EUROPE: ESMA Publishes Report on the Recommendation of the ESRB on Liquidity Risk in Investment Funds

Friday November 13 2020

On 6 May 2020, the European Systemic Risk Board (ESRB) published a recommendation to address liquidity risk in investment funds. The ESRB recommendation requests that ESMA:

• coordinates with the National Competent Authorities (NCAs) to undertake a focused piece of supervisory exercise with investment funds that have significant exposures to corporate debt and real estate assets to assess the preparedness of these two segments of the investment funds sector to potential future adverse shocks, including any potential resumption of significant redemptions and/or an increase in valuation uncertainty; and
• reports to the ESRB on its analysis and on the conclusions reached regarding the preparedness of the relevant investment funds.

The report sets out ESMA’s analysis and conclusions on the preparedness of the investment funds that were reviewed and presents five priority areas identified to enhance the preparedness of funds that have significant exposures to corporate debt and real estate assets to potential future adverse shocks.

In response to the ESRB Recommendation, ESMA coordinated a supervisory exercise which included NCAs collecting data on funds exposed to corporate debt and funds exposed to real estate and reporting the results to ESMA. On this basis, ESMA’s assessment is focussing on potential future redemptions and/or valuation uncertainty shocks and considers whether additional actions are needed.

The assessment is based on individual data and is micro prudential in nature. However, similar to its Guidelines on liquidity stress testing, ESMA considers that reducing the liquidity and valuation risks at the level of the investment fund may reduce the likelihood of funds disposing of assets at significant discounts in order to service redemptions (‘fire sales’). Fire sales by a material proportion of funds would be likely to move asset prices, potentially affecting financial stability.

The following priority areas have been identified to enhance the preparedness of the funds:

Priority area 1 – Ongoing supervision of the alignment of the funds’ investment strategy, liquidity profile and redemption policy.

Market participants are responsible for ensuring the alignment between the liquidity profile of funds’ investments and their redemption policies. In order to supervise compliance with rules on liquidity risk management, NCAs should continue their active engagement with, and supervision of, their market participants. Misalignments between the liquidity profile of funds’ investments and their redemption policies should be corrected in a timely manner. In the context of the ESRB recommendation, this applies in particular to the funds analysed in this exercise if potential misalignments are confirmed by further analyses carried out by NCAs. This monitoring should be taking into account all information at their disposal (in particular the fund liquidity profile established under the AIFMD reporting) and insights gained through their ongoing dialogue with management companies. Management companies should be able to justify the liquidity set-up of their funds, at the authorisation phase or during NCAs supervisory actions (surveillance of funds, thematic reviews, on-site and off-site inspections). Particular attention should be paid to funds investing in less liquid or illiquid assets.

Priority area 2 – Ongoing supervision of liquidity risk assessment.

 As part of their ongoing supervision of management companies, NCAs should supervise the liquidity risk assessment by management companies. Particular attention should be paid to supervising that management
companies in their liquidity risk assessment comply with their obligation to take all factors into account that could have an impact on funds liquidity or that could trigger unwanted sales of assets, such as (i) margin calls which may increase cash needs in case of renewed heightened market volatility, and (ii) loan covenants in the REIFs. Furthermore, all relevant items on the liability side of the fund balance sheet, including items other than redemptions, should be subject to liquidity stress tests, as stated in the Guidelines on liquidity stress testing in UCITS and AIFs

Priority area 3 – Fund liquidity profiles.

In the context of the AIFMD review, additional specifications on how liquidity profiles should be established and reported as part of the AIFMD reporting should be introduced. This includes (i) on the asset side how to determine a realistic and conservative estimate of which percentage of the fund portfolio can be liquidated (estimate for
each asset class based on reliable methodology and data), and (ii) on the liability side, how to take into account arrangements with respect to gates and notice periods in the determination of investor liquidity profiles. These data are important to ensure necessary information on liquidity profiles and to support a risk-based approach in the supervision of liquidity risks mentioned in Priority area 1.

Priority area 4 – Increase of the availability and use of liquidity management tools

As indicated in the letter to the European Commission with regard to the review of the AIFMD, ESMA reiterates its support for the ESRB recommendation calling for a harmonised legal framework to govern the availability of additional liquidity management tools for fund managers in both the UCITS and AIFM frameworks. The legal framework should also include specifications on the required disclosures for the provision and use of LMTs to ensure greater protection and consistency for investors.

Priority area 5 – Supervision of valuation processes in a context of valuation uncertainty.

As part of their ongoing supervision of management companies, NCAs should carry out further supervisory activities to ensure that management companies valuation procedures cover all market situations including valuation approaches for stressed market conditions.

The actions related to the response to the ESRB recommendation to address liquidity risk in investment funds are part of this supervisory convergence work, with the aim to increase the preparedness of UCITS and AIFMs with significant exposures to corporate debt and real estate assets to potential liquidity and valuation shocks.

In particular, ESMA will follow-up with NCAs in relation to priority areas 1, 2, and 5, in order to foster supervisory convergence amongst NCAs in how they supervise firms’ compliance with their obligations in this area. This will include sharing of experiences among NCAs in the areas of ongoing supervision of liquidity risk and valuation in stressed market conditions.

The increase of the availability of liquidity management tools in EU Member States (priority area 4) and further convergence in the establishment of liquidity profiles under the AIFMD (and future UCITS) reporting (priority area 3) are more fit to be taken forward in the context of the AIFMD review.

Click on the link above for further information.