New liquidity stress testing guidelines

From 30 September 2020, new ESMA guidelines on liquidity stress testing for UCITS and AIFs come into effect. The guidelines provide broad guidance on the form and frequency of liquidity stress testing and require firms to adopt a liquidity stress testing policy.

The guidelines apply to all UCITS and alternative investment funds with the exception of unleveraged closed-ended AIFs. While the guidelines will cease to apply in the UK following the end of the Brexit transition period on 31st December, the rules originate from the global standard setting body, IOSCO’s guidelines on liquidity risk management, therefore they will be relevant to UK firms. Moreover, in the wake of the Woodford and the suspension of dealing in a number of open-ended property funds in recent years, liquidity risk management is high up the FCA’s agenda.

This article sets out the key requirements under the guidelines and provides some guidance on how firms should approach liquidity stress testing.

Understanding liquidity risks

The guidelines require that stress testing is tailored to the liquidity risk profile of each fund. This means that firms need to assess and document the key factors driving liquidity risk across the funds they manage. The analysis should include both sides of the equation – liquidity demands and the liquidity of portfolio positions.

On the demand side, the analysis should focus on the profile of the fund’s investor base and historic fund flows to determine the likelihood of large redemptions over a short period. Other fund obligations such as collateral calls should also be taken into account.

Assessing available liquidity in a portfolio is extremely difficult and often it disappears at the point it is required. An analysis should start by measuring the time it takes to run down positions based on average trading volumes. Positions that would take a particularly long time to run down or have erratic trading volumes should be highlighted.

Stress Testing

The guidelines recommend that stress scenarios should be based on a mixture of historical and hypothetical events, constructed on the basis of the key liquidity risks identified for each fund. They should incorporate both increased demand for redemptions and stressed market conditions affecting the speed with which positions can be sold and the price achieved.

The guidelines recommend that stress testing should be carried out at least quarterly, though a less frequent period may be used depending the nature, scale and complexity of the fund and its liquidity profile.

The outcomes of stress testing should be fed back into the day to day liquidity risk management process. The most important outcome, of course, is that a fund can meet redemption requests in stressed conditions, but firms should also be alert to other outcomes such as whether all investors can be treated fairly during a liquidity event and the impact of an event on portfolio composition.

Governance

The guidelines recommend that the stress testing process should be carried out independently of the portfolio management function. In practice, risk management staff will have to work closely with front office staff to construct appropriate scenarios and ensure that the outcomes are fed back into the portfolio management process.

Firms should ensure that they have staff in second line risk and compliance functions with sufficient expertise to oversee and provide challenge to portfolio management staff.

 Stress Testing Policy

The Guidelines require firms to adopt a liquidity stress testing policy, which sets out:

  • The types, frequency and severity of stress test scenarios and the rationale for choosing them, as well as an initial validation of the models and assumptions used;
  • The role of senior management, governance and ownership of the stress testing process;
  • The reporting process; and
  • An escalation procedure.

How can Bovill help

Bovill has worked with a number of fund managers to improve their liquidity risk management, including:

  • Designing and reviewing liquidity risk management frameworks
  • Conducting gap analysis against the new guidelines
  • Drafting liquidity risk management and stress testing policies
  • Assessing fund liquidity risk
  • Constructing stress scenarios

 

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