From the 30th September 2020, new ESMA guidelines on liquidity stress testing (‘LST’) for EU domiciled UCITS and AIFs funds (excluding unleveraged closed-ended AIFs) come into effect. The guidelines are intended to increase the standard and consistency of liquidity stress testing by management companies and to promote convergence in the way in which national competent authorities (NCAs) supervise fund liquidity stress testing across the EU.

While the guidelines will cease to apply in the UK following the end of the Brexit transition period on 31st December, the rules will still be relevant to UK firms as they originate from IOSCO’s guidelines on liquidity risk management. ESMA outline a principle-based approach to LST in order to allow management companies to tailor the LST framework taking into account the nature, scale and complexity of the fund(s) under management. 

We have summarised the key requirements applicable to firms below.

• Ensure that the LST is adapted to each fund
• Have a strong understanding of the liquidity risks arising from the assets and liabilities of a fund’s balance sheet and its overall liquidity profile
• Integrate LST into each fund’s risk management framework and ensure that it is subject to sufficient governance and oversight
• A liquidity stress testing policy, which sets out: (i) the types, frequency and severity of stress test scenarios and the rationale for choosing them, as well as an initial validation of the models and assumptions used; (ii) the role of senior management, governance and ownership of the stress testing process; (iii) the reporting process; and (iv) an escalation procedure
• Develop LST models which takes into account the following: risk factors impacting a fund’s liquidity; scenarios to be used and their severity; outputs and indicators to be monitored based on the results
• LST to be carried out at least annually, though the guidelines recommend that it be done quarterly
• Ensure that LST enables an assessment of the time and cost to liquidate assets
• Stress scenarios should be based on a mixture of historical and hypothetical events and appropriate reverse stress testing
• A manager of a fund which seeks authorisation from an NCA to be able to demonstrate that the fund can remain sufficiently liquid during normal and stressed conditions as part of its product development 
• Depositaries to have appropriate verification procedures to check that a manager has documented LST procedures in place.

Under the guidelines, where a management company has delegated portfolio management to an investment manager, it must avoid placing reliance on the delegated investment manager’s own LST. The management company must ensure that the delegate portfolio manager provides it with appropriate information to allow it to conduct appropriate LST.

Moving forward, management companies are required to comply with the final guidelines by the deadline and ensure that they are embedded in their governance and operational risk models. National regulators may request firms to submit their LSTs to prove that they comply with the relevant rules.