UCITS Liquidity Risk Management: ESMA’s 11 Areas for Improvement
ESMA has published the results of the 2020 Common Supervisory Action (CSA) on UCITS liquidity risk management (LRM).
UCITS are characterised by the offer to investors of on-demand liquidity. Article 84(1) states that UCITS shall repurchase or redeem its units at the request of any unit-holder. If the assets held within the fund cannot be sold quickly to meet redemption requests, there could be severe issues in paying redeeming investors. This can be exacerbated in times of stress when investors may look to redeem en masse whilst the market for the assets is drying up.
UCITS have no specific limits in respect of minimum liquidity.
However, the UCITS regulatory framework does include a broad range of liquidity risk management provisions, which aim at ensuring that UCITS investors are able to redeem their investments on request. These include:
- They must be Open Ended
- Asset Eligibility in terms of holding liquid UCITS eligible instruments
- Diversifications Rules – known as the “5/10/40” rule
- Borrowing Limits
- 100% limit to incremental leverage through derivatives; and
- Concentration & Control Limits
Additionally, further liquidity obligations stem from Implementing Directive 2010/43/EU.
Key requirements include:
Article 38(1) requiring management companies to establish, implement and maintain an adequate and documented risk management policy which identifies the risks the UCITS they manage are or might be exposed to, including, that of liquidity risk.
Article 40(3) requiring management companies to employ an appropriate liquidity risk management process in order to ensure that each UCITS they manage is able to comply at any time with Article 84(1) which as previously mentioned, requires a UCITS to repurchase or redeem its units at the request of any unit holder.
Although not expressly in the text of the Level 1 Directive, stress-tests have become a core requirement for UCITS funds. Article 40(3) continues by specifically including provisions requiring UCITS management companies to conduct where appropriate, stress tests which enable the assessment of the liquidity risk of the UCITS under exceptional circumstances.
Paragraph 4 goes on to state that Member States shall require management companies to ensure that for each UCITS they manage, the liquidity profile of the investments of the UCITS is appropriate to its redemption policy.
Additionally, we have the CESR’s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS which stipulates that stress tests should be adequately integrated into the UCITS risk management process and the results should be considered when making investment decisions for the UCITS.
Moreover, the Guidelines anticipate quantitative and qualitative requirements for the risks to be covered and the appropriate design, frequency and procedures that need to be in place.
We also now have ESMA’s 16 Guidelines on Liquidity Stress Testing and the recommendations of the European Systemic Risk Board (ESRB) on liquidity risk in investment funds.
Throughout 2020, regulators focused on liquidity, and as we settle into 2021, this theme shows no signs of letting up.
ESMA’s Common Supervisory Action with NCA on UCITS Liquidity Risk Management
On 30th January 2020, ESMA launched a Common Supervisory Action (CSA) on UCITS liquidity risk management (LRM). The purpose of the exercise was to simultaneously conduct coordinated supervisory activities in 2020 and to assess whether UCITS managers comply with their liquidity management obligations.
The first stage of the CSA involved NCAs requesting and analysing quantitative data from a large majority of the UCITS managers based in their respective Member States, to get an overview of the supervisory risks faced.
In the second stage, NCAs focused on a sample of UCITS managers and UCITS to carry out more in-depth supervisory analyses.
Overall, most UCITS managers demonstrated that they have implemented and applied sufficiently sound LRM processes. However, in a few cases, some adverse supervisory findings were identified.
NCAs reported areas of improvements with regard the following topics:
11 Reported Areas of Improvement
In some cases, documentation was not available or a lack of granularity/clarity was detected in various key areas such as pre-investment liquidity analyses and forecasts, design phase, escalation processes and verification of data reliability. This observation is in spite of regulatory obligations requiring that relevant activities should be written and documented.
Issues with the quality of the written LRM procedures were detected in some cases. Observations included in some instances, procedures not providing documentation of the LRM arrangements, processes and techniques or did not cover all asset types or the use of LMTs (from the analysis during the product design phase to their ongoing use, etc.). In a few isolated cases, no written LRM procedures were put in place.
In some cases, the methodology was not always appropriate, not forward-looking and, more frequently, not justified and back-tested. For example, insufficient pre-investment checks – measurement of liquidity in pre-investment analyses and forecasts, consideration of portfolio impact, – or ongoing monitoring – absence of analyses involving all liabilities, lack of investors behaviour modelling and forward-looking estimates, verification of data quality were observed.
In some particularly worrying cases, margin calls were not considered at all.
Additionally, in some cases, LRM mechanisms and methodology were too static, with questions raised on the accuracy of LRM modelling during market downturns – including the accuracy of the data used for modelling the liquidity which should give due consideration to the prevailing market circumstances. This may result in unrealistically stable or even improving liquidity forecasts in crisis time.
In some cases, UCITS managers placed an overreliance on the presumption of liquidity referred to in Article 2(1) of the UCITS Commission Directive 2007/16/EC (UCITS Eligible Assets Directive) where they invested in listed securities.
Additionally, without dedicated follow-ups on securities presumed liquid, some ongoing controls were insufficient as they were not based on reliable data on volumes e.g. past volumes, number of brokers and trading size.
The mere lack of any data on volumes should be considered as possible evidence of the lack of sufficient liquidity and would need to be further investigated.
5. Liquidity presumption to financial instruments which are not on a regulated market in violation of Article 2(1) of the UCITS Eligible Assets Directive
NCAs investigations revealed that a few specific supervised entities had applied the presumption of liquidity to all assets, including financial instruments which are not admitted to or dealt in on a regulated market under the conditions set out in Article 50(1) of UCITS Directive 2009/65/EC, where overall portfolio liquidity was deemed sufficient.
In these cases, no liquidity analysis and forecasts were performed for investments subject to Article 50(2)(a) of the UCITS Directive 2009/65/EC, which allows for investments in unlisted securities up to a limit of 10%.
Performing no pre-investment liquidity analyses and forecasts for these financial instruments is not compliant with the UCITS framework and should therefore be further investigated.
Some NCAs identified a few cases where the entity to whom the portfolio management function was delegated effectively also performed the LRM functions. Those cases also revealed an insufficient involvement of the internal risk management function, as well as insufficient delegation monitoring and due diligence. Moreover, the simultaneous delegation of portfolio and risk management functions to the delegate should not be allowed as it contravenes to UCITS delegation and substance rules.
In some cases, NCAs observed a widespread lack of data quality checks in a context of overreliance on very few data providers. In those cases, UCITS managers had not implemented robust and documented control processes, based on cross-checks and back-tests to ensure that they use sound and reliable data as explicitly required by the UCITS Directive.
NCAs reported some cases of missing, inaccurate, or unclear disclosures on liquidity risks and LMTs to investors in UCITS KIID and/or prospectus.
In some cases, insufficient (in terms of frequency, granularity and clarity) and, more rarely, absence of reporting to senior management were detected.
Some processes raised questions regarding the soundness and documentation of the decision-making process, in particular with regard to escalation process or analyses conducted during the design phase.
In some cases, NCAs detected no regular second and third-level controls of LRM policies and procedures, and identified a strong need to strengthen the overall control framework as both compliance and internal audit functions were not performing sufficient controls with respect to LRM processes. In such cases, these control functions have not been able to detect most of the shortcomings and regulatory breaches identified by NCAs in the course of the CSA.
External controls by the depositary and external auditors of the UCITS and UCITS managers are not performed in all cases. With respect to controls by external auditors, this might also be explained by diverging national rules and practices regarding the scope of audit.
Market participants should critically review their LRM frameworks to ensure that none of the adverse supervisory findings referred to above are to be found in their LRM frameworks. Market participants should also ensure compliance with all relevant UCITS regulatory requirements and associated EU and national guidance at all times.
NCAs will be following up on individual cases to ensure that regulatory breaches as well as other shortcomings or weaknesses identified are remedied.