In our final blog of our three-part fund liquidity trilogy, we look at the recently published report from European Securities and Markets Authority (ESMA) on its study of UCITS liquidity risk management.
Early in 2020, ESMA launched a common supervisory action (CSA) focused on UCITS fund liquidity. CSA are a more frequently used device in the ESMA regulatory toolkit, which they deploy when they want to ensure they have a holistic view of the entire E.U. market and to ensure consistency across all national regulators on a subject. The CSA is primarily a supervisory convergence tool, which means it aims to identify and address instances where the rules are inconsistently applied across E.U. Member States. This report follows ESMA’s compilation of detailed information from the various E.U. regulators by way of a common questionnaires on various aspects of UCITS’ Liquidity Risk Management (LRM).
ESMA had previously looked at a stress simulation of over 6,000 UCITS bond funds which flagged “certain vulnerabilities” in the high yield bond sector of the UCITS market, before expanding its review to the entire UCITS universe. The first stage of the CSA was gathering and assessing a large amount of quantitative data from the vast majority UCITS managers across the E.U., followed by a more targeted second stage review where national regulators conducted more in-depth supervisory analyses on a more condensed group of funds identified from the first batch of funds.
To begin, the findings of the report are largely positive. ESMA suggests a low level of instances of UCITS that would struggle to meet redemption requests under stressed market conditions. However, that does not mean that the review did not highlight some specific fund issues or areas which ESMA believes could generally be improved upon. It is nearly impossible that a regulatory review of this scale and complexity won’t result in the industry coming away with some things to work on. The report points to some areas which could be improved upon and certain obvious instances of inconsistent or inadequate application of the rules.
In a few cases, some adverse findings were specifically identified, particularly linked to documentation, procedures, and methodology around a UCITS’ LRM. These funds are likely to be hearing directly from the regulator soon. More broadly, it is suggested that in some cases the pre-investment liquidity assessment framework was identified as an area in need of strengthening, as well as the data reliability verification and the internal control framework.
Like a soccer team sheet, ESMA flag 11 distinct areas where UCITS should review their LRM programs to identify areas in which their regulator could challenge them on. These are:
1. Documentation of LRM processes and techniques
Should include consideration of pre-investment analysis and forecasts and be detailed enough to be fit for purpose.
2. LRM Procedures
UCITS LRM written processes should be of sufficient quality, cover all asset classes and include the liquidity techniques and tools available to the funds.
3. Quality of LRM methodology
ESMA conclude that some methodologies utilized were not always appropriate or comprehensive enough. Some models excluded margin calls altogether, some were not forward-looking, and others appeared to be too static so certain liquidity forecasts were unrealistic or unreasonably positive.
4. Don’t Assume Listed Means Liquid
This was a characteristic of the infamous Woodford liquidity event. ESMA flags the fact that just because a security has a listing that does not mean it automatically is traded frequently and has a depth of market which means one can assume liquidity. ESMA urges UCITS to look at the availability and nature of the available market data and trading activity for a security.
5. Unlisted UCITS Holdings
ESMA urges that UCITS do not presume that financial instruments not trading on a regulated market are liquid. UCITS may hold up to 10% of assets in such securities, the so called “trash bucket”, but these should be regularly tested for liquidity and not be presumed to be liquid and easily sold in a crisis event.
Where delegation occurs, the UCITS retains enough oversight in respect of LRM rather than deferring responsibility entirely to the third-party delegate.
7. Data Reliability
ESMA requests that UCITS conducts data quality checks and ensures that there is not an over-reliance on a small number of liquidity data providers.
8. UCITS KIID & Prospectus Disclosures
UCITS must ensure that liquidity risk disclosures in investor documents are not missing, misleading, or unclear.
UCITS must ensure that reports to senior management on liquidity and LRM are frequent, granular, and clear enough to be of value. There should be a documented process for the escalation of liquidity issues to senior management and boards of UCITS.
10. Three Lines of Defense
UCITS must ensure it has an internal liquidity control framework with second and third-level control functions where the manager, audit, and compliance functions are all working to strengthen the overall control framework.
11. External Controls
UCITS must 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 such audits.
ESMA’s report doesn’t exist in a vacuum either. It should be read together with the November 2020 European Systemic Risk Board’s recommendations on fund liquidity risk. While the focus of the CSA and the findings relate to UCITS, it is fair to suggest that much of the “best practice” is likely to form part of regulator thinking in Europe when it comes to AIFMD funds also seeing how focused ESMA is on regulatory convergence already. Without sounding like a broken record, the theme of fund liquidity is not the sole domain of ESMA either, this is a discernible global regulator focus area.
The International Organization of Securities Commissions (IOSCO) recently launched a thematic review into its principles for fund liquidity risk management. On top of that IOSCO has teamed up with the Financial Stability Board on a joint analysis into the use of liquidity management tools by open-ended funds. In the United Kingdom, the FCA and the Bank of England are together already undertaking a review of liquidity risk management in open-ended funds.
To conclude this trilogy, even if you do believe you are managing your fund liquidity regulation obligations well already, when assessing fund liquidity risk management be sure you also continue to ask yourself…What if?