On 13 November 2020, ESMA released its findings following the co-ordinated NCA supervisory review during February- March 2020 of liquidity in UCITS and AIFs with large corporate debt and property exposure (Report). The review was undertaken in response to recommendations of the ESRB for an assessment of such funds' preparedness for future redemptions and valuation shocks. See our briefing (Central Bank Data Requests Issued to Corporate Debt & Real Estate Funds) for the background to this Report.
Overall Findings
While ESMA acknowledges that, "overall the investment funds under review managed to maintain adequately their activities when they faced redemption pressures and episodes of valuation uncertainty" it considers that the findings "need to be interpreted with caution for many reasons" including the limitation of market stress as a result of Central Bank actions and the identification of potential deficiencies in liquidity risk management or valuation processes under stressed market conditions. As a result, the Report sets out several follow up recommendations for fund management companies and NCAs:
- Review of Liquidity Risk Management Processes: funds/their managers should ensure compliance of liquidity risk management processes with applicable rules. In particular, processes should assess all liquidity risks (most funds analysed failed to take account of redemption shocks and shocks on collateral) and take account of the factors that could trigger unwanted sales of assets, such as (i) margin calls which may increase cash needs in case of renewed heightened market volatility, and (ii) loan covenants in property funds. Furthermore, all relevant items on the liability side of the fund balance sheet other than redemptions should be subject to liquidity stress tests as set out in the Guidelines on Liquidity Stress Testing in UCITS and AIFs.
- Review of Valuation Policies and Procedures: funds/their managers should include provision in their valuation policies and procedures for the valuation of assets in a stressed environment. NCAs are recommended to ensure that funds' valuation procedures provide clear rules for the use of the different valuation methods, and particularly the possibility to switch from one method to another under stressed market conditions. Funds/their managers should not use mark-to-model when mark-to-market provides a reliable value of the asset.
- Increased AIFMD Reporting: AIFMD reporting rules should be amended to introduce additional specifications on how liquidity profiles are established and reported. This includes (i) on the asset side, how to determine a realistic and conservative estimate of which percentage of the fund portfolio can be liquidated (estimate for each asset class based on reliable methodology and data), and (ii) on the liability side, how to take into account arrangements with respect to gates and notice periods in the determination of investor liquidity profiles.
- UCITS Reporting Framework: as per ESMA's recent AIFMD Review letter (see previous briefing for details), a UCITS reporting framework should be introduced which reflects the reporting requirements applicable to AIFMs.
- Continuing Supervisory Engagement: ESMA encourages NCAs to continue to pursue engagement on, and supervision of, funds' compliance with liquidity risk management rules. This could take the form of supervisory action on the implementation of ESMA's liquidity stress testing guidelines and/or liquidity profiling of funds.
Next Steps
ESMA has urged fund managers to "step up their efforts to ensure that the [liquidity] requirements are adequately complied with". ESMA has also asked national regulators to pursue ongoing compliance with the liquidity requirements. Funds and their managers can expect ESMA's recommendations to be a feature of future Central Bank supervisory engagements and would be well advised to take this opportunity to review existing liquidity and valuation policies and procedures in light of ESMAs above summarised recommendations.
Originally Published by William Fry, December 2020
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