When speaking about liquidity we mainly refer to the amount of time and money required to transform an investment into cash. Many investors focus solely on the long-term goal of securing their retirement, failing to contemplate the possibility of extraordinary events. It is important to prepare ahead for the times when cash will be required urgently and not to overlook the liquidity attribute of the investment. In simpler terms, liquidity is the ease with which you may access your investment. This evaluates how long it will take you to access your money when you need it.
Over the previous decade, the investment fund business has grown dramatically. To achieve higher returns, funds appear to have taken on more risks by investing in less liquid and lower-quality securities. As a result, examining the resilience of investment funds and their financial stability implications in times of market stress has become increasingly relevant and necessary.
ESMA guidelines on liquidityThe importance of managing liquidity risk has also risen to the top of the regulatory agenda for investment funds, as following the recommendations put forward by the European systemic risk board, the European Securities and Markets Authority (ESMA) published its final guidelines on liquidity stress testing (LST) of investment funds on September 2, 2019. This was applicable to both Alternative Investment Funds (AIFs) and Undertakings for the Collective Investment in Transferable Securities (UCITS), which were to be aligned by September 30, 2020.
The new ESMA guidelines came into effect when the COVID-19 pandemic caused increased volatility, which depressed asset prices and caused liquidity in financial markets to deteriorate. By introducing these new guidelines, regulators hope to protect investors and mitigate the systemic risks that may arise from increased redemption requests. The purpose of these guidelines is to instil consistent, effective, and operative regulatory practices within the European financial regulatory system, and to ensure the common, uniform, and consistent application of EU laws. Its purpose is to improve the existing LST standards, consistency, and frequency in some cases, and to promote unified supervision of LST by national authorities.
What is meant by liquidity stress testing?
Stress testing entails producing scenarios, which might be historical events like the global financial crisis or a hypothetical event like price swings and a widening of the bid-ask gap. These stress tests will enable the company to ensure that even under stressful market conditions, such as the peak of the COVID-19 pandemic back in March 2020, the fund can still meet the redemption requirements set by investors.
Liquidity stress testing is required to ensure that all funds can continue to operate in the same manner as they were originally established, advertised, and sold, even in stressful market conditions. The fund has certain liabilities which it is obliged to meet when they arise. As such, the company is responsible for ensuring that fund maintenance costs, investor redemptions and other obligations can be fulfilled within the time frame as stipulated in the fund’s documentation.
How LST benefits the investor
Although the funds provide liquidity management tools such as deferral and suspension of redemptions which allow an additional layer of protection to the investor when it comes to liquidity risks in both normal and stressed market conditions, the introduction of LST reassures investors that if they decide to liquidate their investment, the fund they invest in may meet their needs in a timely manner as advertised in the offering documentation of the fund.
UCITS requirements have stringent requirements in terms of transparency, use of leverage, portfolio composition, and use of short selling. These investment restrictions make UCITS funds a sound investment choice for both retail and institutional investors. To continue to guarantee a high level of protection for investors, LST has become a mandatory requirement to be met by the UCITS directive. Investing in UCITS funds therefore provides investors with peace of mind as UCITS are recognised as a safe and well-regulated investment alternative.
The writer and the company have obtained the information contained in this document from sources they believe to be reliable, but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed.
The writer and the company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in this document. They have no obligation to update, modify or amend this article or to otherwise notify a reader thereof if any matter stated therein, or any opinion, projection, forecast or estimate set for the herein changes or subsequently becomes inaccurate.
BOV Asset Management Limited is licensed to conduct investment services in Malta by the Malta Financial Services Authority.
Reana Micallef, Risk manager, BOV Asset Management Ltd