Final governance published at the start of this month will come into force from September 2020.
The guidance comes in the wake of liquidity problems at several high-profile fund management firms including Woodford Investment Management and Natixis H20, London-based firms which are currently under ESMA authority before the UK leaves the European Union.
The guidance, which comes into force in September next year, applies to both UCITs and Alternative Investment Funds.
It says: “ESMA notes that the minimum legal requirement to perform LST is annual under the AIFMD. However, ESMA recommends a quarterly frequency for LST and recognises that there are situations where a higher or lower frequency is necessary.”
Funds will have to make the case for tests of more or less frequency. The guidance says that tests must be quarterly, “unless a higher or lower frequency is justified by the characteristics of the fund”.
That justification must be recorded in the liquidity stress test policy.
ESMA has published industry feedback alongside the guidance which notes concerns from the fund industry about costs, the need for expert validation and the type of funds included.
Some asset managers have also warned about the scarcity of market data about some asset classes.
The feedback notes: “Many respondents noted that the proposed guidelines will require fund managers to design additional systems and to develop and implement IT solutions. They also pointed out that given the scarcity of market data, in particular for some asset classes, the sourcing of good quality data might represent a substantial cost increase. Several respondents also indicated that a change in liquidity stress testing frequency and the obligation of validation of all estimates by an independent expert would entail additional costs.”
Case made to exclude some funds
Some asset managers also made a case excluding money market funds, some forms of closed ended funds and ETFS usually citing overlap with existing regulations.
ESMA says it has agreed to narrow the scope of the regulation for money market funds but otherwise rejects these proposals.
The paper says: “In order to reduce the potential for conflict, ESMA has decided to narrow the scope of applicable provisions to money market funds, focusing on those parts of the guidelines not already covered in the Money Market Funds Regulation (MMFR) rules. ESMA has also kept the provision that in case of conflict, the MMFR rules apply.”
Regarding ETFs and some closed funds, it says: “ESMA has clarified that these guidelines apply in addition to requirements in the ESMA ETF guidelines. Leveraged closed ended alternative investment funds (AIFs) have also been retained in the scope of the guidelines.”
Broadly under the guidelines, fund managers will be required to stress test both the assets and liabilities of the funds they manage.
This includes stress-testing against redemption requests by investors which ESMA describes as the most common and important source of liquidity risk. It notes that such liquidity stresses could also impact financial stability of the system.
The accompanying statement says: “Managers of AIFs and UCITS must be aware of the liquidity risk of the funds they manage and use stress testing as a tool to mitigate this risk. EU-based funds need to regularly test the resilience of their funds to different types of market risks, including for liquidity risk.”
ESMA suggests that the guidelines will foster what it describes as supervisory convergence. It says common requirements will allow convergence in the way national competent authorities (NCAs) supervise liquidity stress testing across the EU.
The guidelines also recommend managers notify NCAs of material risks and actions taken to address them.
Earlier this year, the UK’s Financial Conduct Authority’s chief executive Andrew Bailey suggested that Woodford Investment Funds had been able to exploit loophole in EU regulations, but as Expert Investor Europe reported the European Commission hit back and saying it was UK supervision which was lacking.
The publication of the ESMA Guidelines follows recommendations by the European Systemic Risk Board (ESRB) published in April 2018 on how to address liquidity and leverage risk in investment funds.
ESMA says the requirements set out in the guidelines are supplementary to the requirements on liquidity stress testing which are enshrined in the AIFMD and UCITS Directives and are already applicable.