• Alan Picone, Partner |

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.

Regulatory background

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.

The liability aspect

Considerable attention has been paid to stress testing liabilities – something traditionally put on the back burner.

Scenarios for stress testing should change according to market conditions. For normal conditions, averages and trends of historical outflows could be used. For stressed conditions, however, the guidelines suggest using historical severe outflows or hypothetical/event-driven scenarios, as well as reverse stress testing.

If the historical approach is used, severe outflows could be calibrated by simply relying on the empirical distribution of net flows, or by initially using a parametric distribution and then a VaR or expected shortfall approach.

When looking at redemption from another perspective, we see that fund performance can be a valuable predictor of future outflows. The flow-return relationship is estimated using simple regression analyses and can be a suitable field of application for more advanced data analytics techniques.

In this context, historical time series of subscription and redemption becomes an invaluable asset in setting up and calibrating the liability-side stress.

“Liability side” means considering potential liabilities other than redemptions, such as those related to derivatives trading. Market volatility could indeed lead to larger than anticipated margin calls that need to be covered by the fund’s available liquidity. Due to the Covid-19 crisis, this scenario materialized at hedge fund Parplus Partners, who were unable to meet margin requirements following stressed US market conditions. This emphasizes the importance of considering the interaction between liquidity risk and market risk.

A holistic view

Once stress testing has been carried out on both assets and liabilities, the asset manager should combine the results to assess the overall impact on the fund. Eventually, the LST should be translated into a common metric, such as the redemption coverage ratio (RCR) or, if liquidity is estimated using the time-to-liquidity approach, into the fund liquidation coverage ratio (FLCR) to ensure comparability between an asset manager’s funds. It is likely that ratios like RCR and FLCR will become the indicators most predominantly monitored internally and used to trigger escalation processes.

KPMG expertise

KPMG’s Liquidity Risk Assistant provides liquidity risk assessment as well as liquidity stress testing solutions for asset managers. We are highly experienced in validating RMPs and defining frameworks for liquidity stress testing. We can help.

This article has been written together with Francesco Vittori and Gianmarco Gioia.