Liquidity in the investment fund sector is a key concern for regulators, and will remain so for the time being.
In the short term, the ESMA guidelines will become applicable on 30 September 2020 and will require fund managers to reassess their liquidity stress tests toolkit.
In the medium term, increased reporting requirements under the UCITS Directive, as well as a review of the reporting requirements under the AIFM Directive, are on the horizon.
The investment fund sector represents an ever-growing part of global and EU securities markets. Tellingly, it represents more than half of the EU’s total financial sector assets.
Over the past two years, liquidity in collective investment schemes has been under increasing scrutiny from regulatory bodies, both at a global and EU level. Recent market volatility as a result of uncertainty surrounding the COVID-19 outbreak have, if anything, underlined the importance of appropriate liquidity management tools and procedures.
In February 2018, the International Organisation of Securities Commissions (IOSCO) and the European Systemic Risk Board (ESRB) issued recommendations on liquidity risk management (the “IOSCO recommendations”) and liquidity and leverage risks (the “ESRB recommendations”). These recommendations kicked off a range of supervisory guidelines and actions impacting the EU fund industry. More recently, on 2 September 2019, the European Securities and Markets Authority issued guidelines on liquidity stress tests for investment funds (the “ESMA guidelines”) and launched on 30 January 2020 a joint supervisory action on the supervision of UCITS’ managers liquidity risk management.
In this article, we provide an overview of the ESMA guidelines, before considering what is yet to come.
Where we are now – ESMA guidelines
The ESMA guidelines are applicable from 30 September 2020 and are the main regulatory milestone for EU investment managers. Strictly speaking, the guidelines apply to national competent authorities, who will have to implement the guidelines in their respective national markets. In any case, UCITS management companies and alternative investment fund managers (AIFMs) should expect increased scrutiny from their local regulators as regards their liquidity stress testing (LST) policies.
Under the guidelines, fund managers will need to establish LST models and policies that reflect a range of elements impacting their funds and their management processes.
Fund managers should adapt LST models to each investment fund (and where applicable, to each sub-fund/compartment), and employ both historical and hypothetical stress scenarios. In addition, stress testing should be conducted at the asset level taking into account not only the time and cost involved to liquidate assets, but also whether this would be permissible.
Fund managers should also incorporate LST for the liabilities of the investment fund (and where applicable, to each sub-fund/compartment), taking into account risk factors related to the investor type and concentration.
It is worth highlighting that the guidelines underline the responsibilities of fund managers with regards to liquidity data availability. For example, fund managers will have to justify their reliance on third parties’ LST models, including those of third party portfolio managers.
What to expect – legislative changes
One key change to expect, as indicated in the ESRB recommendations, is the harmonisation of liquidity reporting requirements under the UCITS Directive. In the ESRB’s view, these requirements are currently too divergent across EU member states. The ESRB recommends frequent – at least quarterly – reporting of liquidity risk and leverage data.
As the ESRB suggests, the most likely context for this harmonisation would be an amendment of the UCITS Directive to bring it closer to the requirements of the AIFM Directive and EU Money Market Fund Regulation. At a minimum, reporting should cover the following:
- Assets under management
- Traded instruments and individual exposures
- Investment strategy
- Global exposure and leverage
- Stress testing
- Efficient portfolio management techniques
- Counterparty risk and collateral
- Liquidity risk
- Credit risk
- Trading volumes
The Commission is due to report on the implementation of this recommendation by 31 December 2020, by which time market participants should already know more about this specific regulatory action.
Less certain is what can be expected under the review of the AIFM Directive, which the Commission could launch in the course of 2020. While this legal framework already has enhanced reporting requirements on liquidity, the Commission’s 2018 report suggested that national supervisory practices diverge.
Add to this ESMA’s recent report on the EU AIF market, which expresses a range of concerns regarding liquidity mismatches and the quality of reported data, and we can conclude that liquidity will be a key topic under the review of the AIFM Directive as well.
With a range of policy actions and legislative changes on the horizon, liquidity remains an issue to monitor closely. If anything, the unprecedented market movements in the wake of the COVID-19 outbreak have underlined the importance of liquidity management tools and procedures.
 See ESRB (2019), EU non-bank Financial Intermediation Risk Monitor 2019, No 4/July 2019
 European Commission, Report on the Operation of the Alternative Investment Fund Managers Directive (AIFMD) – Directive 2011/61/EU, 10 December 2018, p. 113.