Regulatory scrutiny of mutual fund liquidity has been an ongoing area of focus for several years now. Regulators have already put exchange traded funds (ETFs) and money market funds (MMFs) under their microscope, but they are now intensifying that scrutiny on all open-ended investment funds, particularly in Europe. In tandem with certain high profile liquidity events in the market, there has also been a flurry of activity from European regulators on the theme of liquidity.
ESMA addresses Pan European Funds Liquidity
Earlier this year, the European Securities and Markets Authority (ESMA), conducted an industry consultation on 14 principles-based guidelines related to liquidity stress testing (LST) for UCITS and AIFMD funds. ESMA released their final report and guidelines on September 5, 2019 which will apply to all UCITS and AIFMD funds starting September 30, 2020.
During the consultation period, some managers expressed concerns that the one-year implementation timeline isn’t long enough. The required changes to core trade monitoring systems to adhere to the new liquidity stress testing regimes come with costs and such projects take time and resources to be implemented properly. Asset managers had requested a longer implementation period but ESMA rejected their appeals, in part to avoid any more high-profile liquidity events before the rules take effect.
Managers also raised concerns that liquidity data for certain asset classes is not readily available, and since it is so scarce, it can come with a hefty price tag from those who provide the data. Data costs are increasingly an area of focus for both asset managers and regulators. With this in mind, it’s possible that ESMA is already starting to look at data provisioning as seen in its recent assessment of MiFID II data costs.
Managers should note some of the key guidelines for LST that include:
- Validating models independently from the portfolio management function
- Using both historical and hypothetical scenarios
- Trying to reverse stress test, where appropriate
- Testing both the assets and liabilities of the fund
Other important takeaways from the guidelines include:
- MMFs are in scope of the guidelines to the extent that the requirements are not already covered by existing EUMMFR prevailing regulations.
- ETFs are also included in the scope of the requirements, despite comments from the industry that they should not be.
- LST is just one tool among many that can help fund managers combat liquidity risk.
- Access to the required liquidity data remains a chief concern of asset managers across all investment classes and markets, a point ESMA will come back to separately.
- The liquidity profile, nature, scale, and complexity of the fund determines the cadence of stress testing. Adjusting an LST program based on market conditions and other factors is central to its success.
- LST should be initiated prior to a fund launch. That entails stress tests in the product development stage, ideally via model portfolios.
Just days after releasing its LST guidelines, ESMA published its “Economic Report – Stress simulation for investment funds 2019.”
This report outlined findings from a liquidity stress testing simulation it conducted in tandem with Morningstar to over 6,000 UCITS bond funds. We expect data driven quantitative research such as this exercise to become the “new normal” for regulators. Regulators have better access to data thanks to regulatory reporting, and regulators like asset managers and other businesses will increasingly look to use technology to conduct their work and make better informed decisions.
ESMA specifically looked at redemption shocks (large redemption requests resulting from stressed market conditions). Results showed most funds proved their resiliency against liquidity risk and the ability to meet investors’ redemption requests, but it also identified some “pockets of vulnerabilities.” In particular, the report flags high yield bond funds as susceptible to liquidity shortfalls (i.e. holdings of liquid assets alone would not be capable of covering redemption requests in a shock scenario and less liquid assets would need to be sold to honor the redemptions.) The report suggests up to 40 percent of high yield bond UCITS fall into this category.
ESMA also calculated the likely consequences to the wider securities market of mass redemptions from funds. Mutual funds are only a sub-set of the financial markets, but a selloff in large mutual funds could exacerbate downward price and trading pressures in the wider markets. However, the report’s general assessment concluded that downward price pressure on fund assets was in fact relatively limited with exception of more limited liquidity assets such as high yield and emerging markets bonds, where a run on funds could have wider impacts.
Finally, ESMA shared its research methodology with national regulators to ensure the knowledge gained from this case study can benefit the day to day supervision of this sector.
A Global Theme
The focus on liquidity is playing out across the global mutual fund arena. We are seeing regulatory activity on both a regional and national level and expect the focus to only intensify as policymakers enshrine new rules and standards.
The most prominent mutual fund liquidity regulation work completed to date is in the US with the SEC’s Liquidity Rule, but several European regulators have also conducted their own market studies and incorporated reporting on fund liquidity including regulators in Belgium, France, and the Netherlands.
In the UK, the Financial Conduct Authority (FCA), published a report in January 2019, which identified growth in less liquid assets in UK-domiciled investment funds. Then in response to vocal criticisms of the FCA in the wake of the Woodford event, it appeared to indicate that a willingness to revise UCITS rules and perhaps consider the adopt a US-style definition of liquidity and bucketing system.
Last month, the Central Bank of Ireland (CBI) issued private a “Dear CEO” letter to all Irish fund management companies (ManCos) setting out prescriptive expectations to assess fund liquidity on an ongoing basis “taking into account investors redemption demands.” While both UCITS and AIFMD are already required to conduct liquidity stress testing, the new guidelines set down a principle-based approach to LST in order for ManCos to tailor their LST framework to allow for the nature, scale, and complexity of funds under management. The letter highlights the importance of the execution by fund management companies of an appropriately calibrated liquidity risk management for each fund, considering on an ongoing basis the fund’s dealing frequency, investment strategy, portfolio composition and investor profile.
And in Luxembourg, the EU’s largest fund domicile, regulators have recently been consulting with the industry aiming to enhancing its liquidity risk management framework for funds.