Fund Liquidity Continues to Define European Regulatory Agenda

February 24, 2020

A number of high-profile fund suspensions last year, coupled with the forthcoming European Securities Market Authority (ESMA) Liquidity Stress Testing Guidelines set for September 2020, were strong indicators that the thorny issue of fund liquidity would be high on European regulators' agenda in 2020. So far, the focus on liquidity has panned out as predicted, and with several regulatory releases on the horizon, there will be a lot for asset managers to unpack in the coming months. 

Pockets of vulnerability

The intensity of focus on liquidity has ratcheted up a few notches in recent months, primarily due to the confluence of some high-profile fund issues with regulatory developments already in motion. Speaking on the topic last year, ESMA chairman Steven Maijoor noted that the prevailing low interest rate environment had prompted many managers to hunt for higher yields more aggressively, and that ESMA's checks had identified some “pockets of vulnerabilities” in certain types of UCITS funds, notably high-yield bond funds.

That speech and subsequent regulator actions show that ensuring asset liquidity, particularly in daily dealing retail funds, has become a central focus and will remain under the microscope for EU funds throughout the year ahead. 

ESMA flexes its muscles

The latest move by ESMA to launch a common supervisory action (CSA) on UCITS liquidity risk management is interesting for reasons beyond liquidity. The move shows that ESMA is again looking to standardize regulatory review criteria to ensure a consistent approach across Europe. This recognizes the fact that for the past few years, there have been several national level liquidity regulatory reviews in Ireland, UK, Luxembourg, and elsewhere but no pan-European review. 

As recently flagged, ESMA now has a stronger mandate for direct market supervision to ensure greater regulatory convergence across the bloc. The CSA is a two-stage process, the first of which is that all national regulators will collect quantitative data from a large majority of UCITS they supervise. After review of the data collected, a sample of UCITS will be selected for a more comprehensive review.  

ESMA and the national regulators have also agreed on a liquidity questionnaire template, which now forms “a common methodology” to assess how UCITS management companies across the EU manage liquidity risk. The questionnaire has already been circulated by national regulators to UCITS under their supervision, and with very tight deadlines attached it is imperative for UCITS to make sure these submissions are accurate.

Stress testing challenges

While the ESMA questionnaire will be the primary short-term focus for any UCITS managers who have received a request, the impending September 30th deadline for adherence with the new ESMA stress test guidelines for UCITS and AIFMD funds also looms large. The guidelines published last year contain several new and potentially challenging areas. For instance, managers are advised to use both historic and hypothetical market scenarios to determine how easy it would be to liquidate assets given their existing portfolio composition and meet investor redemption requests. The manager must also model how the fund would be expected to behave in a range of hypothetical market situations with a view to ensuring that even in extremely adverse market conditions, the fund could meet redemption requests should there be a run of investor exits.   

As asset managers dive into these stress testing reviews in anticipation of September, some managers are already finding certain challenges in adhering to the ruleset. There are three notable areas of data scarcity and uncertainty which make such stress testing difficult:

1. Some asset classes and geographies have limited market data available

The nature of certain markets and asset classes mean that they have limited data available and are not frequently traded. The less market data available on a security, the more difficult it is to model how it will fare in various market conditions.   

2. Knowing your ultimate investor and predicting their future behavior is difficult

Another complicating factor for asset managers is simply modeling investor behavior in the event of a market slump. In the case of UCITS funds, this is particularly difficult because by their nature they tend to have several intermediaries, such as fund platforms, in their distribution chain. As such, it is often difficult for a UCITS fund to know who is ultimately investing in its fund, never mind how that investor is likely to behave stressed market conditions.

3. Reverse stress testing can be subjective  

In certain cases, managers must conduct “reverse stress testing,” which assumes a hypothetical worst-case scenario for their portfolios, and then requires an assessment of how quickly assets could be sold to meet redemption requests. The actual design of the test within the ESMA guidelines is left up to the discretion of the individual fund manager, allowing for subjective interpretation of the rules for asset categorization and portfolio composition. By contrast, the US SEC liquidity rules require managers to place assets in one of four buckets depending on how many days it would take to liquidate them and has a fixed limit on illiquid assets.

This inherent lack of data on important areas of the stress testing means that there is a high degree of subjectivity and assumption required to be built into the modelling. That is never ideal when dealing with a regulatory deliverable. How asset managers balance these known constraints against regulatory expectations will be crucial. 

The upshot of these concerted regulatory efforts is that regulators are increasingly worried about the convergence of two trends:

  • A shift towards more risky assets and strategies in retail funds
  • Increased nervousness of a market downturn after a decade of record upswing.

Since many of these assets and fund strategies haven't been rigorously tested in a severe market downturn such as the 2008 bear market, regulators are keen to ensure that history doesn't repeat itself to the detriment of Europe's burgeoning retail investor class. Fund Liquidity looks set to be one of the defining regulatory issues for asset managers in 2020. 

Brown Brothers Harriman & Co. (“BBH”) may be used as a generic term to reference the company as a whole and/or its various subsidiaries generally. This material and any products or services may be issued or provided in multiple jurisdictions by duly authorized and regulated subsidiaries.This material is for general information and reference purposes only and does not constitute legal, tax or investment advice and is not intended as an offer to sell, or a solicitation to buy securities, services or investment products. Any reference to tax matters is not intended to be used, and may not be used, for purposes of avoiding penalties under the U.S. Internal Revenue Code, or other applicable tax regimes, or for promotion, marketing or recommendation to third parties. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed, and reliance should not be placed on the information presented. This material may not be reproduced, copied or transmitted, or any of the content disclosed to third parties, without the permission of BBH. All trademarks and service marks included are the property of BBH or their respective owners.© Brown Brothers Harriman & Co. 2020. All rights reserved.

This browser is not fully supported by our public website and may not display or function as expected for this reason. Please note, the Infuse Portal and BBH client applications fully support the IE 11 browser.

Important Information for Non-U.S. Residents

You are required to read the following important information, which, in conjunction with the Terms and Conditions, governs your use of this website. Your use of this website and its contents constitute your acceptance of this information and those Terms and Conditions. If you do not agree with this information and the Terms and Conditions, you should immediately cease use of this website. The contents of this website have not been prepared for the benefit of investors outside of the United States. This website is not intended as a solicitation of the purchase or sale of any security or other financial instrument or any investment management services for any investor who resides in a jurisdiction other than the United States1. As a general matter, Brown Brothers Harriman & Co. and its subsidiaries (“BBH”) is not licensed or registered to solicit prospective investors and offer investment advisory services in jurisdictions outside of the United States. The information on this website is not intended to be distributed to, directed at or used by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. Persons in respect of whom such prohibitions apply must not access the website.  Under certain circumstances, BBH may provide services to investors located outside of the United States in accordance with applicable law. The conditions under which such services may be provided will be analyzed on a case-by-case basis by BBH. BBH will only accept investors from such jurisdictions or countries where it has made a determination that such an arrangement or relationship is permissible under the laws of that jurisdiction or country. The existence of this website is not intended to be a substitute for the type of analysis described above and is not intended as a solicitation of or recommendation to any prospective investor, including those located outside of the United States. Certain BBH products or services may not be available in certain jurisdictions. By choosing to access this website from any location other than the United States, you accept full responsibility for compliance with all local laws. The website contains content that has been obtained from sources that BBH believes to be reliable as of the date presented; however, BBH cannot guarantee the accuracy of such content, assure its completeness, or warrant that such information will not be changed. The content contained herein is current as of the date of issuance and is subject to change without notice. The website’s content does not constitute investment advice and should not be used as the basis for any investment decision. There is no guarantee that any investment objectives, expectations, targets described in this website or the  performance or profitability of any investment will be achieved. You understand that investing in securities and other financial instruments involves risks that may affect the value of the securities and may result in losses, including the potential loss of the principal invested, and you assume and are able to bear all such risks.  In no event shall BBH or any other affiliated party be liable for any direct, incidental, special, consequential, indirect, lost profits, loss of business or data, or punitive damages arising out of your use of this website. By clicking accept, you confirm that you accept  to the above Important Information along with Terms and Conditions.

 
1BBH sponsors UCITS Funds registered in Luxembourg, in certain jurisdictions. For information on those funds, please see bbhluxembourgfunds.com


captcha image

Type in the word seen on the picture

I am a current investor in another jurisdiction