The Canadian Securities Administrators (CSA) has published guidance to help investment fund managers (IFMs) develop and maintain effective liquidity risk management (LRM) frameworks for investment funds.
Under the Canadian securities regulatory regime, both NI 81-102 and NI 31-103 contain provisions which are relevant to LRM and the roles and responsibilities of IFMs in managing liquidity risk. Part 3.3.1 of Companion Policy 81-102CP states that the CSA expects an IFM to establish an effective LRM policy that considers the liquidity of the types of assets in which the investment fund will be invested and the fund’s obligations and other liabilities. It also states the view that the IFMs should regularly measure, monitor and manage the liquidity of the investment fund’s underlying portfolio assets, keeping in mind the time to liquidate each underlying portfolio asset, the price the asset may be sold at and the pattern of redemption requests.
A quick glance at the recently published Canadian guidelines reveals a lot of obvious similarities with the ESMA liquidity stress test guidelines entering into force this month.
Governance Principles
Similar to the ESMA guidelines, a large proportion of the guidelines extend beyond just liquidity stress testing. Both guidelines cite governance as an essential element for an effective LRM process and provide that oversight of the liquidity management of the fund should be independent from the portfolio management function.
Further similarities between the two guidelines can be seen in the Canadian guidelines where they set out six principles, and related practical implementation strategies for creating and maintaining an effective LRM framework:
- Align the investment objectives, strategy, and redemption policy of the fund with the liquidity profile of the fund’s underlying portfolio assets and the redemption demands of the investor base at the design stage and on an ongoing basis.
- Create and adhere to robust policies and procedures that integrate LRM considerations.
- Perform active, ongoing portfolio monitoring using qualitative and quantitative metrics to ensure adequate levels of liquidity exist to meet redemption needs and other obligations. All relevant data should be used to actively manage liquidity risks.
- Set internal liquidity thresholds and targets that management of the fund can use to assess the liquidity profile of a fund and make any necessary adjustments.
- Report material liquidity events in a timely manner for consideration by relevant personnel of the IFM.
- Where possible, identify emerging liquidity concerns and potential liquidity shortages.
Stress Testing
Currently, under Canadian legislation, stress testing is not specifically required. This contrasts with EU legislation under UCITS, AIFMD and the MMFR which all require some form of liquidity stress testing.
Although stress testing is not specifically required under securities legislation in Canada, the CSA guidelines have provided some key factors to consider when conducting stress testing.
| Scenario Analysis | Canada Guidelines | ESMA Guidelines |
|---|---|---|
| Historical | Yes | Yes |
| Hypothetical | Yes | Yes |
| Reverse Stress Testing | No | Yes |
Both guidelines recommend using hypothetical and historical scenarios for liquidity stress testing, citing potential historical scenarios as the dot-com crash in 2000, the global financial crisis 2008-2010 or the European debt crisis 2010-2012.
In terms of hypothetical scenarios, the guidelines include rising interest rates, credit spread widening, or political events.
Unlike the ESMA guidelines, the Canadian guidelines do not provide for recommendations around reverse stress testing (RST). This is a fund-level stress test which starts from the identification of the pre-defined outcome with regards to fund liquidity (e.g. the point at which the fund would no longer be liquid enough to honour requests to redeem units) and then explores scenarios and circumstances that might cause this to occur.
During ESMA’s initial consultation on RST, many respondents opposed the inclusion of RST on a mandatory basis for all funds. These respondents stressed that RST is not required in the UCITS Directive or AIFMD. The respondents were of the view that there is little value in RST, while being very burdensome. Due to this, ESMA removed the “mandatory” RST requirement and instead opted for the phrase “where appropriate”.
Frequency of stress testing
Both the Canadian and ESMA Guidelines provide information on the frequency of stress testing, however, the Canadian Guidelines do not go as far as ESMA in prescribing a recommended frequency.
Under the ESMA liquidity stress test guidelines, LST should be carried out at least annually, although quarterly testing is recommended.
Both guidelines do provide for factors which should be taken into account when determining the frequency.
| Factors | Canada Guidelines | ESMA Guidelines |
|---|---|---|
| Size of the fund | Yes | Yes |
| Nature of the underlying portfolio assets | Yes | Yes |
| Redemption frequency | Yes | Yes |
| Investment strategy | Yes | Yes |
| Investor base | Yes | Yes |
| Market conditions | Yes | Yes |
LST Outcomes
Both guidelines also provide that stress testing should be documented, analysed and communicated and shared with relevant personnel to illustrate and quantify the vulnerabilities of a fund.
Once again similarities are seen in both guidelines as to how the stress test results should be used:
| Canada Guidelines | ESMA Guidelines | |
|---|---|---|
| Help ensure the fund is sufficiently liquid | Yes | Yes |
| Manage fund liquidity in the best interests of investor | Yes | Yes |
| Planning for periods of heightened liquidity risk | Yes | Yes |
| Identify potential liquidity weaknesses | Yes | Yes |
| Assist risk management monitoring and decision-making | Yes | Yes |
How Funds-Axis can help
Effective LRM is an essential element of the management of an investment fund. If a fund does not manage its liquidity risk properly, there could be adverse outcomes for the fund and its investors. For this reason, taking a proactive and preventative approach to LRM is critical to ensuring that this risk is appropriately managed and dealt before liquidity mismatches occur.
Our automated liquidity risk management solution is designed to meet international requirements in respect of liquidity risk management and liquidity stress testing. It is a holistic solution which embeds liquidity risk management into product governance, throughout the product lifecycle.
Need more support on liquidity?
We also offer:
- In- house training programmes
- Gap analysis
- Liquidity risk management and LST implementation consultancy
- Delivery of LST simulation programs
