The Challenges of Liquidity Stress Testing

It seems that ‘liquidity risk’ is the prevalent term on everyone’s lips these days. Following a turbulent 2019, with several high-profile fund suspensions, it is perhaps no surprise that liquidity is a 2020 priority for most regulators. The fund suspensions compounded with the ESMA’s Liquidity Stress Tests (LST) Guideline coming into force 30 September 2020 and the recent launch of a common supervisory action (CSA) on UCITS liquidity risk management demonstrate why liquidity risk is on every fund manager’s priority list.

Although ESMA estimates that 93% of managers already undertake liquidity stress tests, the survey, which was undertaking by the European Systemic Risk Board (ESRB) found a range of shortcomings of stress testing procedures. These included too small haircuts, unsatisfactory stress testing frequency and scenario design, and the naïve use of historical data.

With less than a year now until the liquidity stress test guidelines come into force, regardless of whether managers fall within the 93% category who conduct some form of stress testing, or the remaining 7%, ensuring compliance with the new Guidelines will be an extensive task.

What are the challenges facing managers?

Data

The main challenge faced by fund managers is data scarcity which remains a major obstacle to robust economic modelling and projecting of fund redemptions. One of the challenges of data stems from retail investors and the fact their transactions tend to be carried out by fund distributors who sell products issued by a number of fund managers and which are incorporated into omnibus accounts. This makes it difficult for managers to fully understand the end investors characteristics and in turn their redemption behaviours.

In terms of lack of market data, ESMA has advised managers avoid using “optimistic assumptions”, consider the justified use of third party LST models and exercise “expert qualitative judgement”.

Reverse Stress Testing

Reverse stress testing 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. Numerous concerns have been raised with regards to reverse stress testing and testing for hypothetical scenarios, especially for illiquid funds, again due to the lack of market data.

Further challenges stem from the subjectivity of the “hypothetical scenarios” and ensuring these meet the regulatory requirements.

Flexibility

With there being no “one-size-fits-all” solution, fund managers must ensure flexibility and tailor the liquidity stress test to the circumstance of each fund, its investment strategy, and its investors. The stress tests should be flexible enough to allow institutions, as they create contingency plans, to integrate and quickly modify business strategies.

Firms must also ensure flexibility in the scenarios and that these are updated regularly. For example, it may no longer be relevant to use a particular correlation between country risk factors and equities that have not been updated regularly, especially if a company changes the location of its registered office or expands into new markets.

Meaningful MI

Managers should ensure they have proper and robust systems to report Management Information (MI), the LST must “provides information that enables follow-up action”. Further incentive for meaningful MI stem from ability of NCAs under the guidelines to request managers to notify them of other information relating to the LST, including liquidity stress test models and their results.

How Funds-Axis can help

Management Companies will need to assess the requirements in the ESMA liquidity guidelines against their current liquidity risk management practices, policies and reporting before the 30 September 2020 deadline.

The Funds-Axis liquidity risk management framework 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 the product governance, throughout the product lifecycle.

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