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ALFI Risk Update: Funds come to terms with new Liquidity Stress Tests

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Now in its 15th edition, the ALFI European Risk Management Conference has become a staple among European risk managers, with the one day event providing a whirlwind tour of the risk landscape – and a fantastic opportunity to network with peers.

This year’s edition, which was held virtually on 15th June, was no different, and included a range of panels and discussions on topics such as the CSSF’s regulatory outlook, SFDR and the EU Taxonomy, and other key operational and regulatory issues.

Not surprisingly, fund liquidity was also a key topic, and was the theme of the 11am panel discussion. The panel looked at the practical considerations when implementing a liquidity stress test framework, and how different firms and fund types have come to terms with ESMA’s 2020 liquidity guidelines.

Best practices

Nine months after ESMA’s Liquidity Stress Test Guidelines went live, the panel provided a fantastic update on how EU AIFs and UCITS funds have adapted to the new rules and regulations.

While a lot of funds are running daily stress tests, there is still a clear preference for monthly or quarterly tests, according to an interactive poll on the day. Some 16% of liquid funds said they ran daily stress tests, although the vast majority were running monthly (41%) or quarterly (37%). 4% ran stress tests weekly.

When it comes to less liquid funds, meanwhile, the results were even more stark, with a majority (53% running stress tests quarterly), compared to 26% yearly and 13% biannually.

‘According to ESMA, you should be doing liquidity stress tests on an annual basis, at least, but there is a clear recommendation to perform it on a quarterly basis,’ said Andreas Herresthal, Associate Director of Investment Risk at Fidelity International.

‘But you should also consider additional factors to assess the frequency,’ he added. ‘You shouldn’t apply a one size fits all and you should consider the fund characteristics when deriving the frequency of the liquidity stress testing.’

And best practices should go beyond liquidity stress tests, too, with overall liquidity risk management becoming far more important for funds going forward.

‘Having clearly documented procedures and practices is really important,’ Herresthal continued. ‘It’s important for overall governance. You can run your LST on a daily basis, but what’s important is clear escalation paths and clear roles and responsibilities.’

Dr Martin Ewen, Chief Risk Officer at ARKUS FS, concurred. ‘When it comes to real assets, the reporting frequency is usually aligned with the board meeting frequency, but the governance is certainly similar.’

‘Liquidity risk management is becoming more holistic. While we don’t have accessible data when it comes to overall liquidity risk management, it is certainly becoming a bigger part of risk management.’

Redemptive stresses

The other hot topic was how funds are dealing with redemptive stresses, something that has become a key concern following the suspension of a number of EU funds following the Covid-19 fallout.

Only 9% of the respondents said they used a strict pro rata, or slicing, approach to meeting redemptive stresses, while 18% said they used a flexible approach. By contrast, some 27% said that they used a maximum liquidity approach, or waterfall, where assets are bucketed according to their liquidity profile and the most liquid assets are sold first. Almost half (45%) said that they use a combination of the two, which reflects the fact that both can be useful in different situations and depending on the fund’s assets.

‘Slicing, or pro rata, has a very limited capability of generating cash,’ cautioned Gildas Blanchard, Senior Manager, Financial Industry Solutions, Deloitte Tax and Consulting. ‘This is why in practice you often see a mix of the two being used, depending on the context. In normal conditions, slicing is far easier, but under stressed conditions you may need to find a compromise. ANd there’s also the consideration that managers have to adapt to their clientele.’

Which is superior, then? ‘In the market there is a general consensus that neither approach is necessarily superior,’ he explained. ‘It will depend on the strategies, and some strategies will need more attention and planning than others.’

Here, there’s a range of options for risk managers. ‘When looking at redemptions, it’s worth looking forward and backward,’ said Fidelity’s Herresthal. ‘The most important forward-looking factors will be investor concentration. The guidelines give some information on how to group them, and we have evidence that retail and institutional investors act differently.

‘I’m also a fan of other forward-looking indicators like performance, your Morningstar rating, indices and especially volatility,’ he added. ‘They help get a feeling for any potentially deterioration of liquidity in the market.’

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