European Securities and Markets Authority Consults on Stress Tests for Investment Funds

The European Securities and Markets Authority has published a consultation paper on its proposed guidelines for liquidity stress testing in Alternative Investment Funds and Undertakings for Collective Investment in Transferable Securities. The paper has been published in response to the European System Risk Board's 2018 Recommendation on mitigating liquidity and leverage risks in investment funds, which requires that ESMA produces guidance on the practice to be followed by managers for the stress testing of liquidity risk for AIFs and UCITS. The consultation paper is primarily aimed at managers of UCITS and AIFs, as well as depositaries and the regulators that oversee those entities. However, it will also be of interest to AIF and UCITS trade associations, investors and consumer groups. Responses to the consultation should be submitted by April 1, 2019. ESMA expects to publish its final report by the summer of 2019.

The Alternative Investment Fund Managers Directive and the UCITS Directive require that AIFMs and UCITS conduct liquidity stress testing. However, in recent years funds have been subject to regulatory scrutiny in light of concerns that they: (i) may not be adequately managing liquidity risk; (ii) may not be able to meet redemption requests when they are made by investors; and (iii) may need to resort to "fire sales" of assets, accepting large discounts on prices, in order to meet redemption requests.

The draft guidelines set out 14 criteria that fund managers should consider when conducting liquidity stress tests, including the integration of liquidity stress testing into a fund's risk management framework, at least annual stress testing, employment of hypothetical and historical scenarios in stress testing and utilization of tests that allow funds to test both fund assets and fund liabilities to determine the effect on fund liquidity. There is also a draft guideline which would become applicable to depositaries, specifying that they should verify that a fund has documented procedures for its liquidity stress testing program.

View ESMA's Consultation Paper.

View details of the European Systemic Risk Board's Recommendation on funds' liquidity and finance risks.

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