The 16 ESMA Guidelines on Liquidity Stress Testing for UCITS and AIFs

On 2nd September 2019, the European Securities and Markets Authority (ESMA) published its final guidance regarding liquidity stress tests of investment funds – applicable to both Alternative Investment Funds (AIFs) and Undertakings for the Collective Investment in Transferable Securities (UCITS).

ESMA also published a stress simulation framework for the investment fund sector on 5th September 2019. The report is intended to help regulators to stimulate stress situations and could be referred to as a source of information on what a regulator might expect from liquidity stress testing (LST). It can also potentially help asset managers to implement their internal LST framework.

The liquidity stress testing (LST) guidelines require fund managers to stress test the assets and liabilities of the funds they manage. This includes redemption requests by investors which are the most common and important source of liquidity risk and can also impact financial stability.

The guidelines require management companies to not prescribe a “one size fits all” solution as this would not be able to take specific fund’s characteristics into account. It sets out the following 16 guidelines applicable to fund managers.

ESMA Guidelines on Liquidity Stress Testing

1. The Design of the LST Models

In building its liquidity stress testing (LST) model, a manager should determine:

The risk factors that may impact the fund’s liquidity;
The types of scenarios to use and their severity;
Different outputs and indicators to be monitored based on the results of the liquidity stress testing (LST);
The reporting of liquidity stress testing (LST) results, outputs and indicators to management; and
How the results of the liquidity stress testing (LST) are used by risk management, portfolio management and by senior management.

A manager should ensure that liquidity stress testing (LST) provides information that enables follow-up action.

2. Understanding Liquidity Risks

A 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, in order to employ liquidity stress testing (LST) that is appropriate for the fund it manages”

The manager should also strike a balance by using liquidity stress testing (LST) that is focused, specific to the fund and highlights the key liquidity risk factors but, at the same time, uses a range of scenarios sufficiently wide to adequately represent the diversity of the fund’s risks.

3. Governance principles for LST

The manager should ensure that liquidity stress testing (LST) is properly integrated within the fund’s risk management framework and is subject to appropriate governance and oversight, including appropriate reporting and escalation procedures.

4. The LST Policy

Liquidity stress testing (LST) should be documented in an liquidity stress testing (LST) policy within the UCITS and AIF RMP requiring the manager to periodically review the LST and adapt, if necessary, the LST as appropriate.

The Guidelines set out a list of minimum content requirements for an liquidity stress testing (LST) policy. These include:

A clear definition of the role of senior management in the process
Its internal ownership and which management function(s) is/are responsible for its performance;
Its interaction with other liquidity risk management procedures, including the manager’s contingency plans and the portfolio management function;
A requirement for regular internal reporting of liquidity stress testing (LST) results specifying the frequency and recipients of the report;
Periodic review,
The circumstances requiring escalation,
The funds subject to liquidity stress testing (LST);
Initial validation of the liquidity stress testing (LST) models and assumptions underpinning them, which should be performed independently from portfolio management
The types and severity of stress test scenarios used and the reasons for selecting those scenarios;
The assumptions used relating to data availability for the scenarios, their rationale and how frequently they are revisited
The frequency at which liquidity stress testing (LST) is carried out and the reasons for selecting that frequency; and
The methods for liquidating assets, including the limitations and assumptions used.

5. Frequency of LST

liquidity stress testing (LST) should be carried out at least annually and, where appropriate, employed at all stages in a fund’s lifecycle. The guidelines recommend quarterly or more frequent, depending on the fund’s characteristics.

When deciding on the appropriate frequency, managers should take into account the following:

The liquidity of the fund determined by the manager and any change in the liquidity of assets;
The frequency should be adapted to the fund rather than a ‘one-size-fits-all’ approach being taken to all funds operated by the manager; and
The nature of the vehicle (closed versus open ended), the redemption policy and LMTs, such as gates or side pockets, may be additional factors to take into consideration when determining the appropriate frequency of liquidity stress testing (LST).

The frequency should be justified in the liquidity stress testing (LST) policy. Factors which may increase the frequency of regulation liquidity stress testing (LST), include:

Higher unit dealing frequency.
Increased risks emanating from liabilities, such as a concentrated investor base.
Complex investment strategy (e.g. extensive use of derivatives).
Less liquid asset base.
Forthcoming event which could negatively affect fund liquidity. A highly liquid asset base.
Less frequent dealing in the fund’s unit.

6. The use of LST outcomes

The Guidelines state that liquidity stress testing (LST) should help ensure the fund is sufficiently liquid and help identify potential liquidity weaknesses, assist risk management monitoring and decision makings, and strengthen the manager’s ability to manage fund liquidity in the best interests of investors.

The liquidity stress testing (LST) should assist a manager in preparing a fund for a crisis, and in its broader contingency planning. This contingency planning may involve a manager’s plans to operationalise applying ex post a-LMT to a fund.

7. Adapting the LST to each fund

liquidity stress testing (LST) should be adapted appropriately to each fund, including:

The frequency of liquidity stress testing (LST);
The types and severity of scenarios;
The assumptions regarding investor behaviour and asset liquidation;
The complexity of the liquidity stress testing (LST) mode
In the case of an ETF, the specificities of ETFs, for example, by taking into account the role of authorised participants, redemption models and replication models.

8. LST scenarios

Liquidity stress testing (LST) should employ hypothetical and historical scenarios and, where appropriate, Reverse Stress Testing (RST). liquidity stress testing (LST) should not overly rely on historical data as future stresses may differ from previous ones.

ESMA suggest historical scenarios for liquidity stress testing (LST) could include the global financial crisis 2008-2010 or the European debt crisis 2010-2012. Hypothetical scenarios could include rising interest rates, credit spread widening, or political events.

Managers using Reverse Stress Tests (RST) should simulate assets being liquidated in a way that reflects how the manager would liquidate assets during a period of exceptional market stress. RST should take into account the treatment of remaining, as well as redeeming, unitholders as well as the role of transaction costs and whether or not fire sale prices would be accepted.

9. Data

Liquidity stress testing (LST) should demonstrate a manager is able to overcome limitations related to the availability of data, including by:

Avoiding optimistic assumptions;
Justifying reliance on third parties’ liquidity stress testing (LST) models, including where the model is developed by a third party portfolio manager; and
Exercising expert qualitative judgement.

10. Product development

During product development, a manager of a fund which requires authorisation from an NCA should:

Be able to demonstrate to NCA that key elements of the fund, including its strategy and dealing frequency enable it to remain sufficiently liquid during normal and stressed circumstances; and
Where appropriate, undertake liquidity stress testing (LST) on the asset side (using a model portfolio) as well as on the liability side, incorporating the expected investor profile both from the early and late stages of the fund’s existence.

11. Stress testing fund assets to determine the effect on fund liquidity

Liquidity stress testing (LST) should enable a manager to assess not only the time and/or cost to liquidate assets in a portfolio, but also whether such an activity would be permissible taking into account:

The objectives and investment policy of the fund;
The obligation to manage the fund in the interests of investors;
Any applicable obligation to liquidate assets at limited cost; and
The obligation to maintain the risk profile of the fund following liquidation of a portion of its assets.

Managers should reflect a significant number and variety of market stresses in the estimation of the liquidation cost and time to liquidation under stressed conditions, which are typically characterised by higher volatility, lower liquidity (e.g. higher bid-ask spread) and longer time to liquidate (depending on asset class). In this context, managers should not only refer to historical observations of stressed markets.

A manager should choose the method of liquidating assets in liquidity stress testing (LST) taking into account the assets and liabilities, as well as the redemption terms of the fund. The manager should also be aware of the method’s limitations and make conservative adjustments to its broader liquidity risk management to mitigate these limitations.

The method of liquidating assets in an liquidity stress testing (LST) should:

Reflect how a manager would liquidate assets during normal and stressed conditions in accordance with applicable rules, either legal requirements (according to the UCITS Directive), or limitations specific to the fund that are imposed in the prospectus or fund rules;
Ensure the model used for the fund is and stays in compliance with its objectives and investment policy and fund rules;
Reflect the fund being managed in the interests of all investors, both those redeeming and remaining;
Comply with applicable obligations for the fund to maintain the risk profile envisaged by fund documentation;
Be reflected in the liquidity stress testing (LST) policy;
Take into account, where relevant, the potential negative effects on other investors or on overall market integrity.

12. Stress testing fund liabilities to determine the effect on fund liquidity

Liquidity stress testing (LST) should incorporate scenarios relating to the liabilities of the fund, including both redemptions and other potential sources of risk to liquidity emanating from the liability side of the fund balance sheet.

Liquidity stress testing (LST) should incorporate risk factors related to investor type and concentration according to the nature, scale and complexity of the fund. ESMA has provided a table of examples of factors regarding investor behaviour which may be incorporated into the liquidity stress testing (LST) model, including:

Investor Category – Liquidity stress testing (LST) model may simulate funds of funds posing more redemption risk than other types of investors, and simulate their withdrawal from the fund first;
Investor Concentration – The manager may model one or a number of the largest investors redeeming simultaneously from the fund over a given period of time;
Investor Location – The manager may simulate a material proportion of investors located in a specific country redeeming over a given time period first; and
Investor Strategy – The manager may simulate redemptions from investors following similar strategies in stressed and normal market conditions.

13. LST on other types of liabilities

A manager should include other types of liabilities in its liquidity stress testing (LST) in normal and stressed conditions, where appropriate. All relevant items on the liability side of the fund’s balance sheet, including items other than redemptions, should be subject to liquidity stress testing (LST).

Liability examples and potential factors which may affect liquidity risk include:

Derivatives – change in the value of the underlying of the derivative leading to a larger than anticipated margin call.
Committed capital – unexpected event causing new/higher outlay of capital to a real estate investment.
Securities Financing Transactions / Efficient Portfolio Management – default of the counterparty to a securities lending operation.
Interest/credit payments – increased interest rates on the payment obligations of the fund.

14. Funds investing in less liquid assets

Risks arising from less liquid assets and liabilities risks should be reflected in the liquidity stress testing (LST).

Low probability, but high impact scenarios, including the potential difficulty of reliably pricing less liquid assets during a period of market stress, will be important in respect of less liquid assets. RST may be a particularly valuable tool in this context, helping to identify scenarios which could lead to significant fund liquidity risk (e.g. identifying scenarios which would lead to the imposition of special arrangements or suspensions).

Furthermore, fund of funds which gain indirect exposure to less liquid assets via their target funds should pay due regard to considerations relating to less liquid assets. This is due to the underlying exposure of those target funds which can result in the suspension of the target investment vehicle or other measures.

15. Combined asset and liability LST

After separately stress testing the assets and the liabilities of the fund balance sheet, the manager should combine the results of the liquidity stress testing (LST) appropriately to determine the overall effect on fund liquidity.

The guidelines state that managers should incorporate risk scoring into the liquidity stress testing (LST) where it enables an enhanced view of liquidity across the funds they manage, including in contingency planning and the operational preparation for a liquidity crisis.

16. Aggregating LST across funds

A manager should aggregate liquidity stress testing (LST) across funds under its management where it assesses such an activity to be appropriate for those funds.

Guidelines Applicable to Depositaries

A depositary should set up appropriate verification procedures to check that the manager of a fund has in place documented procedures for its liquidity stress testing (LST) programme.

The verification does not require the depositary to assess the adequacy of the liquidity stress testing (LST).

Where the depositary is not satisfied that liquidity stress testing (LST) is in place, it should take action as per any other evidence of a potential breach of rules by a manager. Depending on the national regime, this may require a depositary to inform (or require a manager to inform) the applicable NCA of the manager’s failure to comply with applicable rules.

The depositary does not need to replicate or challenge the liquidity stress testing (LST) undertaken by a manager.

Interaction with National Competent Authorities

NCAs may at their discretion request submission of a manager’s liquidity stress testing (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.

How Funds-Axis can help

Management Companies will need to assess the requirements in the ESMA liquidity guidelines against their current liquidity risk management practices, policies and reporting before the 30 September 2020 deadline.

The Funds-Axis liquidity risk management framework is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into the product governance, throughout the product lifecycle.

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