Stronger EU investment fund liquidity stress tests to begin in 2020

Managers of EU alternative investment funds (AIFs) and funds governed by the Undertakings for Collective Investment in Transferable Securities regime (UCITS) must regularly test the resilience of their funds to different types of market risks including liquidity risk, such as increased redemption requests by investors.

ESMA's new guidelines (46-page / 347KB PDF) should be applied by fund managers when designing the scenarios, policies and frequency of liquidity stress tests on the funds that they manage. The requirements are supplementary to the liquidity stress testing requirements already set out in the Alternative Investment Fund Managers Directive (AIFMD) and UCITS Directive.

ESMA said that the new guidelines would "allow convergence in the way [national regulators] supervise liquidity stress testing across the EU".

"The issue of liquidity is high on the agenda for regulators and the industry alike," said asset management expert Elizabeth Budd of Pinsent Masons, the law firm behind Out-Law. "ESMA has followed up these guidelines with a warning that although most funds would have sufficient liquidity to meet redemption requests if there were market shocks, there were what it described as 'pockets of vulnerability' in particular high-yield bond funds, who would struggle to meet redemption requests."

The guidelines recommend that liquidity stress tests be carried out quarterly, although a higher or lower frequency may be adopted depending on the size and risk profile of the fund. The AIFMD stipulates that liquidity stress tests must be carried out at least annually.

The guidelines recommend the use of 'reverse stress testing' alongside traditional stress testing where appropriate. This would require fund managers to assess the changes in circumstances that would make the business model unworkable, as well as the impact on the fund of those changes in circumstances. ESMA has decided not to make reverse stress testing mandatory following its consultation on the guidelines.

Fund managers should now notify national competent authorities where their stress tests uncover material risks to the fund, along with any actions taken to address those risks. The guidelines also introduce a new requirement that depositaries verify that the fund manager has put documented procedures for regular liquidity stress testing in place. However, depositaries are not required to review or challenge those procedures.

Elizabeth Budd said that liquidity was also an area of focus for the FCA in the UK. It is expected to publish a policy statement on illiquid assets and open-ended investment funds shortly, following its 2017 discussion paper (DP17/01) and 2018 consultation paper (CP18/27).

"Firms also need to be alert to the potential impact of Brexit on liquidity - not just on the funds themselves, but also on the products that invest heavily in funds, especially open-ended funds," she said. "A liquidity crisis could arise suddenly, and firms need to be alert to the potential impact of such a crisis and know what their possible options are in advance."