The European Systemic Risk Board (ESRB) has published a Recommendation on liquidity and leverage risks in investment funds. This topic has received significant attention from international bodies due to concerns about systemic risk. In 2017 the Financial Stability Board (FSB) published its Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (see our blog). The International Organization of Securities Commissions (IOSCO) has recently updated its Recommendations for Liquidity Risk Management for Collective Investment Schemes (see our blog) and is due to make recommendations on fund leverage measures later in 2018.
The ESRB Recommendation provides an important indication of how these FSB and IOSCO recommendations are likely to be implemented in the EU. Overall, the ESRB's Recommendation is expected to lead to:
- increased scrutiny of liquidity management processes and tools and of fund stress testing;
- a wider range of additional liquidity management tools for use in stressed market conditions being available in some EU countries;
- more clarity on the situations where the regulatory powers of imposing leverage limits on funds and of suspending fund redemptions may be used; and
- new and potentially extensive liquidity and leverage reporting requirements for UCITS funds.
Liquidity management tools
The ERSB recommends that the European Commission ("the Commission") proposes a common legal framework governing the inclusion of additional liquidity management tools for EU funds to be used in stressed market conditions. Currently, the availability of such tools depends on national legislation and this recommendation is intended to ensure that asset managers have a diverse set of tools available to them. The ESRB sets out which liquidity management tools are currently available in each EU jurisdiction. In the UK, the rules allow the use of gates, anti-dilution levies, redemption fees, in-kind redemptions, suspensions of redemptions, swing pricing, short-term borrowings and side letters, but do not allow side pockets or mandatory liquidity buffers. Some jurisdictions allow a much narrower range of tools. This recommendation is therefore likely to increase the options available to asset managers.
The ESRB also recommends that the Commission proposes new requirements on asset managers, including requirements to assess which tools are suitable for each of the funds they manage, and to ensure they have the necessary operational capacity and contingency planning for the timely activation of any tools they may use. Asset managers will need to ensure that they have clear processes for deciding when such tools should be used and that they can demonstrate their operational capacity to implement and unwind them in a transparent, fair and orderly manner.
The ESRB recommends that EU legislation specifies the role of national regulators when using their powers to suspend redemptions in situations where there are cross-border financial stability implications, as well as the advisory and coordination role of the European Securities and Markets Authority (ESMA) in relation to these powers. In its paper Recommendations for Liquidity Risk Management for Collective Investment Schemes, IOSCO notes that while some securities regulators have the power to suspend redemptions, this power has rarely been used. The FCA has the power to suspend redemptions for UK-authorised funds; however, it notes in its Discussion Paper on Illiquid assets and open-ended investment funds that a direction to suspend some or all funds investing in a particular asset class might send a signal that investors should not have confidence in that entire asset class, so the use of this power would need to be carefully assessed. The ESRB's recommendation may result in more clarity on the situations in which this power may be used by EU regulators.
Excessive Liquidity mismatches
The ERSB recommends that the Commission proposes measures to limit the extent to which the use of liquidity transformation in open-ended alternative investment funds (AIFs) could contribute to the build-up of systemic risk or the risk of disorderly markets. It recommends that ESMA draws up a list of less liquid assets (such as real estate, unlisted securities and loans), and that open-ended AIFs holding a large proportion of their investments in these assets should be required to demonstrate to national regulators their capacity to maintain their investment strategy under stressed market conditions. This assessment should include the use of tailored redemption policies, additional liquidity management tools and/or internal limits of less liquid assets.
This recommendation is likely to lead to more scrutiny of liquidity management processes and tools for funds investing in illiquid assets. In the UK, the FCA is already reviewing how open-ended funds may invest in illiquid assets, although it does not propose to ban open-ended funds from holding illiquid assets or to prevent retail investors from acquiring units in open-ended property funds.
Fund stress testing
The ERSB recommends that ESMA develops guidance on the stress testing of liquidity risk for individual funds. This should include guidance on the design of scenarios, the stress testing policy, considerations for the asset and liability sides of fund balance sheets, and the timing and frequency of stress tests. ESMA said in its Supervisory Convergence Work Programme that it expects to publish fund stress testing principles for national regulators in Q3 2018.
Currently, AIF managers are already required to conduct fund stress tests and to report the results to regulators, while UCITS fund managers must carry out stress tests where appropriate. ESMA's guidance is likely to make supervisory expectations around fund stress testing clearer and more harmonised. Asset managers will need long-term strategic plans and appropriate governance arrangements to carry out effective fund stress testing.
The ESRB recommends that the Commission proposes legislation requiring UCITS management companies to report regularly to regulators data on the liquidity risk and leverage in their funds. This information should be reported at least quarterly by a sufficiently relevant proportion of all UCITS funds and management companies. The ESRB recommends that, where appropriate, the reporting requirements in the UCITS and AIFMD directives should be harmonised, and the reporting requirements in the Money Market Funds Regulation (MMFR) should also be taken into account.
Currently, many EU countries have reporting obligations for UCITS but these differ widely in terms of the reporting frequency, the funds covered, and the data reported. More harmonisation should enable the use of existing reporting platforms for firms managing both AIFs and UCITS funds. However, the reporting requirements in the AIFMD and MMFR are fairly extensive, so this could introduce significant new costs for some firms.
The AIFMD allows national regulators to impose leverage limits on funds managed by fund managers in their jurisdiction to ensure the stability and integrity of the financial system. However, so far no EU regulator has implemented this tool. The ERSB recommends that ESMA gives guidance on the design, calibration and implementation of macro-prudential leverage limits under the AIFMD. This may make it more likely that this tool will be used in the future. In developing its guidance, ESMA is likely to take into account the analysis in the European Central Bank's Occasional Paper on Developing macroprudential policy for alternative investment funds, including its suggestion that that "constant leverage limits targeted at economic leverage and the redemption and/or liquidity profile of the funds should be explored at EU level".
Implications for firms
While the precise details of the new requirements are not yet known, this ERSB Recommendation provides a clear indication of the direction of travel. Asset managers will need to review their liquidity management processes and tools, their fund stress testing procedures, and their fund leverage limits in the expectation of increased scrutiny.
It is now up to the Commission and ESMA to respond to the ESRB's recommendations. The ESRB has requested reports on the implementation of these recommendations by 30 June 2019 for the recommendations on fund stress testing and leverage limits, and by 21 December 2020 for the recommendations on liquidity management tools, excessive liquidity mismatches, and UCITS reporting.
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