Last month, both the Central Bank and ESMA mandated that fund management companies assess the adequacy of fund liquidity risk management frameworks (LRMFs) in light of adverse findings identified during 2020 supervisory reviews.
Central Bank Mandated Review of LRMFs
On 12 March 2021, the Central Bank published a letter (dated 10 March) issued to certain fund management companies (FMCs) on the findings from the ESMA co-ordinated, NCA review of liquidity risk in corporate bond and real estate UCITS and AIFs. This review was completed during February - March 2020 and ESMA published review findings on 13 November 2020 (see previous article ESMA Recommends Liquidity Action Items for Funds).
The Central Bank letter was sent to those FMCs with corporate bond UCITS and/or AIFs which were included in the ESMA liquidity review. The Central Bank requires FMCs in receipt of the letter to "now consider how liquidity risk management frameworks and fund structures should be adapted to take into account the experience and lessons learned from the market and redemption activity in 2020 and the findings of the ESMA report."
Relevant FMCs must complete their review of funds' LRMFs, with results presented to and approved by FMC Boards, no later than the end of June 2021. FMCs must make any necessary amendments to funds' LRMFs, following their review, by no later than end December 2021.
The Central Bank requires FMCs to consider the following as part of their review of LRMFs:
- Liquidity profile: the alignment of investments' liquidity profiles, investors' risk profiles, redemption policies and settlement periods and the development of policies to correct misalignments in a timely manner;
- Liquidity management tools or LMTs: funds' ability to access, and their use of, LMTs including consideration of when it may be appropriate, outside of stress scenarios, to use LMTs given their potential to enhance investor protection and dampen the effect of large redemptions on markets. In this context, FMCs should consider the extent to which the use of swing pricing or ADLs are required to ensure that transaction costs, including liquidity premia, associated with redemptions are borne by the redeeming investor thus limiting the effect on remaining investors, in particular in stress scenarios.
- Policies & procedures: the policies and procedures in place for the use of LMTs should provide for appropriate disclosure in fund documents and investor communications to ensure clarity and transparency on the regular use of LMTs and conditions for their implementation.
- Liquidity risk triggers: all factors that could impact fund liquidity or trigger unplanned asset sales e.g. the possibility of increased margin calls that may increase cash needs.
- Liquidity profile: a realistic and conservative estimate of what percentage of a fund's assets can be liquidated over a period of what time to ensure redemption policies are aligned with portfolio liquidity. Any misalignment should be corrected in a timely manner.
- Investor profile: information on the investor profile to identify potential risks associated with probable redemption patterns, particularly in stressed conditions.
- Design and testing: designing and texting liquidity risk management frameworks and planning for future market stress scenarios which should not assume market interventions in the form actioned during the initial COVID market stresses.
ESMA Mandated Review of LRMFs
On 24 March 2021, ESMA published the results of its 2020 common supervisory action on UCITS liquidity risk management. While the majority of UCITS reviewed were found to demonstrate sufficient implementation and application of sound LRMFs, in a few cases, adverse supervisory findings, as outlined below, were identified. ESMA instructs UCITS managers to "critically review" their LRMFs to ensure that none of the below exist in their frameworks.
According to ESMA, NCAs are undertaking follow-up actions on individual cases:
"NCAs will undertake follow-up actions on individual cases to ensure that all regulatory breaches as well as any other shortcomings or weaknesses identified are remedied, especially regarding the key findings referred to in paragraph 11 above. Some NCAs have also indicated that they need to further interact with some UCITS managers, through on-site visits and/or desk-based reviews of the latest documents provided, to complete their supervisory analysis. Stringent supervision of the existing UCITS regulatory requirements is key to prevent regulatory breaches and deficiencies that may undermine investor confidence in the UCITS product and EU/EEA capital markets."
ESMA also identified a lack of convergence by certain NCAs in relation to follow-up actions, including enforcement actions and further work will be carried out at ESMA level to address these findings.
Adverse supervisory findings
- Documentation of liquidity risk management (LRM) arrangements, processes and techniques: In some cases, the CSA review identified no documentation available or a lack of granularity/clarity in key areas such as pre-investment liquidity analyses and forecasts, design phase, escalation processes and verification of data reliability, despite regulatory obligations requiring that relevant activities should be written and documented.
- LRM procedures: Issues with the quality of the written LRM procedures were detected in some cases. For instance, some procedures did not provide for the documentation of the LRM arrangements, processes and techniques or did not cover all asset types or the use of liquidity management tools (LMTs) (from the analysis during the product design phase to their ongoing use, etc.). In a few isolated cases, no written LRM procedures were put in place.
- Quality of LRM mechanisms and methodology: in some cases, the methodology was not always appropriate, not forward-looking and, more frequently, not justified and back-tested. In some particularly worrisome cases, margin calls were not considered at all. LRM mechanisms and methodology were identified as too static, with, for instance, questions raised on the accuracy of LRM modelling during market downturns – including the accuracy of the data used for modelling the liquidity which should give due consideration to the prevailing market circumstances. This may result in unrealistically stable or even improving liquidity forecasts in crisis time.
- Overreliance on liquidity presumption with regard to listed securities: In some cases, UCITS managers placed an overreliance on the presumption of liquidity for listed securities. In addition, without dedicated follow-ups on securities presumed liquid, some ongoing controls were insufficient as they were not based on reliable data on volumes e.g. past volumes, number of brokers and trading size. The mere lack of any data on volumes should be considered as possible evidence of the lack of sufficient liquidity and would need to be further investigated.
- Application of liquidity presumption to financial instruments which are not admitted to or dealt in on a regulated market in violation of UCITS rules: NCAs investigations revealed that a few specific supervised entities had applied the presumption of liquidity to all assets, including financial instruments which are not admitted to or dealt in on a regulated market under UCITS rules, where overall portfolio liquidity was deemed sufficient. In these cases, no liquidity analysis and forecasts were performed for investments subject to the 10% limit on unlisted securities. Performing no pre-investment liquidity analyses and forecasts for these financial instruments is not compliant with the UCITS framework and should therefore be further investigated.
- Delegation: Some NCAs identified a few cases where the entity to whom the portfolio management function was delegated effectively also performed the LRM functions. Those cases also revealed an insufficient involvement of the internal risk management function, as well as insufficient delegation monitoring and due diligence. Moreover, the simultaneous delegation of portfolio and risk management functions to the delegate should not be allowed as it contravenes the UCITS delegation and substance rules.
- Data reliability: in some cases, NCAs observed a widespread lack of data quality checks in a context of overreliance on very few data providers. In those cases, UCITS managers had not implemented robust and documented control processes, based on cross-checks and back-tests to ensure that they use sound and reliable data as explicitly required by UCITS rules.
- Disclosures: NCAs reported some cases of missing, inaccurate, or unclear disclosures on liquidity risks and LMTs to investors in the UCITS KIID and/or prospectus.
- Governance: In some cases, insufficient (in terms of frequency, granularity and clarity) and, more rarely, absence, of reporting to senior management was detected by NCAs. Some processes raised questions regarding the soundness and documentation of the decision-making process, in particular, with regard to escalation processes or analyses conducted during the design phase e.g. formalisation of the decisions relating to the design of the UCITS, the set up and calibration of LMTs, procedures for monitoring the actual use of LMTs, lack of documentation of the cases escalated to the board or to senior management and their resolution, and lack of formalisation of the criteria that trigger the escalation process;
- Internal control framework: In some cases, NCAs detected no regular second and third-level controls of LRM policies and procedures, and identified a strong need to strengthen the overall control framework as both compliance and internal audit functions were not performing sufficient controls with respect to LRM processes. In such cases, these control functions have not been able to detect most of the shortcomings and regulatory breaches identified by NCAs in the course of the CSA; and
- External controls: External controls by the depositary and external auditors of the UCITS and UCITS managers are not performed in all cases. With respect to controls by external auditors, this might also be explained by diverging national rules and practices regarding the scope of audit.
More broadly, ESMA notes that the COVID-19 crisis revealed cases of lack of reactivity or adaption of the LRM assessment i.e. adapting risk analyses and forecasts, understanding of the limits of the models employed to the changed market conditions, etc. and governance e.g. escalation processes, which NCAs will also address in their follow-up supervisory actions.
While the Central Bank and ESMA liquidity reviews have been completed and findings issued, both regulators reference follow-up actions in the context of continuing liquidity management issues, particularly those highlighted by the market turmoil at the start of the coronavirus crisis. IOSCO and the FSB are currently reviewing how the funds sector dealt with such market volatility. On 5 March 2021, IOSCO launched a thematic review of the extent to which its Recommendations for Liquidity Risk Management for Collective Investment Schemes have been implemented. Regulators are clearly of the view that there are liquidity risk management issues within the sector that require to be addressed. FMCs should begin now assessing LRMFs in place and ensuring their alignment with regulatory expectations as outlined above.
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