Esma preps stricter stress-testing rules for EU funds

New guidance expected to be released for consultation in early 2019

Esma data montage

European investment funds will be required to conduct standardised stress tests to gauge their resilience in extreme market conditions under new guidance being finalised by European Union authorities.

The European Securities and Markets Authority (Esma) is expected to release a draft proposal at the beginning of 2019, and is aiming to have the guidance finalised by mid-year.

European Ucits and alternative investment funds (AIFs) already perform regular, in-house stress tests in accordance with an EU directive issued in 2010. However, a report published by the European Systemic Review Board (ESRB) in December 2017 criticised the lack of uniformity in current stress-testing practices.

“While they all do stress-testing, they don’t all do extreme situations properly,” says a national regulator in an EU member state. “The Esma guidance will aim to promote good standards of liquidity management, which will include extreme shocks.”

The ESRB found wide variations in the scenarios used for stress-testing and the frequency with which they were conducted. The scenarios varied widely in severity, and in many cases failed to properly account for redemptions during an economic shock. Funds that had not experienced large outflows in the past were basing their scenarios on historical data, without regard for how investors might behave in a crisis. Asset managers also tended to stress-test the funds they manage on a firm-wide basis, rather than tailoring them to the individual characteristics of each fund.

In its report, the ESRB called on Esma to “develop guidance on the practice to be followed by managers for the stress-testing of liquidity risk for individual AIFs and Ucits”.

An Esma spokesperson tells the regulator “should be in a position to consult the industry on a draft” of the guidance in early 2019.

EU regulators are concerned about the spillover effects of a fund failure on banks and clearing houses. Money market funds (MMFs) provided roughly €300 billion of wholesale funding to eurozone banks in 2017, primarily through holdings of debt securities.

Standards were tightened for MMFs in a 2017 regulation, which requires them to conduct stress tests at least semi-annually. Esma published guidelines on stress-test scenarios for MMFs earlier this year.

The more successful the non-banking sector becomes, the more we have to be on top of systemic risk issues

National regulator in an EU member state

“There is a special law for MMFs, recognising they have in the past had a unique role in the way stresses have become amplified in the marketplace,” says the national regulator. “We’re focused on how systemic they are because they’re connected to the banking sector. The more successful the non-banking sector becomes, the more we have to be on top of systemic risk issues.”

Esma is expected to issue an update to stress-testing guidelines for MMFs as early as next week.

The guidance Esma is expected to release in early 2019 will be broader, and apply to all regulated investment funds, not just MMFs.

Ucits and AIFs could pose a systemic risk if they are forced to sell assets to meet redemption requests in a crisis, causing asset prices to fall even further. “If the funds’ liquidity management is weak, they will be less able to absorb shocks, and will pass it on by selling assets into a falling market. What we’re trying to do is dampen that mechanism,” says the national regulator.

In the US, the Dodd-Frank Act requires the Securities and Exchange Commission to conduct supervisory stress tests of asset managers and investment funds. But momentum for buy-side stress-testing has stalled, and the Treasury department called for the statutory requirement to be repealed in a report published last year.

The SEC was exploring the use of risk measures such as conditional value-at-risk to gauge the spillover effect of a sudden rise in fund redemptions on the financial system as a whole. However, those efforts appear to be on hold.

“Given that the SEC hasn’t focused on this, we have diverted our attention to other areas,” says the chief risk officer at a large US asset management firm. “I think there’s still value in what the regulators are trying to do to give investors more information before making investment decisions, but the current political climate will probably lessen these requirements.”

The European national regulator insists the EU’s buy-side stress tests will not suffer the same fate: “There will be no rolling back. There was full involvement from Esma and the European regulators in developing this.”  

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