The Covid-19 crisis brings the market and, in particular, the fund industry face to face with unprecedented challenges. In this context, investment funds need to implement effective liquidity risk measurement and management processes to ensure viability and survival.
Investment funds are shockingly exposed to constrained liquidity and market turmoil, which could materialize as increased risk stemming from both sides of the balance sheet.
Through more regular inquiries, regulators are closely monitoring how investment funds manage and assess liquidity risk.
During these unique times, asset managers should avoid common mistakes, such as failing to recognize and monitor liquidity shortages and pressures or failing to understand the extent of Covid-19’s impact on the liquidity of different asset classes.
The fund’s ability to satisfy investor redemptions does not solely depend on an asset’s intrinsic liquidity. Investment managers should consider and closely adhere to investment strategies and risk profiles in order to preserve – and even increase – investor confidence.
In this context, quickly recognizing liquidity imbalances via an unbiased, market-based liquidity model is key to effectively navigating the uncertainty created by Covid-19.
Following consultations initiated in April 2019, ESMA published its final guidelines on liquidity stress testing (LST) in UCITS and AIFS on 2 September.
The newly released guidelines will take effect on 30 September 2020.
UCITS, AIFS (including ETFs that operate as UCITSs or AIFs), MMFs and leveraged closed-ended AIFs all fall within the scope of the guidelines.
Why is liquidity stress testing so important?
Liquidity risk has made headlines recently. The announced suspension of the Woodford Equity Income Fund, followed by H2O Asset Management’s heavy outflows due to concerns over the liquidity of certain bonds, resulted in increased scrutiny from regulators and the market.
Additionally, the Covid-19 crisis caught several investment managers off guard and unable to promptly recognize materializing liquidity constraints or gauge the relationship between liquidity and market risk. LST likely represents the best and most effective way for risk managers to simulate market turmoil and liquidity shortages in order to get a sense of the potential liquidity risk.
What does this mean for asset managers?
Asset managers have been given an ambitious implementation timeline for complying with the new requirements.
LST will have to be carried out on an annual basis, at minimum, but ESMA recommends quarterly testing; specific situations (for instance, high dealing frequency) increase or decrease the frequency required.
Following the consultations, ESMA also clarified that reverse stress testing (RST) – albeit useful, especially for funds exposed to high-impact and low-probability events – will not be mandatory for all funds in light of the complexity of implementation, and the limited added value for the majority of funds.
As a result, the LST should take into account both historical and hypothetical scenarios and, if necessary, RST.
Lastly and most importantly, the guidelines require the asset management industry to demonstrate or build up an acceptable level of substance in terms of liquidity risk management and measurement knowledge.
The asset perspective
The Covid-19 crisis fueled a rapid increase in transaction costs across different asset classes, with changes more visible on both investment grade and high-yield corporate bonds.
To simulate severe liquidity and market pressure, stress testing should be conducted on the asset side to account for both historical (Lehman’s crisis, for example) and hypothetical (say, rising interest rates) scenarios and, if relevant, reverse stress testing.
The guidelines include an innovative improvement: While assessing the time and cost of asset liquidation, the manager will need to ensure compliance with investment objectives and restrictions.
Being able to liquidate assets to meet redemption requests might no longer be enough to maintain investor confidence, especially from those remaining in the fund.
Consequently, the simulation of asset liquidation would likely result in a sort of “slicing” of the fund as opposed to a “waterfall” approach, which can potentially translate into portfolios that are not compliant with existing investment restrictions and policies.
The slicing approach would offer a more realistic picture of how a manager would liquidate assets under normal conditions and determine the “true” liquidity of the funds’ assets. On the other hand, the presence of even small pockets of illiquid assets might impair the ability of the fund to obtain liquidity in a short amount of time.