Liquidity of investment funds remains a key supervisory and regulatory priority at both local (Irish) and European Level.
The Central Bank of Ireland (“CBI”) in its letter dated 7 August 2019 to the Chairs of fund management companies emphasized the importance of effective liquidity management and their obligations under the relevant legislations in this regard. The CBI also notes that as part of its Brexit preparedness work, it will continue to monitor and collect data on investment fund liquidity and redemption activity. It also states that the contents of the Letter will form part of future supervisory engagements.
ESMA recently issued its final report on guidelines on liquidity stress testing in UCITS and AIFs which set down minimum standards for liquidity stress testing (“LST”) in EU domiciled UCITS and AIF funds. The guidelines have been published following a consultation process (published 9 February 2019 and closed 1 April 2019) earlier this year by ESMA and on the back of the European Systemic Risk Board’s (ESRB) recommendations in April 2018 to address liquidity and leverage risk in investment funds. The ESRB’s ‘Recommendation C’ requests that ESMA, in order to promote supervisory convergence, “develop guidance on the practice to be followed by managers for the stress testing of liquidity risk for individual AIFs and UCITS”.
The guidelines will be effective in full by 30 September 2020.
Within two months of the date of publication of the guidelines on ESMA’s website, national competent authorities (“NCA”) need to notify ESMA of their intention to apply or not to apply the guidelines. In case of non-adoption, the national competent authorities will have to notify ESMA of the reasons for non-adoption.
Given the CBI’s focus on liquidity management, we expect that the CBI will notify ESMA of its intention to comply with the requirements in full.
The guidelines apply to fund managers, depositaries and NCAs in respect of the following:
- UCITS & AIFS ;
- ETFs, however LST for such funds should be adapted to take into account the specifications for ETFs, including the role of authorised participants, redemption models and replication models;
- Leveraged Closed-Ended Funds; and
- Money Market Funds to the extent that they are not already covered in the Money Market Fund Regulation.
The guidelines are subject to the proportionality principle as ESMA has stated that these should be adopted based on the nature, size and complexity of the fund.
The objective of the guidelines is to have a common/consistent framework for LST across the member states for EU domiciled funds and to promote convergence of supervisory practice across the EU national competent authorities.
The guidelines require fund managers to stress test the assets and liabilities of the funds they manage and the following is expected of the managers:
- Manager should have a strong understanding of the liquidity risks arising from the assets and liabilities of the fund’s balance sheet and its overall liquidity profile.
- LST should be properly integrated and embedded into the fund’s risk management framework supporting liquidity management. It should be subject to appropriate governance and oversight, including appropriate reporting and escalation procedures.
- LST models to be developed which should ensure that the LST provides information enabling follow-up action. The LST models should factor in at least the following:
- the risk factors impacting the fund’s liquidity;
- scenarios to be used and their severity;
- outputs and indicators to be monitored based on the results;
- the reporting of LST results, and
- use of results by risk management, portfolio management and by senior management.
- LST should be documented in an LST policy within the UCITS and AIF RMP, which should require the manager to periodically review. The following should at least be included in the policy:
- clear definition of the role of senior management in the process;
- its internal ownership;
- its interaction with other liquidity risk management procedure;
- regular internal reporting of LST results specifying the frequency and recipients of the report;
- periodic review;
- the circumstances requiring escalation;
- the funds subject to LST;
- initial validation of the LST models and assumptions underpinning them, which should be performed independently from portfolio management, though not necessarily by an entity/person external to the manager;
- the types and severity of stress test scenarios and the reasons for selection;
- the assumptions used relating to data availability for the scenarios, their rationale and how frequently they are revisited;
- the LST frequency and the reasons for selecting that frequency; and
- the methods for liquidating assets, including the limitations and assumptions used.
- LST should be carried out at least annually and, where appropriate, employed at all stages in a fund’s lifecycle. It is recommended to employ quarterly or more frequent LST. The frequency of LST should be determined based on the following:
- the liquidity of the fund;
- the nature of the funds (closed versus open ended);
- Liquidity management techniques.
Portfolio management delegation
ESMA stated in the feedback statements and also in the guidelines that where portfolio management is delegated, particular attention should be paid to independence in respect of LST to avoid over reliance on delegates. Therefore Management Companies which appoint an investment manager to manage the assets of a fund should ensure that the delegated portfolio manager provides them with adequate information to allow them to conduct appropriate LST at their own level.
Obligation of depositaries
Depositaries are obligated under the guidelines to have appropriate verifications procedures to ensure that the fund managers have documented procedures for the LST programme. The depositary however is not expected to assess the adequacy of the LST programme.
Interaction with national competent authorities
NCAs may at their discretion request submission of a manager’s LST to help demonstrate that a fund will be likely to comply with applicable rules, including regarding the ability of the fund to meet redemption requests in normal and stressed conditions. Furthermore, managers should notify NCAs of material risks and actions taken to address them.
NCAs may at their discretion request managers to notify them of other information relating to the LST, including liquidity stress test models and their results. This may be particularly the case during a period of large redemptions across the market.
Grant Thornton’s view
Given the CBI’s recent emphasis on liquidity management, we expect it to adopt the guidelines in full. As the guidelines are expected to take effect from 30 September 2020, the Fund Management Companies will have to consider how to embed the LST guidelines into their current governance and operational risk model.
If you require any assistance in connection with the above developments, please contact any of the below.