ESMA’s upcoming liquidity stress testing for UCITS and AIF funds is likely to be more arduous than many expect, and firms should waste little time in getting prepared. That was the main takeaway as Darell Miller, AQMetrics’ Head of Sales, hosted an Alternative Investment Management Association (AIMA) Fund Managers’ Briefing on 26th of February in front of many of Europe’s largest asset managers.
‘Fund liquidity will dominate the regulatory landscape in 2020,’ Miller explained. ‘The liquidity stress testing in September 2020 is the main event. But ESMA’s supervisory action on fund liquidity this year will also include a questionnaire and potential onsite visits. The regulators have promised to be quite hands-on and intrusive in this regard.’
Following a series of high-profile blow-ups in recent years, financial regulators have turned their attention to the liquidity risks posed by investment funds, with ESMA providing new guidelines for stress testing last September. These new guidelines are set to come into force from 30 September, and it’s recommended that fund managers undertake stress tests quarterly at least.
‘One of the main points in all of this is all happening soon – and often,’ Miller added. ‘While funds must stress test on an annual basis already, ESMA now recommends that they stress test at least quarterly and even more where appropriate. It’s a big step change from today.’
The stress testing, meanwhile, should employ backward and forward-looking scenarios, with ESMA proposing the Global Financial Crisis (2008) and European Sovereign Debt Crisis (2010) as two potential scenarios to backtest. And although pinpointing the future is impossible, parameters such as drawdowns, volatility, interest rate risks, credit spreads, and investor redemptions are good examples of what should be considered.
‘Fund managers really need to gear up for the liquidity stress tests,’ Miller noted. ‘Managers can aggregate the same stress tests across funds with the same strategy or exposure. But you should consider both sides of the balance sheet – assets and investor redemptions. It needs to be managed throughout the whole product cycle and it’s going to be a large undertaking.’
Given that preparations could prove more arduous than expected, Miller recommended that compliance personnel talk to their heads of risk as soon as possible and that they think about what factors might be used and the frequency of the tests. ‘There is no one size fits all, and ESMA has stated that it’s up to asset managers to determine their own tests,’ he said. ‘But this isn’t something you want to leave to the last minute.’
Aside from preparing for the stress tests, AQMetrics also believes that firms should factor in a range of potential hidden costs.
‘There could well be some things you haven’t budgeted for,’ Miller exclaimed. ‘You may have to pay for data sourcing and fees, and this could be quarterly or even daily depending on the frequency of the stress tests. And for some sparsely traded assets, even finding the data could prove difficult. These are all things you should consider.’
‘We are all in this together to some extent,’ he added. ‘So, I think we can all benefit from talking to each other – to other managers, vendors and consultants. Find out best practices and aim to build and test before September.’