In April 2020, we published an overview of the different policy measures taken by international and EU regulatory bodies to address concerns about liquidity risks in the investment funds sector. We concluded that several important changes were still underway.
In this article, we take stock of the various and numerous initiatives that regulators undertook to address liquidity concerns over the course of 2020 and 2021, including:
- ESRB Recommendation on liquidity risks in investment funds
- ESMA report on the ESRB’s 2020 Recommendation
- AIFMD Review Consultation
- IOSCO thematic review of 2018 recommendations
- ESMA reports on Common Supervisory Action on UCITS liquidity risk management
- Financial Stability Board Policy Proposals to enhance Money Market Fund resilience
European Systemic Risk Board (ESRB) recommendation on liquidity risks in investment funds
On 6 May 2020, following the outbreak of the global Covid-19 pandemic, the ESRB, which oversees the EU financial system, issued a recommendation on liquidity risks in investment funds with significant exposures to corporate debt and real estate (the 2020 Recommendation).
The ESRB identified these types of funds as a particularly high priority for enhanced scrutiny from a financial stability perspective.
In order to get a better view of the potential liquidity risks related to such funds, the ESRB recommended the European Securities and Markets Authority (ESMA) launch a coordinated supervisory action to assess their preparedness for potential future adverse shocks.
ESMA report on the ESRB’s 2020 Recommendation
On 12 November 2020, ESMA duly reported on its actions taken following the ESRB’s 2020 Recommendation.
While overall findings resulting from its supervisory action were positive, especially in light of the market shocks resulting from the Covid-19 pandemic, ESMA did identify weaknesses in corporate debt and real estate investment funds that would merit further strengthening.
ESMA identified the following priority areas:
- supervision of the alignment of the funds’ investment strategy, liquidity profile redemption policy
- supervision of liquidity risk assessment
- establishing fund liquidity profiles
- increase of the availability and use of liquidity management tools
- supervision of valuation processes in a context of valuation uncertainty
Several of these priority areas are also part of the review of the Alternative Investment Fund Managers Directive (AIFMD).
European Commission (EC) launches AIFMD review consultation
A key event in the fourth quarter of 2020 was the launch of the AIFMD review consultation by the European Commission on 22 October 2020.
While it covers a wide range of elements that may be subject to legislative change, one section of the consultation focuses on financial stability and related liquidity topics.
Among other elements, the EC enquires about harmonising available liquidity management tools (LMTs) across the EU, reporting by AIFMs on their use of LMTs, and enhancing portfolio reporting by including details on liquidity and a fund’s liquidity profile.
With these elements, the EC in essence seeks to address parts of the ESRB’s recommendation issued in 2018 (the 2018 Recommendation). The 2018 Recommendation contained several policy and legislative changes to harmonise the use and availability of LMTs, and for regulators to obtain better and more granular data on liquidity risk in investment funds.
Indeed, a further element covered by the AIFMD review consultation is the question whether supervisory reporting, including on liquidity, should be introduced for UCITS funds as well. This was another explicit recommendation from the ESRB.
It is no surprise, then, that on 29 January 2021, the ESRB submitted a detailed response to the EC’s AIFMD review consultation.
Specifically on liquidity, the ESRB suggested amending the AIFMD Delegated Regulation reporting template to include, for each of the funds in the AIFM’s scope, an overview of the LMTs that the fund manager can apply based on the fund’s prospectus. It should also be clear in the reporting whether these LMTs are triggered at the fund manager’s discretion, or whether they are triggered automatically in certain (market) circumstances.
In addition, the ESRB encourages the EC to specify how to establish and report liquidity profiles, for example by introducing a methodology to determine asset and investor liquidity profiles.
The EC is expected to adopt the legislative proposal to amend the AIFMD by end of 2021. Given the above, it is likely that increased scrutiny of liquidity risk and management will form an important part of this proposal.
IOSCO thematic review of 2018 recommendations
On 5 March 2021, the International Organization of Securities Commissions (IOSCO) launched a thematic review of its 2018 Recommendations for Liquidity Risk Management for Collective Investment Schemes (the 2018 Recommendations).
The objective of the thematic review is to assess the extent to which its 2018 Recommendations have been implemented by IOSCO members, and through what type of regulatory practices.
A report on the thematic review will be published in the fourth quarter of 2022.
While this development does not constitute in itself a legislative or policy measure with a direct impact on investment funds, it shows the commitment of global and regional regulators to develop a more harmonised framework to address liquidity issues in the asset management sector.
ESMA reports on Common Supervisory Action (CSA) on UCITS liquidity risk management (LRM)
On 24 March 2021, ESMA reported on the results of its 2020 CSA specifically directed at UCITS managers and their compliance with liquidity management obligations.
The report notes a generally positive outcome of the CSA: overall, UCITS managers demonstrated that they have implemented and applied sufficiently sound liquidity risk management (“LRM”) processes.
As areas of potential concern and improvement, ESMA reported among others the following:
- Lack of clarity, granularity, and quality of LRM procedures;
- Overreliance on liquidity presumption with regard to listed securities, and extending this presumption to all assets in the investment’s portfolios;
- Delegation of both portfolio and risk management functions; and
- Lack of data quality checks in a context of overreliance on very few data providers.
While the CSA is now concluded, ESMA encourages market participants to critically and periodically review their LRM frameworks, while national competent authorities will undertake follow-up actions on individual cases.
Financial Stability Board (FSB) Policy Proposals to Enhance Money Market Fund (MMF) Resilience
On 11 October 2021, the FSB issued a report with policy proposals to increase the resilience of MMFs.
According to the FSB, due to their specific nature, and the tendency of market participants to use these funds for (short-term) liquidity purposes, any market disruption affecting MMFs could have significant financial stability implications.
The report therefore proposes a policy “toolkit” to address potential vulnerabilities in MMFs. The proposed toolkit contains, among other measures, the following:
- introducing swing pricing mechanisms
- setting a minimum balance at risk to absorb credit losses
- addressing regulatory thresholds that may give rise to cliff effects
- reducing liquidity transformation
Over the course of 2020 and 2021, regulators have stepped up their efforts to tackle potential liquidity risks in investment funds.
For UCITS management companies and AIFMs (and their delegates performing asset and/or risk management functions), this has resulted in increasing scrutiny of the frameworks they have put in place to deal with these risks.
In the short term, the legislative proposal to amend the AIFMD is a key development to watch, as it will likely contain several new or increased obligations for AIFMs to show their overall preparedness in case of liquidity shocks.
As recommended by the ESRB’s 2018 Recommendation, while not confirmed yet, a review of the UCITS Directive will probably also see added provisions on liquidity management and reporting.
It is safe to say that liquidity will remain a top priority of both regulators and fund managers for some time to come.