ESMA warns fund managers to improve readiness for future adverse shocks
17 November 2020 France
Image: dsheremeta/Adobe Stock
The European Securities and Markets Authority (ESMA) has told fund managers to improve readiness for future adverse shocks in its latest report ‘Recommendation of the European Systemic Risk Board (ESRB) on liquidity risk in investment funds’.
The report is in response to the ESRB’s recommendation to coordinate with national competent authorities (NCAs) a focused supervisory exercise on investment funds that have significant exposures to corporate debt and real estate assets.
The report identifies five priority areas for action which would enhance the preparedness of investment funds with significant exposures to corporate debt and real estate assets, for potential future adverse liquidity and valuation shocks.
One priority area identified to enhance the preparedness of the funds is the ongoing supervision of the alignment of the funds’ investment strategy.
In order to supervise compliance with rules on liquidity risk management, NCAs should continue their active engagement with, and supervision of, their market participants, ESMA said.
Misalignments between the liquidity profile of funds’ investments and their redemption policies should be corrected in a timely manner.
ESMA highlighted the introduction of these measures may take some time, as national provisions may provide for different requirements to be satisfied prior to their adoption, such as informing investors and obtaining authorisation by the regulator.
“In the context of the ESRB recommendation, this applies in particular to the funds analysed in this exercise if potential misalignments are confirmed by further analyses carried out by NCAs,” the authority noted.
According to ESMA, this monitoring should be taking into account all information at their disposal. Management companies should be able to justify the liquidity set-up of their funds, at the authorisation phase or during NCAs supervisory actions.
Meanwhile, particular attention should be paid to funds investing in less liquid or illiquid assets, ESMA stipulated.
The second priority area is the ongoing supervision of liquidity risk assessment. ESMA suggested that NCAs should supervise the liquidity risk assessment by management companies.
Particular attention should be paid to supervising management companies in their liquidity risk assessment to comply with their obligation to take all factors into account that could have an impact on funds liquidity or that could trigger unwanted sales of assets, it explained.
Additionally, the report highlighted that all relevant items on the liability side of the fund balance sheet should be subject to liquidity stress tests.
The third priority is fund liquidity profiles. In the context of the Alternative Investment Fund Managers Directive (AIFMD) review, additional specifications on how liquidity profiles should be established and reported as part of the AIFMD reporting should be introduced, according to ESMA.
This includes how, on the asset side, to determine a “realistic and conservative estimate” of which percentage of the fund portfolio can be liquidated.
Secondly, it includes, on the liability side, how to take into account arrangements with respect to gates and notice periods in the determination of investor liquidity profiles.
It was noted in the report that this is important to ensure necessary information on liquidity profiles and to support a risk-based approach in the supervision of liquidity risks mentioned in the first priority.
Elsewhere in the report, ESMA explained the fourth priority deals with the increase of the availability and use of liquidity management tools.
ESMA reiterates its support for the ESRB recommendation calling for a harmonised legal framework to govern the availability of additional liquidity management tools for fund managers in both the UCITS and AIFM frameworks.
It was stipulated that the legal framework should also include specifications on the required disclosures for the provision and use of liquidity management tools to ensure greater protection and consistency for investors.
The last priority area involves the supervision of valuation processes in a context of valuation uncertainty.
As part of its ongoing supervision of management companies, ESMA said NCAs should carry out further supervisory activities to ensure that management companies valuation procedures cover all market situations including valuation approaches for stressed market conditions.
“The circumstances of delegated portfolio management should be taken into account to ensure
that the team in charge of the valuation has sufficient expertise and access to information to
analyse the reliability of the valuation sources it uses and establish a fair valuation of the portfolio,” the authority affirmed.
Steven Maijoor, chair of ESMA, commented: “In the wake of COVID-19’s initial impact on markets, the EU investment fund industry faced a significant deterioration in liquidity in some segments of the fixed income markets as well as valuation uncertainty in the real estate sector. This coincided with large-scale investment outflows from investors.”
He continued: “ESMA coordinated a supervisory exercise with national securities regulators involving collecting and analysing data on funds exposed to corporate debt and funds exposed to real estate. The exercise showed that the funds in question managed to respond adequately to redemption pressures.”
“However, the work also revealed shortcomings that must be addressed in order to enhance funds’ preparedness to future shocks, and we have identified a number of priority areas that funds and supervisors should focus on to address potential liquidity risks in the fund sector. This will contribute to ensuring investor protection, orderly markets and financial stability.”
“We also encourage swift proposals to amend the EU legislative framework to ensure that liquidity management tools are widely available to asset managers across the EU,” Maijoor added.
The report is in response to the ESRB’s recommendation to coordinate with national competent authorities (NCAs) a focused supervisory exercise on investment funds that have significant exposures to corporate debt and real estate assets.
The report identifies five priority areas for action which would enhance the preparedness of investment funds with significant exposures to corporate debt and real estate assets, for potential future adverse liquidity and valuation shocks.
One priority area identified to enhance the preparedness of the funds is the ongoing supervision of the alignment of the funds’ investment strategy.
In order to supervise compliance with rules on liquidity risk management, NCAs should continue their active engagement with, and supervision of, their market participants, ESMA said.
Misalignments between the liquidity profile of funds’ investments and their redemption policies should be corrected in a timely manner.
ESMA highlighted the introduction of these measures may take some time, as national provisions may provide for different requirements to be satisfied prior to their adoption, such as informing investors and obtaining authorisation by the regulator.
“In the context of the ESRB recommendation, this applies in particular to the funds analysed in this exercise if potential misalignments are confirmed by further analyses carried out by NCAs,” the authority noted.
According to ESMA, this monitoring should be taking into account all information at their disposal. Management companies should be able to justify the liquidity set-up of their funds, at the authorisation phase or during NCAs supervisory actions.
Meanwhile, particular attention should be paid to funds investing in less liquid or illiquid assets, ESMA stipulated.
The second priority area is the ongoing supervision of liquidity risk assessment. ESMA suggested that NCAs should supervise the liquidity risk assessment by management companies.
Particular attention should be paid to supervising management companies in their liquidity risk assessment to comply with their obligation to take all factors into account that could have an impact on funds liquidity or that could trigger unwanted sales of assets, it explained.
Additionally, the report highlighted that all relevant items on the liability side of the fund balance sheet should be subject to liquidity stress tests.
The third priority is fund liquidity profiles. In the context of the Alternative Investment Fund Managers Directive (AIFMD) review, additional specifications on how liquidity profiles should be established and reported as part of the AIFMD reporting should be introduced, according to ESMA.
This includes how, on the asset side, to determine a “realistic and conservative estimate” of which percentage of the fund portfolio can be liquidated.
Secondly, it includes, on the liability side, how to take into account arrangements with respect to gates and notice periods in the determination of investor liquidity profiles.
It was noted in the report that this is important to ensure necessary information on liquidity profiles and to support a risk-based approach in the supervision of liquidity risks mentioned in the first priority.
Elsewhere in the report, ESMA explained the fourth priority deals with the increase of the availability and use of liquidity management tools.
ESMA reiterates its support for the ESRB recommendation calling for a harmonised legal framework to govern the availability of additional liquidity management tools for fund managers in both the UCITS and AIFM frameworks.
It was stipulated that the legal framework should also include specifications on the required disclosures for the provision and use of liquidity management tools to ensure greater protection and consistency for investors.
The last priority area involves the supervision of valuation processes in a context of valuation uncertainty.
As part of its ongoing supervision of management companies, ESMA said NCAs should carry out further supervisory activities to ensure that management companies valuation procedures cover all market situations including valuation approaches for stressed market conditions.
“The circumstances of delegated portfolio management should be taken into account to ensure
that the team in charge of the valuation has sufficient expertise and access to information to
analyse the reliability of the valuation sources it uses and establish a fair valuation of the portfolio,” the authority affirmed.
Steven Maijoor, chair of ESMA, commented: “In the wake of COVID-19’s initial impact on markets, the EU investment fund industry faced a significant deterioration in liquidity in some segments of the fixed income markets as well as valuation uncertainty in the real estate sector. This coincided with large-scale investment outflows from investors.”
He continued: “ESMA coordinated a supervisory exercise with national securities regulators involving collecting and analysing data on funds exposed to corporate debt and funds exposed to real estate. The exercise showed that the funds in question managed to respond adequately to redemption pressures.”
“However, the work also revealed shortcomings that must be addressed in order to enhance funds’ preparedness to future shocks, and we have identified a number of priority areas that funds and supervisors should focus on to address potential liquidity risks in the fund sector. This will contribute to ensuring investor protection, orderly markets and financial stability.”
“We also encourage swift proposals to amend the EU legislative framework to ensure that liquidity management tools are widely available to asset managers across the EU,” Maijoor added.
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