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ESMA’s Liquidity Stress Testing (LST)

ESMA objective: To promote consistency and increase the frequency of current LST practices while also enhancing the existing LST standards.

When: On the 30th September 2020 the new ESMA’s Liquidity Stress Testing Guidelines (“the Guidelines”) will take effect. Competent authorities shall be incorporating these Guidelines into their national legal and supervisory frameworks as appropriate.

To whom it applies:

  • Alternative Investment Funds (AIFs);
  • Undertakings for the Collective Investment in Transferable Securities (UCITS);
  • EU Money Market Funds.

Overview:

The requirements set out in the Guidelines are supplementary to the requirements on liquidity stress testing which are included in the AIFMD and UCITS Directives and are already applicable.

Fund Managers will need to apply a comprehensive set of guidelines when designing the scenarios, policies and frequency of liquidity stress tests for the Funds under their management.

In addition, Fund Managers in accordance with the Guidelines shall notify National Competent Authorities (NCAs) of material risks and actions taken to address them.

Implementation:

From an implementation perspective, the guidelines fall into three categories:

Governance Framework:

  • Design of LST Models – determine risk factors, types of scenarios etc.;
  • Understanding Liquidity Risk – LST shall be specific to each Fund and use a wide range of scenarios;
  • Governance Principles for LST – LST shall be integrated and embedded into the Fund’s risk management framework supporting liquidity management;
  • LST Policy – LST shall be documented in an LST policy within the Fund’s Risk Management Policy.

Scenario Definition:

  • Frequency of LST – LST shall be carried out at least annually and, where appropriate, employed at all stages in a Fund’s lifecycle;
  • Adapting LST to each Fund;
  • LST Scenarios – LST shall employ hypothetical and historical scenarios;
  • Liability Based LST – LST shall incorporate scenarios relating to the liabilities of the Fund;
  • LST on other types of Liabilities – Managers shall include other types of liabilities in their LST in normal and stressed conditions.

Stress Test Results:

  • Use of LST outcomes – LST results shall strengthen the ability to manage liquidity etc.;
  • Data Availability – LST should demonstrate a manager is able to overcome limitations related to the availability of data;
  • Product Development – During product development Managers shall be able to demonstrate to the competent authorities that the Fund is able to remain sufficiently liquid during normal and stressed circumstances);
  • Asset Based LST – LST shall enable Manager to assess not only the time and/or cost to liquidate assets in a portfolio, but also whether such an activity would be permissible;
  • Funds investing in less liquid Assets – Risks arising from less liquid assets and liabilities shall be reflected in the LST;
  • Combined Asset & Liability LST – Managers shall combine the results from Assets and Liabilities stress testing to determine the overall effect on fund liquidity;
  • Aggregating LST Across Funds – Managers shall aggregate LST across Funds under its management where it assesses such an activity to be appropriate for those Funds.

Should you need more information or assistance in implementing these guidelines and updating your LST framework you may contact us on info@mnkriskconsulting.com or 25 508 201.

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