New Liquidity Stress Testing Rules For Investment Funds

Author:Mr Kevin Murphy, Tara O'Reilly, Sarah Cunniff, Dara Harrington, Cormac Commins, Ian Dillon and Siobhan McBean
Profession:Arthur Cox

Fund liquidity looks set to remain a regulatory and supervisory priority at both domestic and EU level over the coming year.

In an industry letter issued 7 August 2019, the Central Bank highlighted the importance of liquidity risk management and liquidity stress testing in investment funds and at EU level, ESMA has published its final guidelines on liquidity stress testing ("Guidelines") in UCITS and AIFs.

The Guidelines apply to fund managers and provide guidance on how they should carry out liquidity stress tests on the individual funds that they manage and how depositaries should fulfil their obligations regarding these stress tests. The Guidelines, are supplementary to the requirements on liquidity stress testing ("LST") in the AIFM and UCITS Directives and may be applied proportionately, having regard to the nature, scale and complexity of each fund. The Guidelines apply to all UCITS and AIFs, with ESMA clarifying that this includes those funds established as money market funds, ETFs, and leveraged closed-ended AIFs(1).

The Guidelines require fund managers to stress test the assets and liabilities of the funds they manage, which includes redemption requests by investors. Managers should be aware of the liquidity risk of the funds they manage and use stress testing as a tool to mitigate this risk. Under the Guidelines, fund managers must:

integrate LST into a fund's risk management framework and LST should be subject to appropriate governance and oversight; have a strong understanding of liquidity risks and a fund's overall liquidity profile; develop LST models, ensuring that the LST provides information enabling follow-up action; adapt the LST to each fund; include an LST policy in the UCITS and/or AIF risk management process. This policy should be kept under review and the LST adapted as appropriate. This policy should include at a minimum: a statement of ownership of the policy and the management function responsible for its performance; a clear definition of the role of senior management in the LST process; the interaction of the LST policy with other liquidity risk management procedures, including the fund manager's contingency plans and the portfolio management function; a requirement for regular internal reporting of LST results specifying the frequency and recipients of the report; provision for periodic review, documentation of the results and a procedure for amending the policy where required by the review; the...

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