Since Woodford’s Equity Income Fund collapsed, regulators have been especially concerned with managers’ ability to achieve promises to pay out to investors of their funds while managing the liquidity of their portfolio. In September 2019, ESMA undertook a stress test of around 6,000 UCITS bond funds and found up to 40% experienced difficulties under severe but plausible market shocks. Consequently, ESMA asked national regulators to undertake a review of liquidity risk management in their local UCITS funds using a common methodology. ESMA has now published the results of the Common Supervisory Assessment.
Generally, the findings are positive. There were low reported instances of funds that would struggle to meet redemption requests under stressed market conditions. Most funds were reported to be adequately complying with liquidity risk management (LRM) regulations.
However, ESMA has identified several desired improvements. ESMA recommends that managers should review their LRM programmes against the following list to identify areas in which supervisors might challenge the manager; in addition, to ensuring compliance with the UCITS and local regulations.
- ensure that there is available documentation to the regulators on the firm’s LRM arrangements, processes and techniques, such as pre-investment analysis and forecasts, with enough granularity;
- retain written evidence of the firm’s LRM processes, covering all relevant asset classes and the use of liquidity management tools;
- check that the LRM methodology and tools are appropriate, justified, forward-looking and back tested. Liquidity forecasts should be robust and not unrealistic or unreasonably positive;
- not over-rely on the liquidity presumption for listed securities in the UCITS legislation but rather look at the availability and nature of the available market data;
- not apply the liquidity presumption to financial instruments that are not trading on a regulated market;
- ensure that if delegation occurs, the delegating entity retains sufficient oversight in respect of LRM rather than deferring responsibility entirely to the delegate;
- review data quality and ensure that there is not an over-reliance on a small number of data providers;
- ensure that disclosures to investors on liquidity risks and liquidity management tools in the UCITS KIID are not missing, misleading or unclear;
- check that there are reports on liquidity and LRM with sufficient frequency, granularity and clarity to senior management and adequate documented processes for the escalation of issues to senior management and boards;
- ensure that the firm has an internal liquidity control framework with second and third-level control functions; and
- ensure that external controls, via external auditors and depositaries, are performed, while being mindful that there might be diverging national rules and standards in respect of the audit.
ESMA’s statements chime with the European Systemic Risk Board’s recommendations on fund liquidity risk issued in November 2020. While ESMA’s recommendations strictly only apply to UCITS, the broader nature of the EU’s review suggests that managers of open-ended AIFs should hav regard to ESMA’s conclusions too.
At the global level, IOSCO recently launched a review into its principles for fund liquidity risk management. In addition, IOSCO and the Financial Stability Board are conducting a joint analysis into the use of liquidity management tools by open-ended funds.
In the UK, the FCA and the Bank of England are undertaking a review of liquidity risk management in open-ended funds. The UK is also set to launch by the end of 2021 a new fund vehicle, the Long Term Asset Fund, that better aligns its redemption terms with the liquidity of the fund’s assets.