RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD

of 6 May 2020

on the liquidity risks of investment funds

(ESRB/2020/4)

(2020/C 200/01)

THE GENERAL BOARD OF THE EUROPEAN SYSTEMIC RISK BOARD,

Having regard to the Treaty on the Functioning of the European Union,

Having regard to Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on macro-prudential oversight of the financial system in the European Union and establishing a European Systemic Risk Board (1), and in particular Article 3(2)(b), (d) and (f), and Articles 16 to 18 thereof,

Having regard to Decision ESRB/2011/1 of the European Systemic Risk Board of 20 January 2011 adopting the Rules of Procedure of the European Systemic Risk Board (2), and in particular Article 15(3)(e) and Articles 18 to 20 thereof,

Whereas:

(1) The coronavirus (COVID-19) pandemic and the subsequent necessary containment measures have caused an unprecedented severe disruption to European economies. In light of this situation, at its meeting on 2 April 2020, the General Board of the European Systemic Risk Board (ESRB) announced that it would focus its attention on five priority areas where coordination among Union authorities was likely to be particularly important to safeguard the financial stability of the Union (3). One of those priority areas is the liquidity of financial markets and its consequences for asset managers and insurers.

(2) The sharp fall in asset prices observed at the beginning of the COVID-19 pandemic was accompanied by a significant level of redemptions in some investment funds and a considerable worsening of financial market liquidity. Although market conditions have since stabilised, largely thanks to the decisive action of central banks, supervisory authorities and governments, in the Union and worldwide, there remains great uncertainty regarding macro-financial prospects.

(3) Previous ESRB assessments (4) of non-bank financial intermediation have highlighted possible vulnerabilities related to investment funds with short maturity profiles but investing in less liquid assets. These liquidity mismatches increase the risk of greater pressure on asset valuation in times of stress, if investment funds attempt to sell less liquid assets in a short period of time to meet redemptions, which may lead to mark-to-market losses for other financial institutions exposed to the same or related assets, or a sudden tightening of financial conditions.

(4) Current Union rules establish explicit obligations for fund management companies regarding the liquidity risk management of the funds they manage (5). In the case of Undertakings for Collective Investment in Transferable Securities (UCITS), the liquidity profile of investments must be consistent with the redemption policy set out in the fund rules, the instrument of incorporation or the prospectus. Similarly, the investment strategy, liquidity profile and redemption policy of Alternative Investment Funds (AIFs) must be consistent with each other (6). These rules are complemented by guidelines from the European Securities and Markets Authority (ESMA) on liquidity stress testing for UCITS and AIFs, according to which fund managers must subject them periodically to stress tests for resilience to liquidity risk under both normal and exceptional liquidity conditions (7).

(5) This recommendation aims to improve the level of preparedness to respond to possible future adverse disruptions capable of causing a worsening of financial market liquidity that may negatively affect the conditions of financial stability in the Union.

(6) The ESRB recognises that the Union investment fund sector is large and heterogeneous. Taking this into account, the ESRB has determined that there are two segments of that sector whose enhanced scrutiny from a financial stability perspective is particularly prioritised.

(7) The first of those segments is that of investment funds with significant exposure to corporate debt. Shortly after the start of the COVID-19 pandemic, there were many redemptions in investment funds investing in corporate debt. Furthermore, investment funds hold a significant share of the outstanding balances of non-financial corporate bonds in the Union. Any future redemption pressure on variable capital investment funds with short maturity profiles could lead fund managers to quickly sell less liquid assets, thereby contributing to the worsening of liquidity conditions in corporate debt markets. This could lead to adverse contagion effects on other financial institutions with exposures to those assets, such as insurance companies, pension funds or banks, or to adverse effects on the cost and availability of market-based financing for non-financial corporations.

(8) The second segment whose enhanced scrutiny from a financial stability perspective is considered by the ESRB to be particularly prioritised is that of investment funds with significant exposures to the real estate sector. The public health restrictions necessary to contain the spread of COVID-19 could lead to a reduction in the volume of real estate market transactions and greater uncertainty in valuations. It is estimated that real estate investment funds hold around one third of the commercial real estate market in the Union. Future redemptions from investment funds with significant real estate holdings could contribute to downward pressure on real estate valuations if accompanied by sales of real estate assets in an environment of low transaction volumes. This could negatively affect other financial institutions with real estate exposures, including those providing credit secured by real estate.

(9) To ensure that the Union financial system contributes to absorbing and not amplifying the disruptions caused by COVID-19, considerable coordination is needed, both among supervisory authorities responsible for different segments of financial markets and cross-border. This is especially the case for capital markets activities, including those carried out by investment funds, activities whose cross-border flows are significant and whose proper functioning depends on various actors throughout the financial system.

(10) The ESRB recognises the current highly prioritised work of ESMA towards greater supervisory convergence in liquidity risk management by fund managers, which includes the common supervisory action on liquidity risk management by UCITS managers announced in 2020 (8) and the continuous coordination of supervisory action by ESMA in response to COVID-19.

(11) This recommendation is without prejudice to the monetary policy mandates of the Union central banks.

(12) The ESRB recommendations are published after their addressees have been consulted and once the General Board has informed the Council of the European Union of its intention to publish them and has given it the opportunity to react.

HAS ADOPTED THIS RECOMMENDATION:

SECTION 1

RECOMMENDATION

Recommendation A – Coordination of supervisory action regarding investment funds to assess their level of preparedness

It is recommended that the European Securities and Markets Authority (ESMA):

1. coordinate with national competent authorities to carry out a supervisory exercise focused on investment funds with significant exposures to corporate debt and real estate assets and aimed at assessing the level of preparedness of these two segments of the investment fund sector against possible future adverse disruptions, including the possible resumption of significant redemptions, increased uncertainty in valuations, or both circumstances;

2. report to the ESRB its analysis and conclusions regarding the level of preparedness of the relevant investment funds.

SECTION 2

IMPLEMENTATION

1. Definitions

1. For the purposes of this recommendation, the following definitions shall apply:

(a) ‘national competent authority’ (NCA) means the competent authority defined in Article 2(1)(h) of Directive 2009/65/EC of the European Parliament and of the Council (9), or in Article 4(1)(f) of Directive 2011/61/EU of the European Parliament and of the Council (10);

(b) ‘investment fund’ means: (i) the Undertaking for Collective Investment in Transferable Securities (UCITS) defined in Article 1(2) of Directive 2009/65/EC and authorised in accordance with Article 5 of that Directive, and (ii) the Alternative Investment Fund defined in Article 4(1)(a) of Directive 2011/61/EU.

2. Implementation criteria

1. The implementation of this recommendation shall be governed by the following criteria:

(a) due consideration shall be given to the principle of proportionality, taking into account the objective and content of the recommendation;

(b) the specific implementation criteria set out in the Annex shall be met.

3. Follow-up timetable

1. In accordance with Article 17(1) of Regulation (EU) No 1092/2010, the addressees of the recommendations shall communicate to the European Parliament, the Council, the Commission, and the ESRB the measures taken in response to the recommendations, as well as adequate justification for any inaction. ESMA shall submit its communication by 31 October 2020 at the latest.

4. Monitoring and evaluation

1. The ESRB Secretariat shall, as appropriate:

(a) assist ESMA, contributing to certain parts of the analysis from a financial stability perspective;

(b) coordinate the follow-up procedure;

(c) provide ESMA with the assistance it requests.

2. The General Board shall evaluate the measures and justifications communicated by ESMA and, where appropriate, may decide that this recommendation has not been implemented and that ESMA has not adequately justified its inaction.

Done at Frankfurt am Main, 6 May 2020.

For the General Board of the ESRB,

The Head of the ESRB Secretariat,

Francesco MAZZAFERRO

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ANNEX

IMPLEMENTATION CRITERIA OF THE RECOMMENDATION

The implementation criteria for Recommendation A are as follows:

1. For the exercise to be targeted and timely, ESMA must coordinate with NCAs to:

(a) Determine which Union investment funds are highly exposed to corporate debt and real estate markets and are of special importance from a prudential perspective. By limiting the exercise to these funds, this recommendation aims to ensure that the exercise can be carried out within the available time. In determining the funds subject to the exercise, ESMA should also take into account other relevant characteristics, such as redemption frequency, the degree of leverage, or both.

(b) Target supervisory action towards the subset of investment funds determined in accordance with point (a) to help assess their current level of preparedness against an unexpected increase in redemptions, increased uncertainty in valuations, or both circumstances, and to form an opinion on how these funds would respond to possible short-term adverse disruptions.

(c) Evaluate the level of preparedness of the corporate debt and real estate segments of the investment fund sector and examine whether other measures are needed to improve that level of preparedness. The evaluation should focus in particular on possible future disruptions related to redemptions, uncertainty in valuations, or both, and examine whether other measures are necessary, for example, complementary guidelines for funds or supervisors regarding the use of liquidity management tools, the management of uncertainty in valuations, or both.

2. The following considerations should be taken into account as part of the supervisory exercise, with special attention to aspects relevant from a financial stability perspective.

(a) Funds highly exposed to corporate debt

As part of the targeted exercise regarding funds highly exposed to corporate debt, the following information may be of special importance from a financial stability perspective:

i) Information to assess fund behaviour at the start of the COVID-19 pandemic. This information could include: i) the level of redemptions observed at the beginning of the COVID-19 pandemic, when redemptions in various corporate bond funds were high; ii) how liquidity management tools were used at that time, including specific tools activated by various types of funds, and iii) what types of assets were sold and how (for example, by vertical slice) to meet redemptions.

ii) Information to assess the current level of preparedness. This information could include a description of: i) the set of liquidity management tools available to the funds subject to the exercise; ii) how fund managers themselves prepare for possible future adverse disruptions; iii) how fund managers themselves would likely respond to a possible resumption of redemptions; iv) the current holdings of liquid assets of the funds subject to the exercise, and v) the number and type of investors in the funds (for example, whether they are retail or institutional).

(b) Funds highly exposed to the real estate sector

As part of the targeted exercise regarding funds highly exposed to the real estate sector, the following information may be of special importance from a financial stability perspective:

i) Information to determine the current level of redemptions and uncertainty in valuations. This information could include a description of: i) the valuation uncertainty issues faced, where applicable, by real estate funds in various countries; ii) how liquidity management tools have been used so far, including specific tools activated, and iii) the volume of redemption requests since the start of the COVID-19 pandemic and how the funds subject to the exercise have handled redemption requests.

ii) Information to assess the current level of preparedness: The information could include a description of: i) the structural characteristics of real estate funds (for example, trading frequency, notice periods, etc.); ii) the set of liquidity management tools available to the funds subject to the exercise; iii) how fund managers themselves prepare for possible future adverse disruptions; iv) how fund managers themselves would likely respond to increased uncertainty in valuations, an increase in redemptions, or both circumstances; v) the current holdings of liquid assets of the funds subject to the exercise, and vi) the number and type of investors in the funds subject to the exercise (for example, whether they are retail or institutional).

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(1) OJ L 331, 15.12.2010, p. 1. (2) OJ C 58, 24.2.2011, p. 4. (3) See the press release published after the General Board meeting of the ESRB on 2 April 2020, available in English at: https://www.esrb.europa.eu/news/pr/date/2020/html/esrb.pr200409~a26cc93c59.en.html. (4) See, for example, the annual report titled ‘EU Non-bank Financial Intermediation Risk Monitor 2019’, available in English at: https://www.esrb.europa.eu/pub/pdf/reports/nbfi_monitor/esrb.report190717_NBFImonitor2019~ba7c155135.en.pdf?aad1f4a011a6d589537645242475aa89. (5) See Article 40(4) of Commission Directive 2010/43/EU of 1 July 2010 laying down implementation requirements for 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 content of the agreement between depositaries and management companies (OJ L 176, 10.7.2010, p. 42). (6) See Article 16(2) of Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (OJ L 174, 1.7.2011, p. 1). (7) See the ESMA report of 2 September 2019 titled ‘Final Report: Guidelines on liquidity stress testing in UCITS and AIFs’, available at: https://www.esma.europa.eu/sites/default/files/library/esma34-39-882_final_report_guidelines_on_lst_in_ucits_and_aifs.pdf. (8) See the ESMA press release of 30 January 2020, available in English at: https://www.esma.europa.eu/press-news/esma-news/esma-launches-common-supervisory-action-ncas-ucits-liquidity-risk-management. (9) 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) (OJ L 302, 17.11.2009, p. 32). (10) Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (OJ L 174, 1.7.2011, p. 1).