying potential liquidity weaknesses of current investment strategies
- Monitoring risk on an ongoing basis for informed decision-making in crisis situations
On an EU level, ESMA is prioritizing the supervision of UCITS (particularly in the UK) and real estate funds, which ESMA found to be the most vulnerable to liquidity risks in their 2019 report.
What does this mean?
EU fund companies need to consider what will happen to their assets and liabilities in case of redemptions and ‘fire sales’ – the liquidation of a firm’s assets at extremely discounted prices. They need to think about what resources and time it might take them to liquidate all of their assets.
Fund managers should also act in the best interest of investors in case of significant restrictions to redemptions. For example, they should avoid taking on excessive risk in order to meet and surpass performance expectations while still marketing the fund as a safe investment. On an operational level, funds need to make sure their technology stack is capable of reporting under the new regulations and performing the required liquidity controls.
Here’s a quick overview of the standout points from the guidelines:
- LST should be executed at least annually, but ESMA recommends more frequent testing. Specific factors, such as dealing frequency, for example, increase or decrease the recommended frequency of testing.
- LST should take into account both historical and hypothetical scenarios.
- LST should enable managers to assess not only the time and/or cost to liquidate assets in a portfolio, but also whether such an activity would be permissible.
- LST should demonstrate that managers are able to overcome limitations related to the availability of data.
- LST should incorporate risk factors related to investor type and concentration according to the nature, scale, and complexity of the fund.
How have ESMA and other authorities reacted to the coronavirus situation?
ESMA has acknowledged that the COVID-19 outbreak brings significant challenges for fund managers, and may substantially impair their ability to publish the annual market or fund reports on time. They urge supervisors to give extra time for reporting obligations and not prioritize supervisory measures on fund managers. The European Banking Authority (EBA) has urged national authorities to provide one month’s flexibility for reporting due dates.
The EBA recommends that national authorities help to alleviate the burden on market participants by providing information on the risks of money laundering and terrorist financing posed by the coronavirus situation, setting precise operational requirements for market participants to prevent the risk of money laundering and using control measures flexibly. They also recommend that companies refrain from profit distribution at this time.
Time to get ready
With not long until September 30th, firms have an ambitious task to get ready for the new regulation. Here are three starting questions every company and fund manager should be asking in preparation:
- Do we have an LST procedure in place?
- Do we have quality security data and reports for the purpose of LST?
- Can we test the risk scenarios from an investor’s behavior perspective?
Compliance with new ESMA regulations will push fund companies towards taking charge of their data.