ESMA To Release New Liquidity Stress Testing Guidance In Early 2019

For the most part, asset managers deal with risks according to market best practices. But what about risks for which best practices haven't yet been fully established? Liquidity risks are one such area, and consequently regulators have been focusing on providing more guidance.

To that end, in February 2018, following the work of the Financial Stability Board (FSB) and the International Organization of Securities Commission (IOSCO), the European Systemic Risk Board (ESRB) published its recommendations on liquidity and leverage risks in investment funds.

Investment funds, because they gather money from a wide variety of investors in order to put it into the market, represent a source of systemic risk. Open-ended funds are of particular interest to regulators, since they allow investors to frequently redeem money, potentially forcing asset managers to sell assets on a significant scale in a falling market, triggering spirals in price. Another source of systemic risk is illiquidity, which can expose assets to the risk of unexpectedly high redemption demands. Since market conditions can change very quickly, asset managers may end up having to rely on levels of liquidity less resilient than expected.

Liquidity risk management, for all these reasons, is thus immensely important.

To enhance the liquidity risk management framework, the European Securities and Markets Authority (ESMA), building on IOSCO's and ESRB's recommendations, plans to release guidance on investment fund stress-testing. Its first draft is expected by June 2019, and will probably define stricter rules for such tests.

Why does liquidity risk need further guidance?

An ESRB survey revealed that such tests, although conducted regularly by most EU fund managers, differ widely in complexity, frequency, and type of scenario used. For instance, many fund managers determine the frequency of stress tests based on an arbitrary firm-wide policy, rather than taking the fund's specificities into account. Additionally, the scenarios tested are often not representative enough to properly capture risks arising from market turbulence or redemption flow spikes.

ESMA has previously published guidelines on stress test scenarios, but the guidelines only apply to money market funds on which consultations are open. The guidance expected in June 2019, on liquidity stress testing at the investment fund level, should have a broader scope.

The target capability

Ultimately, asset managers will need to be...