This contribution is focused on the main challenges regarding both governance and methodology of liquidity stress testing due to emerging regulatory attention and the increasing importance of liquidity stress testing in the light of current developments in the financial markets.
Current market conditions further facilitate liquidity risks
In current capital markets, participants are faced with an environment of persistently low interest rates since the financial and sovereign debt crises. Tighter regulation, Brexit, balance-sheet consolidations and cost pressure as well as the current global COVID-19 crisis offer no indication of any substantial change to this situation.
While both institutional and retail investors seek new ways to generate yield, manage risk and access new asset classes, the fund industry, which provides access to global capital markets through a wide range of investment vehicles, product types, investment styles and regions has grown greatly in size, diversity, scope, complexity and market significance.
In the period between 2011 and 2019 global net flows in investment funds have approximately doubled according to Bundesbank, in “The European market for investment funds and the role of bond funds in the low interest rate environment” (October 2019). Between 2007 and 2017, investment funds’ assets under management (AUM) have increased from approx. EUR 6.2tn to approx. EUR 9.3tn for EU-based UCITS. Meanwhile, the net asset value (NAV) of EU alternative investment funds (AIFs) amounted to around EUR 4.9tn (ESMA Economic Report, “Stress simulation for investment funds 2019”, 05 September 2019, p.5).
In order to service the increasing demand for riskier, less liquid securities bearing higher interest and having longer duration, asset managers have enhanced their product offerings accordingly. Creating exposure to relatively illiquid long-term investments across global markets, the European fund universe as a whole is now more vulnerable to liquidity risk – the risk that a position in the fund cannot be sold, liquidated or closed at limited cost to comply at any time with obligations to redeem shares (ESMA, Final Report Guidelines on liquidity stress testing in UCITS and AIFs, 02 September 2019, p.30).
ESMA is concerned with liquidity risk in investment funds
Together with the National Competent Authorities (NCAs), the European Securities and Markets Authority (ESMA) is closely monitoring the growing activities of the fund industry in EU capital markets. With increasing market participation, direct and indirect interconnectedness with other participants in capital markets, EU regulators are responding by making recommendations to address concerns about potential systemic vulnerability arising from liquidity risks in the fund industry. Funds may be forced to sell assets in a stressed environment further depressing overall asset valuation and transmitting stress to other institutions with the risk of mutli-round effects.
On 02 September 2019, ESMA published its “Final Report on Guidelines on liquidity stress testing in UCITS and AIFs” to assess the resilience of the fund industry and its potential impacts on the financial stability related to liquidity risk. By providing a set of recommendations on best-practice approaches for fund managers regarding stress testing of liquidity risk for individual AIFs and UCITS, ESMA aims to harmonize different liquidity stress testing practices across Europe.
In the aftermath of the financial and sovereign debt crises, stress testing has proven to be a particularly useful tool for the banking industry to assess its resilience to substantial economic shocks. ESMA’s initiative on liquidity stress testing (LST) is thus intended to help ensuring sufficient fund liquidity, strengthening the fund manager’s ability to identify potential vulnerabilities, assisting in investment decision-making, increasing confidence in the industry and decreasing potential reputational risks, i.e. managing fund liquidity in the best interest of investors and stakeholders.
While LST is already an important tool within the risk management process of asset management companies, the guidelines aim to further strengthen the role and understanding of liquidity risk in general and address questions on how to design an effective liquidity risk governance framework.
To assess the resilience of a fund, LST should be explained in detail and fully documented in the LST policy. Within the LST policy, methodology should be reviewed periodically and adapted, if necessary. The ESMA’s final guidelines recommend that the LST policy should – among other aspects – at least include statements regarding an initial validation of the methodology used, which is ideally performed by a person external to the management company. Further requirements for a periodic review of the LST results include the formulation of well-defined follow-up actions and escalation procedures.
Methodological challenges in LST
Accompanying ESMA’s final report on guidelines, the ESMA has published the “ESMA Economic Report on Stress simulation for investment funds” on 05 September 2019. This Report provides an overview of the framework used by ESMA for stress simulation. It discusses the calibration of redemption shocks for funds, different methods to assess the resilience of funds to shocks, ways to measure the impact of fund managers` liquidation strategies on financial markets and possible second-round effects. Nonetheless, in order to adapt appropriate measures against liquidity risks arising from the assets and liabilities of the fund’s balance sheet as well as its overall liquidity profile, risk managers need to better understand their funds, including their individual vulnerability to liquidity risks.
When assessing the resilience of funds against liquidity shock scenarios, both the impact on the asset side and the liability side shall be considered. Figure 1 illustrates the interaction of the main features of the LST exercise.
Figure 1: Schematic overview the liquidity stress testing (LST) mechanism.
Asset Liquidity: Scenario impact on fund holdings
The scenario impact on the assets will manifest in a shift in value of specific market parameters, such as the price and volatilities of equities, interest rates, credit spreads, and FX rates and will thus have an effect on the valuation of the fund’s constituents.
Liquidation cost and/or time to liquidation are typically considered by fund managers in order to quantify their overall asset liquidity. These are supposed to be adversely affected by stress scenarios and should hence be taken into account when assessing asset liquidity under adversely stressed conditions. The assessment of liquidation cost and time to liquidation should differentiate by asset type, liquidation horizon and the size of the trade.
Funding Liquidity: Scenario impact on investor behavior
While funds may have several potential sources of a shortage in funding liquidity, redemption requests by investors typically constitute the most crucial source of liquidity risk for investment funds. The assessment and modelling of investors’ redemption claims given certain market conditions is a non-trivial task and a major challenge within the LST requirements set out by the ESMA.
For the purpose of stress testing, redemptions may be modelled via historical events or anticipated trends that have already been observed historically. However, hypothetical and event-driven scenarios shall also be assessed. It might also be reasonable to conduct reverse stress testing for a particular sample of funds, e.g. assets subject to particular investment strategies.
Since investor behavior differs across investor types (e.g. institutional investor, retail investor, wealth managers and pension scheme providers, etc.), investor concentration, investor location and investor strategy, fund managers should furthermore consider varying redemption risks depending on the different types of investors.
Liquidation strategies and KPIs
For scenarios that are adverse enough to force the manager to liquidate positions beyond their cash reserve, fund managers should choose appropriate asset liquidation strategies for each fund in line with the recommendation set out by the guidelines.
In order to combine stress testing outcomes of assets and accompanied liabilities of the fund balance sheet, fund managers need to combine the results of the asset and liability LST through common metrics such as the redemption coverage ratio (RCR) to estimate the overall impact on its fund liquidity.
Liquidation strategies need to take into account whether the fund is treated on a stand-alone basis or whether it is part of a larger investment strategy, that is – as a whole – affected by the scenario. Metrics on a single-fund level as well as potential second-round effects will certainly depend on the extent of the relevant economic development of the scenario.
The full coverage of both, requirements on governance and requirements on methodology, will be a challenging task. Each asset management company needs to analyze their compliance and associated shortcomings. They need to fully assess their individual level of ambition, analyze their model deficiencies and adapt processes in order to comply accordingly.
We are currently anticipating a lot of ongoing discussions evolving around ESMA’s focus on liquidity issues and are looking forward to the exchange of ideas and design approaches of appropriate solutions for conceptualizing and implementing an effective and efficient liquidity stress test framework. Please feel free to contact us.
ESMA Economic Report, “Stress simulation for investment funds 2019”, 05 September 2019
Final Report Guidelines on liquidity stress testing in UCITS and AIFs, 02 September 2019
Telephone +49 69 9585 2697
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Dr. Tim-Oliver Müller
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The authors would like to thank Nils Röder and Philipp Böhme for their valuable support in writing the article