Exploration of the Application of Liquidity Stress Tests by Asset Managers

December 2024 Report

1 Introduction

In recent years, several market-wide shocks have occurred (such as the coronavirus pandemic and the war in Ukraine) that have impacted the economy and financial markets. Even at present, financial institutions face significant risks due to the deteriorating economic and geopolitical climate. For example, geopolitical tensions are arising from conflicts in Ukraine and the Middle East, and trade restrictions may increase following the election results in the US. These tensions can manifest, among other things, as stress on financial markets (in the event of escalation of conflicts), thereby affecting the financial system. Such events occur unexpectedly and can impact financial institutions, including investment undertakings.

It is therefore of great importance that managers of investment undertakings and UCITS are well prepared for unexpected events. Conducting regular liquidity stress tests (LSTs) helps with this and thereby contributes to mitigating risks. It is therefore important that managers have established and implemented an adequate LST policy.

In the second half of 2023, the Authority for the Financial Markets (AFM) and De Nederlandsche Bank (DNB) conducted a thematic review with six large managers of investment undertakings and UCITS (hereinafter: managers) regarding the application of LSTs by managers for their investment undertakings (both AIFs and UCITS). The ESMA guidelines concerning LSTs were taken as the starting point. This report feeds back the findings of the review to the sector.

By publishing the findings, the AFM and DNB aim to give managers an impression of how various components of the LST policy (according to the ESMA guidelines) have been implemented by asset managers. With the findings presented in this exploration, managers can scrutinize their own LST policy and implement improvements where necessary.

Relevant Legislation and Regulation

**Legal Framework	Articles Relevant for Liquidity Stress Tests**
Directive 2011/61/EU (AIFMD) on managers of alternative investment funds.	Article 16.
Commission Delegated Regulation (EU) No 231/2013 (AIFMD Regulation).	Articles 46, 47, and 48.
Directive 2009/65/EC of the European Parliament and of the Council (UCITS Directive).	Article 51.
Commission Directive 2010/43/EU (UCITS II Directive).	Article 40.
ESMA34-39-897, Guidelines on liquidity stress testing in undertakings for collective investment in transferable securities (UCITS) and alternative investment funds (AIFs).	Full guidelines relevant.

2 General Findings

Below, the findings from the review regarding the main themes concerning LST policy, as included in the ESMA guidelines, are explained. The findings only apply to the managers who participated in the review, but may be relevant for all managers of investment undertakings and UCITS. The general picture that emerges is that the managers under review have their LST policy in order and largely conduct LSTs in line with the ESMA guidelines. However, there are a few points of attention where the ESMA guidelines have not yet been (fully) implemented by all managers. For example, although all managers conduct LSTs frequently, some managers lack sufficient justification for the choice of LST frequency. Also, not all managers use both historical and hypothetical scenarios to conduct their LSTs. If managers only use historical scenarios, they may not have a clear picture of future stress situations that are more severe than previously encountered. Finally, when applying scenarios to the liability side, not all managers take into account risk factors related to the type of investor and investor concentration. Managers can use these findings to scrutinize their own LST policy. The AFM and DNB expect all managers to apply the ESMA guidelines and implement improvements in their LST policy where necessary.

2.1 Governance and Policy

Managers have included their liquidity risk management, including the application of LSTs, in internal policy documents. Some managers explicitly refer to the ESMA guidelines regarding LSTs, for example by indicating how certain aspects of the LST policy (such as the frequency of stress tests, choice of scenarios, etc.) relate to the minimum requirements and/or recommendations in the ESMA guidelines. Managers have clearly documented how and to whom internal reporting on the results of the conducted LSTs is done.

Managers evaluate the current liquidity risk policy annually. In addition, some managers have also included in their policy that the policy can be evaluated earlier in exceptional circumstances.

2.2 Frequency of Stress Tests

All managers conduct LSTs frequently. The frequency varies from weekly to at least once per quarter. Not all managers have sufficient justification for the choice of the LST frequency. According to the guidelines, the determination of a higher or lower frequency must be based on the characteristics of the fund, and the reasons for that determination must be recorded in the LST policy. When determining the frequency for conducting LSTs, managers often take into account the composition of a fund's assets. If the portfolio, for example, is very liquid or trading in participation rights happens less frequently—resulting in little change in the outcome of the conducted LSTs—the frequency is sometimes lower in certain cases. One manager also takes into account the composition of the investor base when determining the frequency. A change in the investor base can indeed impact the maximum withdrawals from a fund during times of stress. One manager has stated that they conducted LSTs on an ad-hoc basis following stress on the financial markets.

2.3 Use of Software and Third-Party Models

Some managers use data models from third parties in the context of their LST policy. In doing so, managers perform additional analyses themselves and interpret the outcomes of stress tests based on software/models from third parties themselves. If managers use models from third parties, the documentation must record that these models must be validated by the manager and specify which department is responsible for this. Some managers use multiple data sources, particularly when an investment fund contains less liquid assets, meaning market data may not be available for all assets. In the latter case, 'expert judgment' is sometimes relied upon to assess the liquidity of the assets.

2.4 Scenarios Used

Most managers use multiple historical and hypothetical scenarios for their LSTs. Common historical scenarios include, for example, the great financial crisis of 2008-2010, the European debt crisis of 2010-2012, and the coronavirus crisis of 2020-2021. Hypothetical scenarios are applied by most managers on both the liability side and the asset side. On the liability side, this mainly concerns percentages of potential withdrawal requests (for example, 5%, 10%, 20% up to the maximum possible exit percentage). On the asset side, some managers apply a percentage increase in the bid-ask spread (for example, bid-ask spread + 100%) and/or a decrease in market depth (for example, a decrease in market depth by 50%). By 'market depth' we mean the volume that can be liquidated at certain costs and within a certain time.

Some managers use only historical or only hypothetical scenarios. If managers only use historical scenarios, they may not have a clear picture of future stress situations that are more severe than previously encountered. Hypothetical scenarios can then be useful, even if these scenarios are further removed from what is considered plausible based on historical data. This also follows from the ESMA guidelines.

2.5 Reverse Stress Tests

Some managers use reverse stress tests. In a reverse stress test, it is identified when a fund can no longer meet liquidity demand. Some managers look at what percentage of withdrawal requests would result in liquidity problems (for example, at a withdrawal request of 10%, 15%, or 20%). A number of managers using leverage use a reverse stress test to determine, for example, at which interest rate change margin requirements become so high that there is insufficient liquidity to meet them. In these situations, a reverse stress test can be a useful addition to the LST policy, especially if regular LSTs do not show a breach of established limits.

2.6 Liquidity of Assets in Stressed Conditions

Managers use different calculations when determining the liquidity of assets under stressed conditions. This is usually a time-to-liquidity approach or a transaction cost approach, depending on the asset class. The time-to-liquidity approach indicates what part of the portfolio can be liquidated within a certain time horizon under normal or stressed market conditions. The transaction cost approach focuses on the costs of liquidating assets (as a % of net asset value), often using bid-ask spreads as input and taking trading volumes into account. Some managers combine both approaches in their stress tests. This can be useful to make it clear whether sufficient liquidity can be generated in time to meet obligations and what the impact of liquidation is on current and exiting investors. The transaction costs can also serve as a limit within which assets may be liquidated.

Some managers define restrictions regarding the liquidation method in their models. This can concern pro-rata, near pro-rata, and waterfall methods. The liquidation method can impact current and exiting investors. By setting restrictions on the liquidation method, managers can take into account the interest of all investors, both those claiming repayment and the remaining investors.

2.7 Withdrawals in Stressed Conditions

Managers primarily rely on the largest historical net outflow when calculating liquidity pressure from withdrawals. In doing so, they calculate, for example, the 95th/99th percentile of the distribution of historical outflows. Some managers also model hypothetical outflow scenarios in their stress tests. This can be useful because future outflows may be larger than historical outflows, and this also follows from the ESMA guidelines. It is also useful if the time series of a fund's outflows is not long enough and therefore does not contain data from stressed conditions. Furthermore, some managers use data on the type of investor in the funds (institutional vs. retail) and investor concentration when modeling maximum outflows.

2.8 Liquidity Demand from Leverage Usage

For modeling liquidity demand from margin calls due to leverage, managers mostly use a Value at Risk (VaR) model. The use of leverage can cause liquidity demand, for example in the case of margin calls on derivative positions. In periods of market stress, this can have a significant impact on the liquidity position, so it is important to include this in the LSTs. The VaR indicates the maximum liquidity demand with a certain probability and within a certain time horizon. This could be, for example, a 99% VaR under stressed conditions with a time horizon of, for example, 1, 5, or 20 days.

2.9 Combining Simulated Stress on the Asset and Liability Sides

Managers incorporate the results of the calculation of asset and liability liquidity into a combined stress test. Many managers calculate a Redemption Coverage Ratio (RCR) or Liquidity Coverage Ratio (LCR) in this process. Here, the amount of available liquid assets is divided by the maximum withdrawals (+ possibly liquidity demand from margin calls and other obligations). This indicator shows to what extent the liquid assets are sufficient to meet obligations and can be calculated for different time horizons (1, 5, 10... days, 1 month, etc.) depending on the type of assets/liabilities. In addition, managers sometimes calculate the RCR/LCR under different historical and hypothetical stress scenarios regarding asset and liability liquidity. Finally, some managers monitor the change in the RCR/LCR of funds over time to identify any trends in available liquidity.

2.10 Escalation Procedure

Managers often define threshold values/limits regarding the LSTs. Some managers use multiple signal values from which a certain action follows: for example, if the outcome is x, the outcome turns green (no action required), if the outcome is y, the outcome turns orange (reason to monitor more intensively), and if the outcome is z, the outcome turns red (reason to escalate immediately). In all managers, exceeding established thresholds triggers a process to return within the established values. However, this process is not always described in the LST policy, whereas this is prescribed by the ESMA guidelines. In addition, some managers link the outcomes of the LSTs to the availability and possible activation of liquidity management tools (LMTs).