Fund managers must improve readiness for future adverse shocks, says Esma

Europe
On the 11/13/20 at 2:49PM

by

Tuba Raqshan

A report by European Securities and Markets Authority (Esma) has identified investment funds with significant exposures to corporate debt and real estate as high priority for enhanced security from a financial stability perspective and lists priority area to bolster preparedness to future liquidity and valuation shocks.
Bloomberg

In the wake of Covid-19’s initial impact on markets, the EU investment fund industry faced a significant deterioration in liquidity in some segments of the fixed income markets as well as valuation uncertainty in the real estate sector, recalled Steven Maijoor, Chair, Esma. Between the second half of March and May, around 140 European Economic Area (EEA) funds had to suspend redemptions mainly due to valuation uncertainty but also due to outflows.  The European Systemic Risk Board (ESRB) had mandated Esma to undertake a focussed supervisory exercise with funds that have significant exposures to corporate debt and real estate assets, to assess their preparedness to future adverse shocks.

Esma’s report showed that funds exposed to corporate debt and real estate funds under review managed to adequately maintain their activities while facing redemption pressures and valuation uncertainty during the peak Covid-19 turbulence earlier this year. Only a limited number suspended temporarily subscriptions and redemptions.

However, the exercise also revealed important areas with weaknesses, which needed addressing. Some funds presented potential liquidity mismatches due to their liquidity set up (for instance combination of high redemption frequency, no/ short notice periods and no liquidity management tools (LMTs), where funds invested in illiquid asset classes). Only a few funds have adjusted their liquidity set-up according to the pursued investment strategy and liquidity issues encountered. Esma further added that these results should be interpreted with caution since the redemption shock linked to Covid-19 was concentrated over a short time-period, amidst significant government and central bank support to the markets.

Valuation concerns of portfolio assets emerged, especially for real-estate funds where the crisis could have a more significant impact. The report pointed out that real estate funds do not frequently adopt LMTs in their liquidity set up. Asset valuation issues have been reported for funds invested in corporate debt, impacting liquidity risk management and asset valuation processes of management companies concerned.

Esma stressed the need for fund managers to enhance their preparedness to potential future adverse shocks. The EU securities regulator has also identified priority areas to this effect.

Ongoing supervision of the alignment of the funds’ investment strategy, liquidity profile and redemption policy. National Competent Authorities (NCAs) should supervise the liquidity risk assessment by management companies, ensuring they take into account all factors that could impact fund liquidity (margin calls which may increase cash needs during market volatility or loan covenants in REIFs).

Fund liquidity profiles should be established and reported as a part of the AIFMD reporting. This includes on the asset side how to determine a realistic and conservative estimate of which percentage of the fund’s liquidity portfolio can be liquidated. On the liability side, it looks at how to account for arrangements with respect to gates and notice periods in determination of investor liquidity profiles.

Increase the availability and use of liquidity management tools. Maijoor added that ESMA encourages swift proposals to amend the EU legislative framework to ensure that liquidity management tools are widely available to asset managers across the EU.

NCAs should supervise valuation processes of management companies in context of valuation uncertainty during stressed market conditions. The circumstances of delegated portfolio management should be accounted to ensure it has sufficient expertise and access to information to analyse reliability of valuation sources for a fair valuation of the portfolio.