We await the new European Commissioner for Financial Services to be announced. Meanwhile, work is well-underway in constructing the agenda and priorities for his/her department. Financial stability in the non-banking sector is certain to feature, and for investment funds that is bound to include a focus on liquidity. Exchange-traded funds (ETFs) and money market funds (MMFs) are firmly under the spotlight, but scrutiny is expected to widen to all open-ended investment funds.
A lot is already happening at supervisory level, with statements and research by ESMA and national regulators, which require response by the industry. The Commission needs to confirm its response in the light of the 2018 recommendations of the European Systemic Risk Board (ESRB) – see below – which could result in additional rules.
What should firms be doing to evidence good liquidity risk management?
EU bodies shape the debate
In 2018, the ESRB said that existing ESMA guidance on fund liquidity management should be enhanced to include:
- The design of liquidity stress testing (LST) scenarios
- An LST policy and internal use of LST results
- Considerations for the asset and liability sides of investment fund balance sheets
- The timing of and frequency for individual funds to conduct LST
Subsequently, ESMA consulted on 14 principles-based guidelines for EU fund management companies and depositaries, relating to existing UCITS and AIFMD requirements. ESMA noted that liquidity risk in investment funds has crystallized infrequently and has largely been contained, but an event could have a considerable impact on investors. LST is only one tool in managing fund liquidity, which the great majority of fund managers already employ. The final guidelines were issued in early September and apply by 30 September 2020. The drafting has been clarified in places but the scope and substance are largely unchanged.
The draft guidelines recognize that a variety of methods can be used to build LST models and therefore do not adopt a one-size-fits-all approach. They cover all UCITS and AIFs, including MMFs, ETFs and leveraged closed-ended AIFs. Industry commentators have expressed concern, though, about whether there is sufficient data available across all asset markets.
National supervisors take an active stance
In line with ESMA's findings, other official studies have commonly concluded that investment funds have been resilient in times of crisis in the capital markets, but policy-makers have noted that some funds do not have sufficient emergency liquidity tools to deal with volatile markets. The Belgian and Dutch regulators, for example, have been looking into this question.
The French AMF has proposed a review and analysis of macro-stress tests in asset management, with possible ways forward to support development. The UK FCA's annual review of the asset management industry, published in January 2019, identified the growth in less liquid assets in investment funds, although slow, to be a risk. It has since called for UCITS regulation to adopt a US-style definition of whether an asset is liquid, rather than depending on an asset being listed.
In response to ESMA's consultation mentioned above and recent events in the U.K., it is reported that the Central Bank of Ireland (CBI) issued in August 2019 a letter to the fund management industry. The letter highlights the importance of the execution by fund management companies of an appropriately calibrated liquidity risk management for each fund, taking into account on an ongoing basis the fund's dealing frequency, investment strategy, portfolio composition and investor profile.
The CBI notes that this may involve daily and intra-day monitoring, and that liquidity stress testing is a key part of the monitoring process, given that liquidity and investor demands can change quickly and without warning. Also, the use of liquidity management tools should be transparent and proportionate, taking into account the best interests of the investors, and all fund documentation should be clear, accurate and in line with relevant legislative and regulatory requirements.
The letter makes it clear that the responsibility of liquidity risk management rests with fund management company boards, but specifically references the responsibility of individual directors and relevant responsible persons within delegate fund service providers.
Stress testing of MMFs
The EU Money Market Funds Regulation requires managers to conduct regular stress tests, identifying how stress events and changes in economic conditions can impact the net asset value and liquidity of the funds. In July 2019, in order to ensure a coherent application of the regulation across the EU, ESMA issued two sets of guidelines on:
- Common reference parameters that MMF managers should include in stress scenarios in relation to potential changes in a fund's liquidity levels, credit and interest rate risks, redemption levels, widening/narrowing of spreads among indexes to which interest rates of portfolio securities are tied, and macro-economic shocks.
- How to complete the MMF reporting template that must to transmitted to national regulators from Q1 2020.
The guidelines will be updated at least annually, taking into account market developments.
Steven Maijoor, ESMA's Chair said, “Money market funds offer high liquidity at lower risk than other funds, contributing to the funding of banks, governments and corporates. However, due to their important role in the money market, any disruption affecting MMFs may impact financial stability. Stress testing is an important tool to assessing and mitigating potential stability risks.”
Exchange-traded funds still on the watch list
Consideration of the growing ETF markets has been a focus of global policy analysis for some time and ETFs remain on the systemic risk watch list. The International Organisation of Securities Commissions is examining “whether the growth of passive investment affects the price discovery process” and scrutinising the effect of passive funds on “the allocation of capital and corporate governance”1.
In August 2019, the FCA published a Research Note on the resilience of fixed income ETF liquidity in times of market stress. The opening presumption is that the rapid growth in ETFs creates potential risks to investor protection and financial stability. The research found that ETF primary markets are highly concentrated, particularly for fixed income ETFs, but that analysis of stress events provides some evidence that alternative liquidity providers step in during times of market disruption. Also, no other immediate features of participation raised financial stability concerns. The FCA says it will continue to research ETF market resilience.
Questions for CEOs
- Are our current liquidity stress testing policy and process in line with latest regulatory expectations?
- Is liquidity stress testing fully embedded in our product governance process, for each fund?
- Do we have an up-to-date understanding of the tools at our disposal in times of market stress?
- How does the board exercise its responsibility and have we established agreed processes with service providers and the fund depositary?
- Does our fund documentation explain clearly what these tools are and how we might use them?
- Can we evidence that we would use such tools in a proportionate manner, in the interests of investors?