Asset Managers Need to Step Up Their Liquidity Efforts – ESMA’s Five Key Priorities

Throughout the year regulators have focused on liquidity, and as this year draws to a close, that focus shows no signs of diminishing. “Asset managers need to step up their efforts to ensure the liquidity of their funds is adequately managed and that they are prepared for future shocks” – that was the closing remarks from Steven Maijoor’s Keynote Address at EFAMA’s Investment Management Forum which heavily focused on liquidity risk.

The address followed the report published by ESMA on the preparedness of investment funds with significant exposures to corporate debt and real estate assets, for potential future adverse liquidity and valuation shocks.

The report was in response to the recommendations from the European Systemic Risk Board (ESRB) to ESMA on liquidity risks in investment funds. In particular, the ESRB recommended that ESMA coordinate with National Competent Authorities (NCAs), a focused supervisory exercise on investment funds that have significant exposures to corporate debt and real estate assets.

Amongst the results of the coordinated supervisory exercise, the report states that fund managers authorised under the UCITS and AIFM Directives should enhance their preparedness to potential future adverse shocks that could lead to a deterioration in financial market liquidity and valuation uncertainty. This includes enhancing valuation procedures, alignment of the liquidity profile and redemption policy, use of special arrangements and stress tests.

In the report, ESMA identifies five priority areas to further enhance the preparedness of corporate debt and real estate funds to potential future redemptions and valuation shocks. Three of them relate to key provisions that management companies should strictly observe. In these areas, ESMA urges asset managers to step up their efforts to ensure that the relevant requirements are adequately complied with.

Another priority area is the increase of the availability and use of liquidity management tools, which should be taken forward in the context of the AIFMD review.

The last priority area relates to the enhancement of the fund liquidity profile reporting under AIFMD, to support a risk-based supervision of liquidity risks. ESMA has also once again put forward that similar provisions should be introduced under the UCITS framework.

Five Key Priorities

The five key priority areas which ESMA have identified to enhance the preparedness of the funds are:

Priority Area 1 – Ongoing supervision of the alignment of the funds’ investment strategy, liquidity profile and redemption policy

Market participants are responsible for ensuring the alignment between the liquidity profile of funds’ investments and their redemption policies. In order to supervise compliance with rules on liquidity risk management, NCAs should continue their active engagement with, and supervision of, their market participants. Misalignments between the liquidity profile of funds’ investments and their redemption policies should be corrected in a timely manner.

This monitoring should take into account all information available (in particular the fund liquidity profile established under the AIFMD reporting) and insights gained through ongoing dialogue with management companies.

Management companies should be able to justify the liquidity set-up of their funds, at the authorisation phase or during NCAs supervisory actions (surveillance of funds, thematic reviews, on-site and off-site inspections). Particular attention should be paid to funds investing in less liquid or illiquid assets.

Priority Area 2 – Ongoing supervision of liquidity risk assessment

Priority Area 3 – Fund liquidity profiles

Priority Area 4 – Increase of the availability and use of liquidity management tools

Priority Area 5 – Supervision of valuation processes in a context of valuation uncertainty

Conclusion

The asset management industry showed resilience when they faced redemption pressures and episodes of valuation uncertainty in the demanding first quarter of 2020. However, as the ESMA report notes, this should be interpreted with caution due to the short duration of the period of stress, and the significant government and central bank interventions, which provided support to the markets in which these funds invest.

As such, liquidity risk management looks set to continue to be high on the priority list as we move into 2021. The current uncertainty fuelled by the second COVID-19 wave sweeping across the US and Europe, and the recent upsurge in volatility in financial markets continues to impact liquidity risk management. This coupled with increasing regulatory scrutiny demonstrates why is it vital for asset managers to focus on optimising their funds’ liquidity profile and explore specific scenarios to ensure they are prepared for future potential disruptions.

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