The 16 ESMA Guidelines on Liquidity Stress Testing for UCITS and AIFs

A manager should have “a strong understanding of the liquidity risks arising from the assets and liabilities of the fund’s balance sheet, and its overall liquidity profile, in order to employ LST that is appropriate for the fund it manages”

The manager should also strike a balance by using LST that is focused, specific to the fund and highlights the key liquidity risk factors but, at the same time, uses a range of scenarios sufficiently wide to adequately represent the diversity of the fund’s risks.

The manager should ensure that LST is properly integrated within the fund’s risk management framework and is subject to appropriate governance and oversight, including appropriate reporting and escalation procedures.

The Guidelines state that LST should help ensure the fund is sufficiently liquid and help identify potential liquidity weaknesses, assist risk management monitoring and decision makings, and strengthen the manager’s ability to manage fund liquidity in the best interests of investors.

The LST should assist a manager in preparing a fund for a crisis, and in its broader contingency planning. This contingency planning may involve a manager’s plans to operationalise applying ex post a-LMT to a fund.

LST should employ hypothetical and historical scenarios and, where appropriate, Reverse Stress Testing (RST). LST should not overly rely on historical data as future stresses may differ from previous ones.

ESMA suggest historical scenarios for LST could include the global financial crisis 2008-2010 or the European debt crisis 2010-2012. Hypothetical scenarios could include rising interest rates, credit spread widening, or political events.

Managers using Reverse Stress Tests (RST) should simulate assets being liquidated in a way that reflects how the manager would liquidate assets during a period of exceptional market stress. RST should take into account the treatment of remaining, as well as redeeming, unitholders as well as the role of transaction costs and whether or not fire sale prices would be accepted.

Risks arising from less liquid assets and liabilities risks should be reflected in the LST.

Low probability, but high impact scenarios, including the potential difficulty of reliably pricing less liquid assets during a period of market stress, will be important in respect of less liquid assets. RST may be a particularly valuable tool in this context, helping to identify scenarios which could lead to significant fund liquidity risk (e.g. identifying scenarios which would lead to the imposition of special arrangements or suspensions).

Furthermore, fund of funds which gain indirect exposure to less liquid assets via their target funds should pay due regard to considerations relating to less liquid assets. This is due to the underlying exposure of those target funds which can result in the suspension of the target investment vehicle or other measures.

After separately stress testing the assets and the liabilities of the fund balance sheet, the manager should combine the results of the LST appropriately to determine the overall effect on fund liquidity.

The guidelines state that managers should incorporate risk scoring into the LST where it enables an enhanced view of liquidity across the funds they manage, including in contingency planning and the operational preparation for a liquidity crisis.

A manager should aggregate LST across funds under its management where it assesses such an activity to be appropriate for those funds.