Embedding ESMA’s new guidelines around liquidity stress testing for investment funds

How prepared are you to meet the new requirements?

The importance of managing liquidity risk takes centre stage on the regulatory agenda for investment funds this month, as ESMA’s new guidelines on Liquidity Stress Testing (LST) come into force on 30 September 2020.

UCITS and AIFs are expected to align themselves to the new guidelines for monitoring and managing liquidity risk, which add on to the LST requirements already embedded in the AIFMD and UCITS Directives.

Liquidity Risk Framework in Investment Funds

Key objectives of the new guidelines

ESMA’s new guidelines come into force at a time of heightened volatility due to the COVID-19 pandemic, which has depressed asset prices and led to a deterioration in liquidity in financial markets.

By introducing these new guidelines, regulators hope to safeguard investors and mitigate the systemic risk which may arise as a result of increased redemption requests.

These guidelines also serve to achieve further convergence in the supervision of LST by national authorities across Europe.

Who are the LST Guidelines relevant to?

The LST guidelines are relevant to UCITS and AIF (or NAIF) funds, their fund managers (or those responsible for asset management in the case of self-managed funds), and their depositories.

From a governance perspective, the LST should be performed at least annually, and be review and approved by the Board of Directors of the fund.  

What’s in the LST Guidelines?

ESMA’s LST guidelines introduce a number of important requirements, including:

  • Fund managers are expected to conduct liquidity stress testing on the assets and liabilities of the funds they manage. This includes stressing prospective redemption requests by investors, which is the most common and important source of liquidity risk and could also impact financial stability.
  • In conducting LST, fund managers will need to apply a comprehensive set of guidelines when designing stress scenarios and policies, and determining the frequency of liquidity stress tests for the funds they manage.
  • EU-based funds are expected to regularly test the resilience of their funds to different types of market risks, including for liquidity risk.
  • Depositaries are required to verify that fund managers have in place documented procedures as part of the liquidity stress testing programme.

The bottom line

Asset managers should be able to demonstrate to the regulator that the fund meets all the regulatory requirements and is able to meet redemption requests under both normal and stressed scenarios.

Furthermore, managers are expected to notify the regulator in case of the emergence of material liquidity risks, and the mitigating actions undertaken. The regulator may also request information about the fund’s liquidity stress testing framework and its results.

How can we help?

Stress testing policy gap analysis.

Current state assessment of your alignment with the new regulation and guidelines, including a review of your liquidity risk framework to ensure full compliance.

Liquidity risk governance support.

Assistance in defining and evaluating the effectiveness and compliance of your liquidity governance framework, including your liquidity stress test policy, contingency liquidity plan and redemption and liquidation strategies.

Design and validation of methodologies.

Support in designing and reviewing your liquidity risk and stress testing methodologies in line with best practice. This includes development of stress test scenarios and the assumptions underpinning them.

Drafting and implementation of policies and procedures.

Assistance in the design and implementation of liquidity risk policies and procedures along with reporting and monitoring processes and liquidity management tools.

Stress testing and liquidity risk training.

Provision of training and support by Deloitte specialists, including Board and executive training and differentiated learning modules for members of staff at all levels.

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