AFM Feedback on Investigation into Liquidity Risk Management for UCITS

Stichting Autoriteit Financiële Markten
Kamer van Koophandel Amsterdam, nr. 41207759
Reference of this letter:
Visit address Vijzelgracht 50
P.O. Box 11723 • 1001 GS Amsterdam
Telephone +31 (0)20-7972000 • www.afm.nl
AFM - Confidential
Email Ondernemersloket@afm.nl
Subject Feedback on findings of the investigation into liquidity risk management for UCITS

Dear Sir or Madam,

The Authority for the Financial Markets (AFM) has conducted an investigation into the management of liquidity risks within Undertakings for Collective Investment in Transferable Securities (UCITS). The investigation took place as part of a Common Supervisory Action (CSA) in the European Union and is coordinated by the European Securities and Markets Authority (ESMA).

With this letter, the AFM provides a generic feedback of this investigation to all managers of UCITS subject to the supervision of the AFM. Where necessary, you can implement improvements in your organization based on these findings. This letter also includes a link to the report published by ESMA on 24 March 2021. This report contains the findings collected by ESMA from all supervisory authorities that participated in this investigation.

It has become apparent that the assessment framework compiled by ESMA extends to standards on which the AFM is not the designated supervisor under legislation and regulations. This feedback letter contains only the findings regarding topics on which the AFM is the designated supervisor.

Based on this investigation, the AFM has determined that the management of liquidity risks meets requirements on most topics for the majority of the investigated managers. There is room for improvement on a number of points. During its investigation, the AFM identified a number of shortcomings in the area of forecasts and analysis of liquidity prior to investment and in the area of governance and internal control procedures. In this letter, the AFM elaborates further on the investigation and the findings.

This letter is structured as follows:

1. Background of the investigation

2. The investigation

3. Findings

4. ESMA Report

5. Conclusion

6. Background of the investigation
   On 30 January 2020, ESMA announced that it would coordinate a joint supervisory investigation in the area of liquidity risk management within UCITS in all member states of the European Union. The AFM subsequently conducted this investigation with thirteen UCITS managers registered in the Netherlands. Through this investigation, the AFM has been able to form a clear picture of the manner in which UCITS managers comply with the requirements regarding liquidity risk management as prescribed in the UCITS guidelines.

7. The investigation
   The objective of the investigation was to gain insight into liquidity within UCITS under certain market conditions and to map and limit the risks regarding that liquidity from a supervisory perspective. The impetus for this was, among other things, the stress-test simulation1 conducted by ESMA in 2019 among 6,000 bond funds. It emerged from this that under extreme but realistic circumstances, up to 40% of the high-yield bond funds within this group could come into serious liquidity problems, whereby the funds could not meet their redemption policy. Additionally, in the past, several incidents occurred with managers2 of UCITS where there was a discrepancy between the liquidity profile of the relevant funds and their redemption policy.

Central to the investigation was the extent to which participating parties comply with obligations regarding liquidity risk management within UCITS. In this regard, the AFM tested compliance against the standards applicable thereto resulting from the UCITS Directive3.

1 ESMA Stress Simulation Framework for Investment Funds (September 2019).
2 In the United Kingdom, incidents regarding liquidity occurred with H2O, Woodford, and GAM (managers of UCITS).
3 Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS).

The obligations regarding liquidity risk management within UCITS were outlined for the investigation in five sub-areas:

1. Forecasts and analysis of liquidity prior to investment
2. Alignment of liquidity profile with redemption policy
3. Availability and reliability of data sources
4. Governance and internal control procedures
5. Investor information

The investigation had two different phases. A primarily quantitative investigation with all UCITS managers in the first phase and a further investigation with four managers in the second phase. The selection of UCITS managers in phase II forms a balanced cross-section of the Dutch market of UCITS managers.

3. Findings
   In this paragraph, the AFM elaborates on the findings made in the second phase of the investigation. Only findings are mentioned regarding the sub-areas where parties are required to improve. Before the findings are presented, a brief explanation will first be given of the legal framework.

ESMA Assessment Framework
In assessing liquidity risk management within UCITS, the AFM tested against Directive 2010/43/EU4, which serves to implement the UCITS Directive, and Regulation 2010/583/EU5. Provisions from the UCITS Directive and implementing directives have been implemented in Dutch legislation and regulations.

4 Implementing Directive 2010/43/EU of the Commission of 1 July 2010 on the implementation of Directive 2009/65/EC of the European Parliament and of the Council as regards organisational requirements, conflicts of interest, conduct of business, risk management and the content of the agreement between a depositary and a management company (hereinafter UCITS Directive). 5 Regulation 2010/583/EU of 1 July 2010 concerning the key investor information and the conditions to be met if the key investor information or the prospectus is provided on another durable medium or via a website.

Forecasts and analysis of liquidity prior to investment Pursuant to Article 23, paragraph 4, first sentence, of Directive 2010/43/EU, UCITS managers are required to formulate forecasts and conduct analyses regarding the contribution of the investment to the composition of the UCITS portfolio, liquidity, and risk-return profile before proceeding with the investment, when implementing their risk management policy and where appropriate, in light of the nature of a planned investment.

The AFM has determined that UCITS managers only formulate liquidity forecasts prior to investment in a limited number of situations. It is not determinable by the AFM why these managers do not conduct forecasts and analyses prior to investments in many cases, as this is not documented. Managers have not demonstrated whether they use the 'presumption of liquidity'6. Consequently, it cannot be determined whether the criteria mentioned in the aforementioned article are met. Furthermore, none of the investigated managers were able to provide recent examples of forecasts and analyses of liquidity prior to investment per investment and per investment category.

Governance and internal control procedures
Pursuant to Article 9, paragraph 2, point f, of Directive 2010/43/EU, UCITS managers are required to ensure that their senior management periodically assesses and approves the policies, arrangements, processes, and techniques of risk management.

Pursuant to Article 9, paragraph 3, of Directive 2010/43/EU, UCITS managers are required to ensure that senior management and, where applicable, the supervisory function: a) conducts a review and periodic evaluation of the effectiveness of the codes of conduct, arrangements, and procedures provided for to comply with the obligations under the UCITS Directive, and b) takes appropriate measures to remedy any deficiencies.

Pursuant to Article 9, paragraph 4, of Directive 2010/43/EU, UCITS managers are required to ensure that their senior management receives frequent, but at least annual, written reports on compliance, internal control, and risk management, indicating in particular whether appropriate measures have been taken in case of deficiencies.

6 As included in Article 2, paragraph 1, of Directive 2007/16/EC of 19 March 2007 implementing Council Directive 85/611/EEC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards the clarification of certain definitions.

The AFM has determined that the senior management of UCITS managers is not informed periodically in all cases on topics lying within the field of liquidity risk management as mentioned in Article 9, paragraph 2, point f, of Directive 2010/43/EU. The documentation received by the AFM also shows insufficient evidence that persons determining the policy at managers approve and evaluate the risk management policy and the procedures and measures for the implementation of the risk management policy, as mentioned in Article 9, paragraph 3, of Directive 2010/43/EU.

Furthermore, it appears that in all cases, senior management of UCITS managers is not reported frequently, but at least annually, in writing on compliance, internal control, and risk management.

ESMA Report
On 24 March 2021, ESMA published a report following the CSA. This report contains the findings made by European supervisors with parties supervised in those countries. The report can be found at the following link: ESMA Report.

4. Conclusion
   The AFM expects all managers to take note of the findings of this investigation and to implement improvements in their organization where necessary. The AFM will maintain ongoing attention for liquidity risk management with managers in its continuous supervision.

If you have any questions following this letter, please contact the Ondernemersloket via ondernemersloket@afm.nl. Always include your license number when asking questions. Due to coronavirus measures, our Ondernemersloket is currently only reachable by email. You can include a callback request in your email. In that case, indicate on which telephone number you can be reached.

Yours faithfully,
Authority for the Financial Markets