European Systemic Risk Board Issues Recommendation to Mitigate Funds' Liquidity and Leverage Risks
02/14/2018The European Systemic Risk Board has published a Recommendation addressed to the European Securities and Markets Authority and the European Commission, outlining a set of recommended actions designed to address the systemic risks that could arise from liquidity mismatches and the use of leverage by investment funds. The ESRB has concerns that, where a fund invests in assets that cannot be liquidated readily to meet redemption requests in times of market stress, "fire sales" could occur, depressing asset prices and affecting not only the funds themselves but also other market participants holding similar or closely correlated assets. Additionally, the impact of negative market movements can be amplified where a fund is leveraged, either through borrowing of cash or securities or through holding derivatives with embedded leverage.
The ESRB notes that the existing EU regulatory framework for funds (comprising the UCITS Directive and the Alternative Investment Fund Managers Directive) already contains measures requiring funds to manage liquidity and to conduct stress tests under normal and exceptional liquidity conditions. The framework also contains measures designed to control the build-up of leverage and national regulators are able to impose leverage limits on AIFs. ESMA can also specify to national regulators remedial measures to be taken where it has determined the leverage employed by an AIFM or group of AIFMs poses financial stability risks.
Despite these safeguards in the existing framework, which provide effective risk management at the micro-prudential level, the ESRB considers that further measures are required to protect financial stability at a macro-prudential level. It recommends the following actions be taken by the Commission and/or ESMA:
a. The Commission should propose legislative enhancements to the EU legal framework to ensure that it includes: additional liquidity management tools in the design of EU investment funds; further specification of the powers of national regulators to suspend redemptions, and of ESMA's facilitation, advisory and co-ordination role.
b. The Commission should propose measures to limit the extent to which the use of liquidity transformation (that is, the creation of liquid claims that are backed by illiquid assets) in open-ended AIFs can contribute to the build-up of systemic risks or the risk of disorderly markets.
c. ESMA should develop guidance for fund managers for the stress testing of liquidity risk for individual AIFs and UCITS.
d. The Commission should propose measures requiring regular reporting, by UCITS and UCITS management companies, of liquidity risk and leverage data to national regulators.
e. ESMA should develop guidance on the provisions of AIFMD that set out obligations for AIFMs managing leveraged AIFs. This guidance should cover: the framework for assessing the extent to which leverage in the AIF sector contributes to the build-up of systemic risk; the design, calibration and implementation of macro-prudential leverage limits; and how national regulators should make notifications when they intend to implement macro-prudential measures. The ESRB recommends that ESMA share knowledge and practices with other macro-prudential regulators.
Further detail on each of the individual recommendations is set out in an Annex to the ESRB Recommendation. The ESRB has set implementation deadlines for each recommendation ranging from June 30, 2019 to December 30, 2020.
The ESRB's Recommendation takes into account recommendations made by the Financial Stability Board to address structural vulnerabilities from asset management activities, which were published in January 2017 and are being implemented by the International Organisation of Securities Commissions.
View the Recommendation (ESRB/2017/6).
View Annex 1 - Compliance Criteria for the Recommendations.
View details of IOSCO's work.