On 2 September 2019, ESMA issued its Final Report entitled Guidelines on liquidity stress testing in UCITS and AIFs (LST Guidelines).
The LST Guidelines, which include 16 guidelines for UCITS managers and AIFMs and one for depositaries, are to be applied to both UCITS and AIFs, including ETFs, leveraged closed-ended AIFs and, in part, to MMFs.
The LST Guidelines will apply in respect of both existing and new funds from 30 September 2020.
Current stress testing requirements for funds
Currently, UCITS managers and AIFMs are, under their respective legislative regimes, required to have liquidity risk management processes in place for the funds they manage. For AIFMs, these requirements provide for the "regular conduct [of] stress tests" in addition to specific and detailed requirements for the performance of liquidity risk management under AIFMD Level 2. UCITS are required to "conduct, where appropriate, periodic stress-tests".
In addition, from a regulatory standpoint, both UCITS managers and AIFMs are in scope of the Recommendations for Liquidity Risk Management (Liquidity Recommendations) published by the International Organisation of Securities Commissions (ISOCO) in February 2018. IOSCO advocates stress testing by managers as an "important component of [the] liquidity risk management process" and sets down a series of good practices under the recommendation for its performance on funds.
UCITS managers v AIFMs
AIFMs are likely to be more familiar with many of the LST guidelines as they take account of and, in many respects materially track, the relevant requirements applicable to AIFMs under the Level 2 Regulations as well as the good practices under IOSCO's Liquidity Recommendations.
As a result, however, the LST Guidelines will represent an increase in obligations for UCITS managers which, understandably given the more stringent portfolio liquidity rules for UCITS funds, are currently subject to less detailed liquidity risk management obligations under the UCITS regime.
Proportional application of LST
While the LST Guidelines result in the effective application of many of the AIFM liquidity risk management requirements in respect of stress testing to UCITS managers, the LST Guidelines also include a general ability to adapt the guidelines to the nature, scale and complexity (principle of proportionality) of the funds under management. In addition, certain of the guidelines specifically provide for flexibility in their adoption on the grounds of proportionality. For example, under paragraph 25 'Frequency of LST', managers must carry out liquidity stress testing at least annually (in line with AIFMD Level 2) but with a recommendation to "employ quarterly or more frequent LST". However, depending on a fund's nature scale and complexity and its liquidity profile, there is flexibility for a manager to determine a lower frequency once the basis for such determination is recorded by the manager.
Action required under LST Guidelines
UCITS managers and AIFMs are obliged to adopt an LST policy, appropriately adapted for each fund under management (paragraph 30), which addresses the items specified, in line with the principles outlined in the guidelines. The LST policy of the manager should be included in the fund's risk management process (RMP) and, as such, will require to be filed with the Central Bank pursuant to applicable regulatory requirements.
LST model & policy
The LST policy should include the LST model (initially validated independently from portfolio management but not necessarily from the manager) adopted by the UCITS manager or AIFM. In building an LST model, the LST guidelines provide that UCITS managers and AIFMs should have regard to;
➢ liquidity risk factors for the fund; The risk factors included should be sufficiently specific to the fund whilst also capturing risks arising under a wide enough range of normal and stress scenarios.
➢ the types of scenarios; Normal scenarios included may reflect historical outflows, average redemptions of peer funds and information from any distribution network regarding forecast redemptions. For stressed scenarios, examples are historical trends, historical events, contemporary trends in peer funds, hypothetical/event-driven scenarios and reverse stress testing (RST). The use of RST is recommended but not mandated by the LST Guidelines following significant resistance from industry during the consultation process.
➢ monitoring of outputs and indicators of the LST; Under the LST Guidelines, outputs/indicators may include identification of a breach of liquidity limits/thresholds set by the manager. During the consultation process, ESMA's proposal to impose an obligation to set liquidity limits was intensively commented upon. Many respondents were of the view that there should be no obligation to set limits and instead their application should be a matter left to the discretion of the manager having regard to the redemption policy of the fund. ESMA has acknowledged the responses and rather than there being an obligation to do so the LST Guidelines refer to the setting of liquidity limits as "an additional risk management tool".
➢ reporting of results, outputs and monitors to management; and LST should be performed under similar conditions to other risk management operations that are subject to regulatory requirements e.g. performed independent of other functions such as portfolio management, and effective management of conflicts of interest.
➢ how LST results should be used by risk, portfolio and senior, management. The LST Guidelines provide for the stress testing of assets, principally the time and/or cost to liquidate, and liabilities, including redemption requests and other liabilities such as margin calls under derivative contracts and counterparty risk from OTC transactions.
LST guidelines for depositaries and interaction with NCAs
In addition to the 16 guidelines for UCITS managers and AIFMs, the LST Guidelines include a requirement for depositaries to verify the existence of a manager's LST policy. The LST Guidelines specifically obviate the need for depositaries to assess the adequacy of LST or challenge the LST undertaken by a manager. The role of the depositary is confined to verification, for example, by confirming that the fund RMP includes provision for the carrying out of LST on the fund.
The facilitation of access to LSTs by NCAs is ensured by the final guideline which provides NCA's with the discretion to request submission of LSTs and notification of other information relating to the LST such as models adopted and their results.
On 13 August 2019, the European Union (AIFM) (Amendment) Regulations (Amending AIFM Regulations) and the European (UCITS) (Amendment) Regulations (Amending UCITS Regulations) were published and became effective. Both sets of regulations amend the principal legislation used to transpose the applicable EU regime into Irish law.
Summary of Amendments
Key amendments introduced by the Amending AIFM Regulations include:
➢ The clarification of the requirements, including under MiFID II/MiFIR, which apply to AIFMs authorised under the AIFM Regulations to carry out individual portfolio management in addition to collective portfolio management of investment funds. ➢ The incorporation of the following provisions which are in line with the soon to be effective Regulation on the Safekeeping Duties of Depositaries (effective 1 April 2020):
- "22(7A) In the event of the insolvency of a depositary, or any third party, located in the Union (a) to which custody of AIF assets has been delegated, or (b) which holds cash assets of an AIF, neither the assets of an AIF held in custody nor the cash assets held shall be available for distribution among, or redistribution among, or realisation for the benefit of, creditors of the depositary or third party concerned.”,
- "22(17) The assets of an Irish AIF shall (a) belong exclusively to the AIF, and (b) be segregated from the assets of the depositary or its agents or both and shall not be used to discharge directly or indirectly liabilities or claims against any other undertaking or entity and shall not be available for any such purpose.”.
➢ The inclusion of a new obligation on the auditor of the AIF's annual accounts to report, during the conduct of an audit, matters which may give rise to a breach, may affect the functioning of the AIF or lead to a refusal to certify or qualification of the accounts. In addition, the auditor should report any of these issues where it becomes aware of them while conducting an audit of an entity with close links to the AIF.
➢ The existing (as referenced in the Central Bank's AIFMD Q&A document) ability of an AIFM to provide IPM on a cross-border basis has been put on a legislative footing.
➢ A specific reference to the ability of the CB to require suspension of an AIF managed by a non-Irish AIFM. This is in addition to the already broad powers of the CB to take any and all appropriate measures against a non-Irish AIFM operating in Ireland to prevent or penalise irregularities.
Key amendments introduced by the Amending UCITS Regulations include:
➢ The clarification of the requirements, including under MiFID II/MiFIR, which apply to UCITS managers authorised under the UCITS Regulations to carry out individual portfolio management in addition to the collective portfolio management of funds.
➢ The incorporation of the following provisions which are in line with the soon to be effective Regulation on the Safekeeping Duties of Depositaries (effective 1 April 2020):
- "33(3) The assets of an investment company shall belong exclusively to the investment company, (4) The assets referred to in paragraph (3) shall be segregated from the assets of the depositary or its agents or both and shall not be used to discharge directly or indirectly liabilities or claims against any other undertaking or entity and shall not be available for any such purpose.”
- "37(5) In the event of the insolvency of a depositary, or any third party, located in the Union (a) to which custody of UCITS assets has been delegated, or (b) which holds cash assets of a UCITS, neither the assets of a UCITS held in custody nor the cash assets held shall be available for distribution among, or redistribution among, or realisation for the benefit of, creditors of the depositary or third party concerned.”
Central Bank 'Dear Chair' letter on liquidity management
On 7 August 2019, the Central Bank issued a letter to Fund Management Companies with the stated aim of "reminding them of the importance of ongoing, effective liquidity management and ensuring compliance with relevant legislation and regulatory obligations for UCITS and AIFs linked to Brexit preparedness"
The letter highlights several of liquidity management obligations of Fund Management Companies including the execution of a liquidity risk management framework which provides for regular liquidity monitoring, stress texting of assets and the deployment of liquidity tools in line with applicable legal and regulatory rules. The Central Bank also took the opportunity to note that, as part of its overall Brexit preparedness work, it will be increasing its monitoring of investment fund liquidity and redemption activity in the manner undertaken prior to the 31 March Brexit deadline.
While no response was necessary, the letter did require that the contents be brought to the attention of all members of the board, the relevant designated persons and "relevant responsible persons within delegate Fund Service providers". As such, and given the Central Bank's intention to "have regard to the contents of this letter as part of future supervisory engagements", Fund Management Companies would be well advised to ensure the availability of demonstrable evidence of the relevant parties having received and considered the contents of the letter. Such evidence may include;
a) documentation of a review of liquidity risk management processes, the consideration of any changes required or advisable, the assessment of the appropriateness of any tests/metrics used and whether these remain in line with the Central Bank's expectations and current best practice.
b) confirmatory reports that the letter has been brought to the attention of relevant designated persons and those relevant responsible persons within the Fund Management Company's delegates.