On 12 November 2020, the European Securities and Markets Authority (ESMA) issued a report, Recommendation of the European Systemic Risk Board (ESRB) on liquidity risk in investment funds.

The report follows an ESRB recommendation that was published on 6 May 2020 that asked ESMA to:

• coordinate with Member State competent authorities to undertake a focused piece of supervisory exercise with investment funds that have significant exposures to corporate debt and real estate assets to assess the preparedness of these two segments of the investment funds sector to potential future adverse shocks, including any potential resumption of significant redemptions and/or an increase in valuation uncertainty; and
• report to the ESRB on its analysis and on the conclusions reached regarding the preparedness of the relevant investment funds.

ESMA’s report sets out its analysis and conclusions on the preparedness of the investment funds that were reviewed and presents five priority areas identified to enhance the preparedness of funds that have significant exposures to corporate debt and real estate assets to potential future adverse shocks.

Key findings in the report include:

• The funds exposed to corporate debt and real estate funds under review overall managed to adequately maintain their activities when facing redemption pressures and/or episodes of valuation uncertainty. The analysis of their behaviour during the market stress linked to the COVID-19 pandemic revealed that only a limited number of the analysed funds suspended subscriptions and redemptions while the vast majority was able to meet redemption requests and maintain their portfolio structure.
• The results should be interpreted with caution since the redemption shock linked to the COVID-19 pandemic was concentrated over a short period of time, amid significant government and central bank interventions which provided support to the markets in which these funds invest.
• There are some important areas of weakness that need to be addressed. For example, some funds presented potential liquidity mismatches due to their liquidity set up and only a few funds have adjusted their liquidity set up according to the pursued investment strategy and in light of the liquidity issues encountered.
• Funds were broadly able to maintain their portfolio structure when meeting redemptions. This means that they also sold their less liquid portfolio assets; thus they were not creating a first-mover advantage for investors redeeming their fund shares early. However, from an aggregate perspective, many funds selling less liquid assets at the same time may lead or contribute to wider market disruptions.
• Fund managers authorised under UCITS and AIFM Directives should enhance their preparedness to potential future adverse shocks that could lead to a deterioration in financial market liquidity and valuation uncertainty (valuation procedures, alignment of the liquidity profile and redemption policy, use of special arrangements, stress tests). Continued oversight by Member State competent authorities is also of utmost importance. In this respect, it is also important to continue promoting supervisory convergence at EU level on the way the compliance with the obligations arising from the relevant regulatory framework is supervised at national level.