On 5 February 2019, the European Securities and Markets Authority (ESMA) issued a consultation paper on draft guidelines regarding liquidity stress tests of investment funds – applicable to alternative investment funds and Undertakings for the Collective Investment in Transferable Securities (UCITS).

The consultation has been produced in response to a recommendation by the European Systemic Risk Board for ESMA to produce guidance ensuring robust and convergent liquidity stress test practices by managers across the EU.

The consultation paper sets out 14 principle-based criteria for managers’ liquidity stress tests to follow when executing liquidity stress tests on their funds. Broadly, the draft guidelines set out that liquidity stress tests should: be tailored towards the individual fund, reflect the most applicable risks to a fund, be sufficiently extreme or unfavourable (yet plausible), sufficiently model how a manager is likely to act in times of stressed market conditions, and be embedded into the fund’s risk management framework. One draft guideline applies to depositaries, outlining how they should fulfil their obligations regarding liquidity stress testing. The draft guidelines are reinforced via a number of sections providing explanatory considerations for managers, to assist their compliance.

The deadline for comments on the consultation paper is 1 April 2019. ESMA expects to publish a final report by the summer of 2019.

Steven Maijoor, ESMA chair, said:

“Liquidity risk in funds, due to the growth in size and importance of the fund sector, has been a subject of regulators’ focus and we need to ensure that these risks are adequately managed by funds to ensure financial stability and investor protection.

““Managers should be aware of the liquidity risk of the funds they manage and use stress

testing as a tool to manage funds’ liquidity and to take appropriate actions to mitigate this risk, especially for scenarios in which redemption requests by investors may exceed funds’ ability to quickly liquidate assets. Redemptions scenarios need to be tested at fund level to avoid contagion to the wider market and any impact on financial stability.”