As part of its actions to address the impact of COVID-19 on the financial system from a macroprudential perspective, on 6 May 2020, the European Systemic Risk Board (“ESRB”) published a recommendation to address liquidity risk in investment funds, requesting that ESMA:
- coordinates with the EU national competent authorities (including the CSSF) (the “NCAs”) to undertake a focused piece of supervisory exercise with investment funds that have significant exposures to corporate debt and real estate assets to assess the preparedness of these two segments of the investment funds sector to potential future adverse shocks, including any potential resumption of significant redemptions and/or an increase in valuation uncertainty; and
- reports to the ESRB on its analysis and on the conclusions reached regarding the preparedness of the relevant investment funds.
On the basis of the data collection questionnaire prepared by ESMA, the CSSF asked, in July 2020, a large sample of selected UCITS as well as alternative investment funds to complete a questionnaire through the CSSF’s eDesk portal.
On 12 November 2020, ESMA published a report (the “ESMA Report”) setting out its analysis and conclusions. Overall, the funds exposed to corporate debt and real estate under review managed to adequately maintain their activities when facing redemption pressures and/or episodes of valuation uncertainty. The analysis of their behaviour during the market stress linked to the COVID-19 pandemic revealed that only a limited number of the analysed funds suspended subscriptions and redemptions while the vast majority was able to meet redemption requests and maintain their portfolio structure.
Some areas of concern identified in the ESMA Report are the following:
- some funds presented potential liquidity mismatches due to their liquidity set up (e.g. a combination of high redemption frequency, no/short notice periods and no liquidity management tools ("LMTs"):
- only a few funds have adjusted their liquidity set-up according to the pursued investment strategy and in light of the liquidity issues encountered (e.g., introduction of LMTs, adaptation of the redemption frequency and notice period);
- concerns around the valuation of assets emerged especially for real estate funds; moreover real estate funds do not frequently adopt LMTs in their liquidity set-up;
- risks arising from loan covenants, i.e. contractual obligations relating to loans received by managers that may trigger fire sales and have a pro-cyclical effect.
The following five (5) priority areas have been identified to enhance the preparedness of funds:
a. Ongoing supervision of the alignment of the funds’ investment strategy, liquidity profile and redemption policy.
Management companies should be able to justify the liquidity set-up of their funds, at the authorisation phase or during NCAs supervisory actions. Misalignments between the liquidity of a fund’s investments and its redemption policies should be corrected in a timely manner. Particular attention should be paid to funds investing in less liquid or illiquid assets.
b. Ongoing supervision of liquidity risk assessment.
NCAs should supervise the liquidity risk assessment by management companies. Particular attention should be paid to supervising that management companies in their liquidity risk assessment comply with their obligation to take all factors into account that could a. have an impact on funds liquidity or that could trigger unwanted sales of assets.
c. Fund liquidity profiles.
In the context of the AIFMD review, additional specifications on how liquidity profiles should be established and reported as part of the AIFMD reporting should be introduced. This includes (i) on the asset side how to determine a realistic and conservative estimate of which percentage of the fund portfolio can be liquidated (estimate for each asset class based on reliable methodology and data), and (ii) on the liability side, how to take into account arrangements with respect to gates and notice periods in the determination of investor liquidity profiles. ESMA notes that this priority area applies equally to UCITS.
d. Increase of the availability and use of liquidity management tools.
Proposal for a harmonised legal framework to govern the availability of additional LMTs for fund managers in both the UCITS and AIFM frameworks, which would include specifications on the required disclosures for the provision and use of LMTs to ensure greater protection and consistency for investors.
e. Supervision of valuation processes in a context of valuation uncertainty.
As part of their ongoing supervision of management companies, 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.
From a financial stability perspective, ESMA considers that the above priority areas aiming at reducing the liquidity and valuation risks at the level of the investment fund should reduce the risk and the impact of collective selling by funds on the financial system. ESMA will continue to monitor this risk through regular assessments of the resilience of the fund sector.
ESMA will take forward items a) b) and e) in coordination with NCAs. Items c) and d) are, in ESMA’s view, more fit to be taken forward in the context of the AIFMD review. It therefore remains to be seen whether the European Commission will introduce further legislative changes in the context of the ongoing AIFMD review.