The European Systemic Risk Board (ESRB) has published a recommendation on action to address systemic risks related to liquidity mismatches and the use of leverage in investment funds. The ESRB 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.
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, potentially affecting other financial market participants holding the same or correlated assets. Leverage may amplify the impact of negative market movements. The recommendation, which takes into account ongoing international and European initiatives on macroprudential policy in this area, is addressed to the European Securities and Markets Authority (ESMA) and the European Commission.
It focuses on five areas where the ESRB sees a need for ESMA to provide supervisory authorities with guidance on applying the macroprudential elements of the current regulatory framework and/or for legislative changes to be made. The recommendation advocates a proportionate framework for managing the systemic risks that can arise in, or be propagated by, the investment funds sector while maintaining the key redemption features that attract investors to open-ended investment funds and facilitate collective investment.
Additional liquidity management tools, further supervisory requirements and tighter liquidity stress testing practices can address risks from liquidity mismatches. The ESRB recommends making a diverse set of liquidity management tools available to fund managers to help them deal with redemption pressures when market liquidity is low. Such tools could include the ability to impose redemption fees and to temporarily suspend redemptions. In order to mitigate or prevent excessive liquidity mismatches at open-ended alternative investment funds (AIFs) holding a large amount of less liquid assets, such funds should be required to show supervisors that they would be able to maintain their investment strategy under stressed market conditions. To reduce liquidity risk and strengthen the ability of entities to manage liquidity in the best interests of investors, the ESRB also recommends that ESMA develop further guidance on how fund managers should carry out liquidity stress tests.
Risks from leverage can be addressed by creating a harmonized reporting framework and by making better use of existing possibilities to set leverage limits. The ESRB recommends establishing a harmonized reporting framework across the EU for undertakings for collective investment in transferable securities (UCITS) to make it easier for authorities to monitor such funds and assess any risks to financial stability. It also recommends that ESMA develop guidance to help supervisory authorities both assess leverage risks in the AIF sector and design, calibrate and implement macroprudential leverage limits. Such guidance would facilitate the implementation of Article 25 of the EU Alternative Investment Fund Managers Directive, which provides an existing macroprudential tool to limit leverage in AIFs.