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.