Liquidity Stress Testing (LST)

The steady growth of the investment fund sector in recent years, the abundance of different investment strategies and the diversity of the investor base have amplified the risks of potential liquidity mismatches on investment fund level, between the liquidity of the funds’ assets and the liquidity offered to its investors. In that context, ESMA published the Final Report “Guidelines on liquidity stress testing in UCITS and AIFs” in September 2019 (ESMA 34-39-882, hereinafter referred as “Guidelines”), subsequent to the recommendations published by the European Systemic Risk Board in February 2018, and a consultation phase in April 2019.

The Guidelines focus on micro prudential liquidity stress testing and its objectives are twofold (i) fostering financial stability by mitigating liquidity risk and (ii) promoting supervisory convergence across EU-domiciled funds and fund managers by setting minimum standards for liquidity stress testing.

The final report confirms the scope of the Guidelines containing UCITS, open-ended AIFs, closed-ended and leveraged AIFs, including ETFs and MMFs – where relevant. The stakeholders affected by the Guidelines include asset managers, depositaries and national competent authorities (“NCAs”).

The Guidelines will apply in addition to existing requirements on liquidity stress testing set out in the AIFMD and the UCITS regulatory frameworks.

The Guidelines take effect from the 30^th of September 2020.

How shall a good LST contribute to achieving the Objective?

The LST framework implemented by an asset manager should improve the operational capacity and preparedness for a liquidity crisis and be integral part of the contingency planning by:

(i) helping to ensure that the fund is sufficiently liquid;
(ii) allowing the asset manager to manage fund liquidity in the best interests of investors;
(iii) helping to identify potential liquidity weaknesses of an investment strategy; and
(iv) being a valuable risk monitoring and decision making tool.

What do the Guidelines require from asset managers?

The Guidelines require the asset manager having a strong understanding of each managed fund’s liquidity risk arising from the asset and liability side and its overall liquidity risk. Furthermore, the Guidelines set down a principle-based approach to LST requiring the asset manager to implementing the Guidelines taking into account the nature, scale and complexity of the fund(s) under management. Its requirements and recommendations/suggestions to asset managers inter alia include:

• The frequency to carry out LST is at least annually, however recommended to be quarterly. Dealing frequency, complexity of investment strategy and liquidity of asset base are amongst other defining criteria to determine the fund-specific frequency. Ad-hoc stress testing must also be carried out “as soon as practicable” if a material risk to fund liquidity is identified while the definition of materiality is at the asset manager’s discretion.
• The governance principles for LST requires it to be properly integrated and embedded into the fund’s risk management framework supporting liquidity management and be subject to appropriate governance and oversight, including appropriate reporting and escalation procedures.
• The LST framework should be documented in an LST policy within the UCITS and/or AIF RMP and should address, amongst other items, the role of senior management, the function in charge of performing the LST and the reporting and escalation structure in place. In addition, the LST policy should outline review procedures and provide justification for the scenarios selected, the frequency chosen and underlying method for liquidating assets.
• The LST model and assumptions underpinning them should be validated initially, performed independently from the portfolio management function however the entity/person need not be external to the asset manager. The alignment between assumptions used and potential limitation in data availability must be ensured.
• The type and severity of scenarios selected for the LST should be adapted to each fund. Both historical and hypothetical scenarios should be used acting with caution when using historical data in order to avoid overreliance given that future stresses may differ from previous stresses and historical data may not provide sufficiently severe examples of stressed conditions. Where appropriate, reverse stress testing should be used.
• On the asset side, the LST should be enable to assess the time to liquidate and liquidation costs. When assessing these under stressed conditions the effect of relevant factors (asset type, liquidation horizon, the size of the order, etc.) and the ability/permissibility to do so should be accounted for.
• On the liability side, the Guidelines confirm redemption (subject to investor type and concentration) as a key indicator and emphasize the need to incorporate scenarios relating to other liabilities such as margin calls, interest payments, committed capital and EPM arrangements (repos, reverse repos).
• LST results derived separately on asset and liability side should be combined, in order to assess the overall effect on fund liquidity. Where appropriate, LST should be aggregated across funds that employ similar investment strategy to gain a broader assessment of its liquidity risks, in particular when funds operated by the asset manager own a material level of assets in a given market.

How does the Guidelines affect depositaries and NCAs?

• Depositaries should set up appropriate verification procedures to check that the fund manager has in place documented procedures for its LST program, whereas such verification does not require assessment of the adequacy of the LST.
• NCAs may at their discretion request submission of a manager’s LST to help demonstrate that a fund will be likely to comply with applicable rules or other information relating to the LST, including liquidity stress test models and their results.

How can Deloitte help?

Deloitte’s risk management specialists leverage on market intelligence and industrial expertise when assisting you to:

• Perform a gap-analysis of your current liquidity stress testing policy against ESMA guidelines
• Design your liquidity risk models and stress tests
• Draft or update your LST policy
• Review and validate your LST models and assumptions underpinning them
• Provide liquidity stress testing trainings either tailor-made or via our Quant Master Class series
• Provide regular liquidity stress testing reports