ESMA Warns Managers to Ready for Future Shocks, as Risks Remain

The European Securities and Markets Authority (ESMA) last week published a report warning investment funds with significant exposures to corporate debt and real estate assets of potential future adverse liquidity and valuation shocks.

While the report noted that most funds have responded positively to whipsawing markets and redemptive stresses this year, 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,’ the report noted.‘The exercise showed that the funds in question managed to respond adequately to redemption pressures,’ outgoing ESMA Chair, Steven Maijoor, added.

Priority areas

However, Maijoor went on to warn that ‘the work also revealed shortcomings that must be addressed in order to enhance funds’ preparedness to future shocks, and we have identified a number of priority areas that funds and supervisors should focus on to address potential liquidity risks in the fund sector. This will contribute to ensuring investor protection, orderly markets and financial stability.’Those priority areas include:

1. Better alignment of a fund’s strategy, liquidity and redemption policy;
2. Ongoing supervision of liquidity risk;
3. Fund liquidity profile reporting;
4. Increasing use and availability of liquidity management tools; and
5. Stronger valuation processes.

Many of these issues continue to dominate the attention of regulators. New fund classes, for instance, have been floated as a way of better aligning a fund’s strategy and risk profile – particularly in property funds – while the ongoing supervision of liquidity risk and stress testing remains a key priority for ESMA in 2021.

Risks remain

The recent market recovery has eased liquidity and redemptive stresses facing managers, but firms can ill-afford to become complacent. In its recentFinancial Stability Report, the Federal Reserve warned that market risks remain elevated, particularly if the pandemic lingers.‘If the pandemic persists for longer than anticipated—especially if there are extended delays in the production or distribution of a successful vaccine—downward pressure on the U.S. economy could derail the nascent recovery and strain financial markets and financial institutions, particularly if many businesses are shuttered again and many workers are laid off and left without a normal income for a long period,’ the Federal Reserve Board cautioned.It added: ‘Investor risk appetite and asset prices have increased in recent months but could suffer significant declines should the pandemic take an unexpected course or the economic recovery prove less sustainable. Given the generally high level of leverage in the nonfinancial business sector, prolonged weak profits could trigger financial stress and defaults.’Liquidity management will therefore continue to be a high priority for financial regulators. Although European firms have already come to terms with ESMA’s liquidity stress test regulations this past September, more regulatory scrutiny seems certain.