European Systemic Risk Board on liquidity and leverage risks in investment funds

On 14 February 2018, the European Systemic Risk Board (ESRB) published a Recommendation addressed to the European Securities and Markets Authority (ESMA) and the EU Commission on actions to address systemic risks related to liquidity mismatches and the use of leverage in investment funds.

It focuses on the following five areas:

  • Additional liquidity management tools for redemption;
  • Additional provisions to reduce the likelihood of excessive liquidity mismatches;
  • Stress testing for individual AIFs and UCITS;
  • Harmonised UCITS reporting; and
  • Guidance on Article 25 AIFMD: ESMA to develop guidance to help supervisory authorities to both assess leverage risks in the AIF sector and design, calibrate and implement macroprudential leverage limits.

Additional liquidity management tools for redemption
It is designed to address the risks that may arise when fund managers do not have adequate liquidity management tools in place such as swing pricing, redemption fees, redemption gates, or the ability to temporarily suspend redemptions.

In the absence of such tools, redemption pressures during times of declining asset prices could cause system-wide liquidity stress and exacerbate asset price falls, which could lead to risks to financial stability.

The goal is to increase the capacity of fund managers to deal with redemption pressures when market liquidity becomes stressed. It also calls for further clarification of the suspension of redemptions by NCAs.

Additional provisions to reduce the likelihood of excessive liquidity mismatches
It is designed to mitigate and prevent excessive liquidity mismatches in open-ended AIFs.

Some open-ended AIFs hold a large proportion of their investments in inherently less liquid assets. This includes investment funds that invest in real estate, unlisted securities, loans and other alternative assets.

There is a need for such investment funds to demonstrate their capacity to NCAs during both the approval process and thereafter that they are all able to maintain their investment strategy under stressed market conditions.

Stress testing
It is designed to promote coherent liquidity stress testing practices at the investment fund level. Stress tests are tools that help the fund manager identify potential weaknesses of an investment strategy and assist in preparing an investment fund for a crisis.

If used correctly, as a risk management and decision-making tool, a stress test should reduce liquidity risk at the investment fund level and contribute to lowering liquidity risk at the financial system level.

Harmonised UCITS reporting
Establishing a harmonised UCITS reporting framework across the EU to make it easier for authorities to monitor such funds and assess any risks to financial stability

Article 25 AIFMD
It provides for a macroprudential tool to limit leverage in AIFs. There is a need to clarify the use of this tool by developing a common approach to ensure that NCAs are able to use the tool in a harmonised manner. Therefore, guidance on a framework to assess leverage risks and on the design, calibration and implementation of leverage limits should be developed.

It advocates a proportionate framework for managing the systemic risks that may arise in, or be propagated by, the investment funds sector, while maintaining the key redemption features that attract investors to open-ended investment funds and facilitate collective investment.

Items to note:
De-minimis/ registered AIFMs are not targeted.

Otherwise, not only loan funds but every type of open-ended AIF is in scope.

The recommendations do not address any grand-gathering provision or transitory period.

Some (German) institutional investors, which are requires to invest in open-ended funds, will have to watch this space carefully.