Fund Management

The European Securities and Markets Authority (ESMA), the EU’s securities markets’ regulator, has developed a framework to be used for stress simulations for the investment fund sector. The method developed by ESMA is presented in detail in its Economic Report published today, and is accompanied by a case study where it is applied to 6,000 UCITS bond funds. 

Steven Maijoor, ESMA Chair, said:

“The stress simulation framework is a key element of ESMA’s stress testing strategy, which also includes guidelines on liquidity stress testing and on money market fund stress testing. The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU financial system. 

“This framework will be an important tool for supervisors to assess risks in the asset management industry, as the methodology developed by ESMA can be applied across the industry’s different sectors.”

The development of the fund industry has provided retail and institutional investors with a range of investment vehicles, and in the period between 2007 and 2018 the total net assets managed by EU-domiciled UCITS funds have increased significantly from EUR 6.2tn to EUR 9.3tn. Therefore, it is crucial to ensure that the fund industry is resilient and is able to absorb economic shocks.

ESMA, in applying the stress simulation framework to the UCITS bond funds sector, has simulated a pure redemption shock, where a large number of investors request to reduce or withdraw their parts in the fund within a short timeframe. The results show that overall, most funds are able to cope with such extreme but plausible shocks, as they have enough liquid assets to meet investors’ redemption requests. However, pockets of vulnerabilities are identified, especially for High Yield (HY) bond funds. Under the severe but plausible assumptions of our simulations, up to 40% of HY bond funds could experience a liquidity shortfall, i.e. a situation in which their holdings of liquid assets alone would not suffice to cover the redemptions assumed in the shock scenario and recourse to less liquid assets would need to be taken.

As a second step, the impact of the funds’ liquidation on financial markets has been modelled, as funds need to sell assets to meet investors’ redemptions, thereby exerting downward pressure on assets prices. The results show that the overall price impact is limited for most asset classes, as sales by funds are only a fraction of aggregate trading volumes. However, for asset classes with more limited liquidity, such as HY bonds and Emerging Markets (EM) bonds, fund sales could have a material impact, ranging from 150 to 300 basis points, and generate material second round effects.

Next steps

The method described in this report can be used by regulators to simulate stress situations for different segments of the fund industry. ESMA has also discussed the underlying data in detail with the relevant national authorities, to ensure the knowledge gained from this case study can benefit the day to day supervision of this sector.  

ESMA will use this stress simulation framework as part of its regular risk monitoring to identify risk and assess possible adverse scenarios that might impact the EU fund industry. 

The European Securities and Markets Authority (ESMA) has published today its final guidance regarding liquidity stress tests of investment funds – applicable to both Alternative Investment Funds (AIFs) and Undertakings for the Collective Investment in Transferable Securities (UCITS). 

ESMA’s guidelines require fund managers to stress test the assets and liabilities of the funds they manage. This includes redemption requests by investors which are the most common and important source of liquidity risk and could also impact financial stability. Managers of AIFs and UCITS must be aware of the liquidity risk of the funds they manage and use stress testing as a tool to mitigate this risk. EU-based funds need to regularly test the resilience of their funds to different types of market risks, including for liquidity risk.

Guidelines will foster supervisory convergence

Fund managers will need to apply a comprehensive set of guidelines when designing the scenarios, policies and frequency of liquidity stress tests for the funds they manage. The Guidelines also recommend managers to notify National Competent Authorities (NCAs) of material risks and actions taken to address them. One Guideline also applies to depositaries, requiring verification that the fund manager has in place documented procedures for its liquidity stress testing programme.

The common requirements will allow convergence in the way NCAs supervise liquidity stress testing across the EU.

The ESMA Guidelines follow recommendations by the European Systemic Risk Board (ESRB) published in April 2018 on how to address liquidity and leverage risk in investment funds. The ESRB mandate asked for the principles to be based on the stress testing requirements set out in the Alternative Investment Fund Directive (AIFMD) and on how market participants carry out stress testing.

Next steps

The Guidelines will become applicable on 30 September 2020. The requirements set out in the Guidelines are supplementary to the requirements on liquidity stress testing which are enshrined in the AIFMD and UCITS Directives and are already applicable.

The European Securities and Markets Authority (ESMA) has today issued two sets of guidelines regarding the stress testing of money market funds and reporting on money market funds to national competent authorities (NCAs), aimed at ensuring a coherent application of the Money Market Fund (MMF) Regulation.

The Guidelines on stress testing establish common reference parameters of the stress test scenarios MMFs or managers of MMFs should include in their stress scenarios. The Guidelines on reporting provide guidance on how to fill in the reporting template on money market funds that managers of MMFs will transmit to competent authorities as of Q1 2020.

Steven Maijoor, Chair, said:

“Money market funds offer high liquidity at lower risk than other funds, contributing to the funding of banks, governments and corporates. However, due to their important role in the money market, any disruption affecting MMFs may impact financial stability. Stress testing is an important tool to assessing and mitigating potential stability risks.

Our guidance will ensure that the same level of care, risk management, and stress testing is applied across the European MMF sector – allowing investors to benefit from similar safeguards across different countries.”

MMFs need to report their stress test results by 2020

MMFs and managers of MMFs are expected to measure the impact of the common reference stress test scenarios specified in the Guidelines, the results of which should be shared with regulators through the reporting template with their first quarterly reports for Q1 2020. Therefore, the Guidelines include stress test scenarios in relation to hypothetical changes in MMFs’:

  • liquidity levels;
  • credit and interest rate risks;
  • redemptions levels;
  • widening/ narrowing of spreads among indexes to which interest rates of portfolio securities are tied; and
  • macro-economic shocks

The guidelines will be updated at least every year and will take into account the latest market developments. The current guidelines include the calibration of the stress test scenarios for 2019.