ESMA Publishes Recommendation on Leverage and Liquidity in Investment Funds
Saturday, February 17, 2018

On February 14, the European Systemic Risk Board (ESRB) published a recommendation (dated December 7, 2017) on liquidity and leverage risks in investment funds managed by regulated EU managers (specifically open-ended alternative investment funds (AIFs) and undertakings for collective investment in transferable securities (UCITS)).

The ESRB raises concerns that increased financial intermediation by such investment funds may result in the amplification of any future financial crisis. This is because mismatches between the liquidity of funds’ assets and their redemption profiles may result in “fire sales” in order to meet redemption requests in times of market stress. Such sales could adversely affect other financial market participants that own the same or closely correlated assets. The recommendation also highlights that in addition to such channels of indirect contagion, an investment fund can spread risk through interconnectedness (e.g., interconnections with its investors), a direct channel through which shocks can be transmitted to other financial institutions.

The recommendation is addressed to the European Securities and Markets Authority (ESMA) and the European Commission and includes the following specific recommendations to address the above concerns:

  • The EC should develop legislation that sets out a legal framework governing liquidity management tools in the design of investment funds;
  • The EC should develop legislation that includes measures to limit the extent to which the use of liquidity transformation in AIFs can contribute to the build-up of systemic risks or the risk of disorderly markets;
  • ESMA should develop guidance for managers of AIFs and UCITS for the stress testing of liquidity risk for individual funds. 
  • The EC should develop legislation that requires reporting of UCITS liquidity risk and leverage data to national competent authorities; and
  • ESMA should give guidance on the framework to assess the extent to which the use of leverage within the AIF sector contributes to the build-up of systemic risk in the financial system.

The recommendation contains timelines for ESMA and the EC to report on any actions they have taken for each specific recommendation, with suggested dates in 2019 and 2020.

The recommendation is available here.

 

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