AIFMs, UCITs & Liquidity Stress Testing (LST)

The investment fund sector across Europe is well established, with jurisdictions like Cyprus growing steadily in the recent years. This has many national competent authorities, on their front foot seeking to enhance their legal and regulatory framework. As the primary aim of the regulator is to ensure the investor protection and overall transparency in services, this attitude is anticipated.

The characteristics of the investment products, the inherent risks and the diversity of investors, amplifies the risks of liquidity mismatches and the use of leverage in investment funds. As a result, the European Securities Market Authority (ESMA) and the European Systemic Risk Board (ESRB) are introducing a set of guidelines on liquidity stress testing (LST) for UCITS, AIFMs and AIFs.

The guidelines are to take effect on the 30th of September, 2020 and in this commentary the team at SALVUS discusses

1. The objectives of the liquidity stress testing
2. Who is in the scope of the new guidelines,
3. The fund managers’ obligations,
4. The depositaries and NCA’s (and CySEC) obligations.

1. The objectives of the liquidity stress testing (LST)

The ESMA and ESRB guidelines are based on micro-prudential liquidity stress testing and its objective is twofold

1. Promoting financial stability
   1. How? By mitigating liquidity risk.
2. Encouraging supervisory convergence across EU-domiciled funds and fund managers
   1. How? By setting minimum standards for liquidity stress testing.

The liquidity stress testing (LST) framework implemented by a fund manager aims to improve the operational capacity of the fund and the contingency planning during liquidity crisis. In a nutshell, beyond ensuring compliance with the regulation, the LST implementation will be there to allow the fund manager to

1. ensure that the fund is sufficiently liquid,
2. manage fund liquidity in the best interests of the investors,
3. to identify potential liquidity weaknesses of an investment strategy,
4. perform risk monitoring and decision making.

2. Who falls under the scope of the new guidelines?

The liquidity stress testing guidelines apply to

• UCITS,
• Open-ended AIFs,
• Leverage closed-ended AIFs,
• ETFs operating as UCITS or AIFs,
• Money Market Funds (MMFs).

The stakeholders affected by the Guidelines include fund managers, depositaries and national competent authorities (“NCAs”).

3. The fund managers’ obligations

The ESMA and ESRB guidelines require the fund manager to acquire strong understanding of the characteristics and the liquidity risks of each managed fund, either for the risks arising from the asset or the liability side.

The principle of proportionality applies and the liquidity stress testing (LST) shall be adapted to the nature, scale and complexity of the managed funds.

The guidelines applicable to the fund managers include

1. Design of the LST models
   1. the risk factors which impact the fund’s liquidity and the different types of scenarios should be validated in order to build the appropriate model.
2. Understanding the liquidity risks
   1. including the risks arising from the assets and liabilities of the fund’s balance sheet, and its overall liquidity profile.
3. Governance for LST
   1. shall be integrated and embedded into the fund’s risk management framework,
   2. shall be subject to appropriate oversight, including adequate reporting and escalation procedures.
4. LST policy
   1. must include the role of the senior management, the function in charge of performing and reporting the LSTs along with the appropriate results and recommendations,
   2. outline the reviews of the procedures and scenarios selected, the frequency chosen, and the methods used for liquidating assets.
5. Frequency of LST
   1. at least annually
   2. recommended to be quarterly,
   3. or more frequent as per the complexity of the investment strategy and liquidity of the asset,
   4. ad-hoc stress testing must be carried out if a material risk of fund liquidity is identified.
6. The use of LST outcomes
   1. ensure the fund is sufficiently liquid,
   2. identify potential liquidity weaknesses of the investment strategy,
   3. assist in investment decision-making and risk management monitoring,
   4. assist in preparing a fund for crisis and for contingency planning.
7. Adapting the LST to each fund
   1. as to the frequency, the types and severity of the LST scenarios on the identified stressed conditions,
   2. the complexity of the LST model.
8. LST scenarios
   1. historical and hypothetical scenarios should be used.
   2. where appropriate, reverse stress testing exercise can be considered.
9. Data availability
   1. the fund manager should avoid optimistic assumptions,
   2. expert quality judgment is recommended.
10. Product development
    1. the fund manager shall be able to demonstrate to NCAs (ie. CySEC) the key elements of the fund including the effectiveness of the LST.
11. Stress testing fund assets and liabilities to determine the effect on fund liquidity
    1. on the asset side, the fund manager should assess factors such the timing to liquidate and the liquidation costs.
    2. on the liability side, a key indicator is the redemptions and sources of risk emanating from the liabilities balance sheet. Risk factors related to the investor type and concentration as per the principle of proportionality shall be considered.
12. Funds investing in less liquid assets
    1. Real estate funds are particularly important on stress periods. Such funds are exposed to liabilities arising from serving and maintaining the assets.
13. Aggregating LST across funds
    1. the LST results derived separately on asset and liability side should be combined, in order to assess the overall effect of the fund liquidity.
    2. the fund manager shall aggregate LST across funds which employ similar investment strategy to gain a broader assessment of the liquidity risks.

4. How does the Guidelines affect depositaries and NCAs (and CySEC)?

1. Depositaries should set up appropriate verification procedures to check that the fund manager has in place documented procedures for its LST program.
   • The LST framework does not require the depositary to assess the adequacy of the LST.
2. NCAs (and CySEC) may at their discretion request submission of a manager’s LST to help demonstrate that a fund will be likely to comply with the applicable rules.
   • Fund managers should notify NCAs of material risks and actions taken to address them.

SALVUS risk management specialists are here to assist you on

• Gap-analysis of your current liquidity stress testing policy against the new ESMA guidelines,
• Designing your liquidity risk models and stress tests,
• Drafting or updating your LST policy,
• Reviewing and validating your LST models and assumptions.

Talk to us. Do not hesitate to contact us if you require further information. We will be glad to support you in finding a solution appropriate or answering your questions.

#StayAhead.

Should you be interested to read about relevant topics on the funds sector, feel free to visit our earlier articles:

• Is it all gloom and doom for hedge funds returns (YTD)?
• The Reasons AIFM, AIF and RAIF come to Cyprus
• The Cypriot AIF: legal forms, types and requirements
• The Cypriot RAIF: substance, requirements and tax
• The latest Cyprus Investment Funds Statistics – February, 2020

The information provided in this article is for general information purposes only. You should always seek professional advice suitable to your needs.