EUROPE: ESMA focused on Fund Liquidity Management – Steven Maijoor Keynote Address

Friday November 22 2019

On 22^nd November 2019, at the EFAMA Investment Management Forum, Steven Maijoor delivered his keynote address focusing on fund liquidity, in particular he discussed:

• Fund liquidity issues,
• ESMA’s activities in relation to fund liquidity, and
• Main requirements regarding liquidity risk under the UCITS framework.

Liquidity is a long-time concern in asset management

Liquidity risk is obviously not a new issue in asset management. From a regulatory perspective, both the UCITS Directive and AIFMD have various requirements in relation to liquidity management which are designed to mitigate this risk. UCITS especially can only invest in a range of assets that are deemed liquid, subject to limitations and rules. With respect to the AIFMD, there are requirements on the fund manager to put in place liquidity management processes and stress tests, especially if they manage open-ended or leveraged funds.

In 2017, the FSB identified the potential mismatch in open-ended funds between the liquidity of fund investments and daily redemption of fund units as a key structural vulnerability, and tasked IOSCO to deliver recommendations, which were published in 2018. Similarly, at EU level the ESRB published a Recommendation on action to address systemic risks related to liquidity mismatches and the use of leverage in investment funds.

There are concerns that the alleged search-for-yield behaviour, coupled with ample market liquidity, leads to mispriced risk and overvaluation of some asset classes. Eventually significant sales by asset managers could depress asset valuations, thereby transmitting stress to other institutions which may in turn be forced to sell assets. Cascading effects from fire sales can ultimately amplify deterioration of market confidence and deepen a crisis.

Challenges posed by the low-yield environment

The lasting low-yield environment has created unprecedented challenges for asset managers. Their business model allows for some flexibility as an asset management company can propose products ranging from equity to bond funds, and active to passive management. But it also creates incentives to take more risks, eventually exposing investors and other market participants. ESMA has observed shifts towards riskier and less liquid assets:

• Since 2013, EU investment funds increased their holdings of corporate bonds rated BBB from 31% to 35% and, for some of them, reduced their cash holdings. While liquid under current market conditions, BBB bonds are susceptible to become less liquid as risk perceptions and underlying credit conditions change.
• There is a rotation from equity to bond funds, and from equity ETFs to bond ETFs, the latter growing by 55% over the last 2 years. ESMA has also seen evidence of funds, including ETFs, investing in less liquid markets such as commodity, gold or high yield. Eventually, this may lead to unrealistic expectations of liquidity, if the perceived liquidity of these funds does not reflect the liquidity of their underlying.

The issue of fund liquidity is at the core of ESMA’s activities

ESMA is particularly focussed on fund liquidity developments. The first priority is to further improve the markets understanding of risks. In that respect data collection such as AIFMD data plays a key role. ESMA published the first AIFMD statistical report in 2019.

The 2019 report highlighted that real estate funds were the most exposed to liquidity risk. They have the largest liquidity mismatch among AIF types: within one week investors can redeem up to 20% of Net Asset Value (NAV) while real estate funds can only quickly liquidate 8% of their assets. Other categories of AIFs do not seem to have significant liquidity mismatches. Indeed, hedge funds may be exposed to financing risk, as one third of their financing is overnight, but they tend to maintain large cash buffers, which mitigate the risk. Private equity funds invest mainly in illiquid securities but funds are overwhelmingly closed-ended.

The AIFMD data allows ESMA to also assess more specific issues. For example, in their cent trends, risks and vulnerabilities report they assessed the risks posed by CLOs as the exposure of European AIFMs increased by 15% during 2018 to reach EUR 109bn. Although risks appear to be limited at this stage, these exposures require active monitoring in a context of deterioration of underwriting standards and lower credit quality of the underlying.

The combination of different data sources will help understanding the channels through which liquidity risks can materialise. This is especially the case for EMIR data. For example, ESMA analysed the use of derivatives such as CDS by UCITS: it showed that the use of CDS was mainly concentrated in large funds following fixed-income or alternative strategies. A key liquidity concern for regulators pertain to the capability of such funds to meet margin calls, for example following a rapid change in the value of the derivatives they hold.

Stress Testing

Going forward, liquidity risk is at the core of ESMA’s stress test strategy, which encompasses three workstreams. First, the ESMA STRESI framework is a simulation-based approach whose general objective is to assess the resilience of the investment fund sector and its capacity to transmit or amplify shocks to the rest of the financial system. It is also a response to FSB Recommendation 9 which asks authorities to give consideration to system-wide stress testing that could potentially capture effects of collective selling by funds and other institutional investors on the resilience of financial markets and the financial system more generally.

The results show that overall, most bond funds are able to cope with extreme but plausible shocks, as they have enough liquid assets to meet investors’ redemption requests. However, pockets of vulnerabilities are identified, especially for High Yield (HY) bond funds. Under the assumptions of ESMA’s simulations, up to 40% of HY bond funds could experience a liquidity shortfall, i.e. a situation in which their holdings of liquid assets alone would not suffice to cover the redemptions assumed in the shock scenario and recourse to less liquid assets would need to be taken.

As a second step, the impact of the funds’ liquidation on financial markets has been modelled, as funds need to sell assets to meet investors’ redemptions, thereby exerting downward pressure on assets prices. The results show that the overall price impact is limited for most asset classes, as sales by funds are only a fraction of aggregate trading volumes. However, for asset classes with more limited liquidity, such as HY bonds and Emerging Markets (EM) bonds, fund sales could have a material impact, ranging from 150 to 300 basis points, and generate material second round effects.

Secondly, as part of its work on funds’ stress testing, ESMA has recently published the Liquidity Stress Testing (LST) Guidelines in UCITS and AIFs, which promote convergence in the way the national competent authorities supervise funds liquidity stress. The Guidelines seek to ensure that asset managers across the EU undertake LST following a set of minimum standards, including the design and frequency of LST models, the governance principles for LST and how LST should be incorporated in the fund’s risk management policies and procedure.

Finally on funds’ stress testing, the framework was also further enhanced by the publication of the MMF Stress Testing Guidelines which have established common reference parameters of the stress test scenarios that MMFs managers are required to conduct. The Guidelines are updated yearly in order to take into account recent market developments, and, where appropriate, improvements to the methodology.

Supervisory action and liquidity requirements under UCITS

The UCITS framework includes a broad range of risk management provisions designed to ensure that all relevant risks, including liquidity risks, are identified, measured and effectively managed. Recent events have led to a focus in ESMA on liquidity management in UCITS in order to assess whether there might be a mismatch between the redemption policies and liquidity profiles of some UCITS which may reveal non-compliance with the applicable UCITS rules.

In order to foster convergence and promote consistent supervision with regard to liquidity risks, ESMA will facilitate a common supervisory action on liquidity management by UCITS. This is an exercise under which EU NCAs will agree to simultaneously conduct supervisory activity in 2020 on the basis of a common methodology to be developed together within ESMA. This initiative, and the related sharing of practices across NCAs, should represent a significant supervisory effort which is expected to help ensuring consistent application of EU rules on UCITS liquidity management and ultimately enhance the protection of investors across the EU.

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