By John Filar Atwood
The European Systemic Risk Board (ESRB) issued recommendations to address the systemic risks related to liquidity mismatches and the use of leverage in investment funds. The recommendations, which are addressed to the European Securities and Markets Authority (ESMA) and the European Commission, focus on five areas where the ESRB sees a need for ESMA to provide supervisory authorities with needed guidance and/or for legislative changes to be made.
In drafting the recommendations, the ESRB took into account the existing international and European efforts in this area. The ESRB said in a news release that it considered a number of risks that may stem from the increasing role played by investment funds in financial intermediation and could result in the amplification of any future financial crisis.
Fire sales. In the ESRB’s view, mismatches between the liquidity of open-ended investment funds’ assets and their redemption profiles could lead to “fire sales” to meet redemption requests in times of market stress. This could affect other market participants holding the same or correlated assets, and may amplify the impact of negative market movements.
The ESRB believes that additional liquidity management tools and supervisory requirements, along with tighter liquidity stress testing practices can address risks from liquidity mismatches. The ESRB recommended making available to fund managers liquidity management tools such as the ability to impose redemption fees and to temporarily suspend redemptions.
In order to prevent excessive liquidity mismatches at open-end alternative investment funds (AIFs) holding a large amount of less liquid assets, the ESRB suggested requiring those funds to show supervisors that they would be able to maintain their investment strategy under stressed market conditions. The ESRB also recommended that ESMA develop further guidance on how fund managers should carry out liquidity stress tests to help reduce liquidity risk and strengthen the ability of entities to manage liquidity in the best interests of investors.
Harmonized reporting. The ESRB stated that risks from leverage can be addressed by creating a harmonized reporting framework and by making better use of existing possibilities to set leverage limits. It recommended establishing a harmonized reporting framework across the EU for undertakings for collective investment in transferable securities.
The ESRB also suggested that ESMA should develop guidance to help supervisory authorities assess leverage risks in the AIF sector, and design and implement macroprudential leverage limits. In the ESRB’s opinion, the guidance would facilitate the implementation of Article 25 of the EU Alternative Investment Fund Managers Directive, which provides a macroprudential tool to limit leverage in AIFs.