On 27th March 2020, the European Securities and Markets Authority (ESMA) launched a consultation on its draft guidance to address leverage risks in the Alternative Investment Fund (AIF) sector. The consultation is part of the ESMA response to the recommendations of the European Systemic Risk Board (ESRB) in April 2018 to address liquidity and leverage risk in investment funds.

ESMA’s draft guidelines aim to promote supervisory convergence in the way National Competent Authorities (NCAs) assess how the use of leverage within the AIF sector contributes to the build-up of systemic risk in the financial system, as well as how they design, calibrate and implement leverage limits.

In April 2018, the European Systemic Risk Board (ESRB) published a set of recommendations to address liquidity and leverage risk in investment funds.

The ESRB ‘Recommendation E’, requested that ESMA provide guidance on Article 25 of Directive 2011/61/EU and, in turn, the ESRB recommended ESMA:

  • give guidance on the framework to assess the extent to which the use of leverage within the AIF sector contributes to the build-up of systemic risk in the financial system (ESRB Recommendation E: Assessment of leverage-related systemic risk); and
  • give guidance on the design, calibration and implementation of macroprudential leverage limits (ESRB Recommendation E: Macroprudential leverage limits).

Article 25(1) of the AIFMD provides that Member States shall “ensure that the competent authorities of the home Member State of the AIFM use the information to be gathered under Article 24 for the purposes of identifying the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system, risks of disorderly markets or risks to the long-term growth of the economy”.

Leverage limits should be based on the leverage measures set out in Directive 2011/61/EU: the gross method as set out in Article 7 of the Delegated Regulation 231/2013 and the commitment method as set out in Article 8.

The guidelines provide that NCAs should impose leverage limits on AIFs posing risks to financial stability. When deciding to impose leverage limits NCAs should consider:

  1. a) risks posed by funds according to their type (hedge funds, private equity, real estate, fund of funds or any other relevant type) and risk profile, as defined by the risk assessment performed in accordance with paragraph 12;
  2. b) risks posed by common exposures. Where the NCA determines that a group of funds of the same type and similar risk profiles may collectively pose leverage-related systemic risks, the NCA should apply leverage limits in a similar or identical manner to all funds in that group.

Furthermore, the guidelines provide that NCA’s should carefully implement leverage limits, both in terms of timing and phasing in and out:

  1. a) where an NCA imposes continuous leverage limits to an AIF or a group of AIFs posing a threat to financial stability, the limits should be maintained for as long as the risks posed by the AIF or the group of AIFs do not decrease;
  2. b) when an NCA imposes temporary leverage limits to limit the build-up of risk, including any procyclical behaviour from an AIF or a group of AIFs, such as when funds contribute to excessive credit growth or the formation of excessive asset prices, the limits should be released when the change in market conditions or fund behaviour stop being procyclical;
  3. c) competent authorities should implement of leverage limits progressively (“the phased-in period”) to avoid procyclicality, especially if imposing limits in a procyclical way could trigger the risk they were supposed to mitigate; and
  4. d) competent authorities should take into account the possibility to apply cyclical limits in order to dampen the build-up and materialisation of risks in the upswing and downswing phases of the financial cycle.

The guidelines also provide for how NCA’s should set the appropriate level of leverage limit. In doing so, NCAs should take into account their effectiveness in addressing the risk of market impact, fire sales, spill-overs to financial counterparties, and disruptions of credit intermediation.

ESMA is seeking stakeholders’ feedback on the proposed principles to set leverage limits under Article 25 of Directive 2011/61/EU. It will consider the feedback it receives to this consultation by 1 September 2020 with a view to finalising the guidelines for publication.