Introduction to the ESMA report

Over the coming year, fund liquidity looks set to remain a regulatory and supervisory priority for the Central Bank of Ireland (“CBI”) and at a European supervisory level.

On the 2nd of September 2019, ESMA issued their Final Report Guidelines on Liquidity Stress Testing for UCITS and AIFs (ESMA Guidelines) which contained 16 guidelines for UCITS managers and AIFMs and one for depositaries. The ESMA Guidelines apply to all UCITS and AIFs, money market funds, ETFs, and leveraged closed-ended AIFs.

Fund managers will be required to comply with the ESMA Guidelines by stress testing the assets and liabilities of individual AIFs and UCITS they manage by adopting a liquidity stress testing (“LST”) policy and model. The LST must be appropriately adapted for each fund in line with the principles outlined in the ESMA Guidelines.

The ESMA Guidelines apply to both existing and new funds from the 20th of September 2020

Currently UCITS managers and AIFMs under their respective regulatory regimes have to have liquidity risk management processes in place for the funds they manage, The ESMA Guidelines will apply in addition to these existing requirements on liquidity stress testing. 

The ESMA Guidelines support the theme of common supervisory convergence in the way National Competent Authorities (“NCAs”) supervise liquidity stress testing across the EU. All NCA’s must ensure through their supervisory work that these guidelines are being complied with. The Central Bank of Ireland (“CBI”) in August 2019, prior to these guidelines being released, issued an industry letter stating the importance of ongoing, effective liquidity management and ensuring compliance with relevant legislation and regulatory obligations. In their letter the CBI highlighted the importance of fund management companies having in place an appropriate liquidity risk management framework. The CBI expects fund management companies to conduct ongoing assessments of the liquidity position of each fund’s portfolio, taking into account potential investor redemption requests.

In the CBI’s letter they confirm that the responsibility for liquidity risk management rests with the board of the fund management company, the individual directors and the relevant designated persons. It is interesting to note that in their letter the CBI specifically references the responsibility of “individual directors” in addition to the collective responsibility of the board of the fund management company.             

ACTION : Fund managers should review their existing policies and procedures to ensure that they comply with the ESMA Guidelines. 

12 key takeaways

On this, the 6th Day of our Deloitte 12 Days of Christmas Legal, Regulatory and Tax Updates 2019, in keeping with the festive theme we highlight 12 points for you to consider in relation to the ESMA Guidelines :

1. The LST should be integrated and embedded in the fund’s risk management framework supporting its liquidity management. The appropriate governance and oversight of the LST must be implemented, including the correct reporting lines and escalation procedures.
2. Fund managers will be required to adapt the ESMA Guidelines to the nature, scale, complexity, and liquidity profile of the fund.
3. An appropriate LST policy must be periodically reviewed and LST Policy and stress testing should provide outcomes which can be used to:
   - Ensure the fund is sufficiently liquid, as required by applicable rules and redemption terms stipulated in fund documentation.
    - Strengthen the ability of managers to manage fund liquidity in the best interests of investors, including in planning for periods of heightened liquidity risk.
   - Help identify potential weaknesses of an investment strategy, and assist in investment decision making.
   - Assist risk management monitoring and decision-making, including setting relevant limits regarding fund liquidity.
4. LST must be performed independently of other functions such as portfolio management and any conflicts of interest must be effectively managed. 
5. LST should be conducted at least annually and employed at all stages in a fund’s lifecycle, where appropriate. LST may need to be conducted more often depending on the characteristics of the fund (nature, scale, complexity and liquidity profile).
6. The LST must be a result of understanding the liquidity risk; arising from the assets and liabilities of the funds balance sheet. It must demonstrate a strong understanding of liquidity risks and a fund’s overall liquidity profile. 
7. LST should employ hypothetical and historical scenarios, they must not reply overly on historical data. 
8. During product development the fund manager must be able to show that the strategy and dealing frequencies will enable the fund to remain sufficiently liquid during stressed and normal circumstances.
9. LST should incorporate scenarios relating to the liabilities of the fund, including both redemptions and other types of potential sources of risk to liquidity emanating from the liability side of the fund balance sheet, for example margin calls under derivative contracts and counterparty risk from OTC transactions. LST should incorporate risk factors related to investor type and concentration, where appropriate. Reverse stress testing is not mandatory.
10. A fund manager should aggregate LST across funds under management where it assesses such an activity to be appropriate for these funds. 
11. A depositary should set up appropriate verification procedures to check that the manager of a fund has in place documented procedures for its LST. The depositary does not to access the adequacy of the LST replicate or challenge it. The depositary can do this by confirming that the fund’s risk management framework requires LSTs to be carried out. 
12. NCAs may request submission of the fund manager’s LST in order to demonstrate that the fund is likely to comply with applicable rules, including those regarding the fund’s ability to meet redemption requests in normal and stressed conditions. NCAs will also have the discretion to request information from fund managers regarding their LST models and the results of their stress tests.

For more help

Please contact us directly for more information on how Deloitte can assist fund managers’ to design, complete an independent review and validate your LST Policy and Model.