Liquidity management: Regulatory scrutiny levels rising – How safe is your life jacket? The new CSSF Circular 19/733

in Regulatory/Compliance, 14.01.2020

At the dawn of this new year, let’s take a moment to look back at 2019 and its impact on the asset management industry and financial markets.

It’s been a rocky road for financial markets which, overall, have shown resistance despite worrying signs including micro crystallization of liquidity risks. For instance, the flagship fund managed by Neil Woodford was suspended in June 2019 by the FCA given its highly concentrated portfolio in illiquid and unlisted assets. Six months later, M&G suspended two of its property funds due to redemption concerns.

The consequences?

Even though scrutiny on fund liquidity is nothing new and has been highly debated at global level, these events have put liquidity risk on regulators’ radars more than ever before. And here’s the proof:

All over the world, regulators have intensified their focus on Liquidity Risk Management in various ways:

  • ESMA intensified its stress-testing requirements for funds’ assets and liabilities, supplementing the existing requirements in AIFMD and UCITS directives.
  • Steven Maijoor, chair of ESMA, instructed EU National Competent Authorities to start simultaneous supervisory checks in 2020 over the liquidity risks at EU-regulated funds (the label known as “UCITS”).
  • The FCA required asset managers investing in hard-to-sell assets to issue clear warnings to investors.
  • In the US, funds are required to classify the liquidity of each investment based on defined metrics in order to improve the reporting and disclosure of liquidity information by registered open-end investment companies.

What about Luxembourg?

As part of supervision and inspection programs, increased vigilance by the regulator on liquidity risk arrangements started in 2019 and is set to continue.

Additionally, the CSSF Circular 19/733 entered into force with immediate effect.

CSSF 19/733 – what does it mean for managers of open-ended funds?

Regulatory Heat Map

Given its immediate entry into force, the circular appears on the left-hand side. Its impact on asset managers is considered “medium-high” due to the complexity of the new requirements, and taking into account the short timeframe of implementation.

Regulatory Impact Matrix

The heaviest impact is evidently on procedures and policies following new documentation requirements. The ManCo operating model will be updated to integrate the daily management of testing activities. As a result, oversight activity is highly impacted, especially with delegated portolio managers. Finally, MIS needs to be enhanced because of data risk flows from the portfolio manager to the ManCo.

Regulatory Impact Matrix: Function and Areas

The circular is fundamentally dedicated to UCITS ManCos and AIFMs managing UCITS-like AIFs. The impact on other alternative funds remains marginal even if they are more affected by the ESMA stress-testing guidelines (ESMA34-39-882).

The circular: pillar by pillar

The circular: pillar by pillar

The challenge for ManCos will be to evidence substance along these three fronts by building up the appropriate governance and a set of protocols and procedures to substantiate the overarching liquidity framework. This means encompassing not only the risk management function as the second line, but also portfolio management as the first line of defense. In turn, management information systems will need to be revisited accordingly.


Pillar I: Robust framework design

LRM systems should be specific and granular, not to mention accordingly reflected in the systems’ design process. Fund idiosyncrasies, therefore, must be considered as well as investor specifics, rather than adherence to a one-size-fits-all approach. Concretely, LRM arrangements should reflect the individual characteristics of each sub-fund resulting from a combination in particular of the liquidity management tools (LMT) available, the individual liquidity risk profiles (LRP) and a liquidity risk register. One main aim is to identify liquidity risk sources (considering in- and off-balance sheet items) as well as their dynamics in distressed market situations.


Pillar II: Daily application of the LRM framework

Liquidity management must be seen as a holistic concept diffusing all lines of defense. Notably, LRM considerations are now explicitly required to be integrated into the investment process. In turn, this impacts the oversight exercises performed by the portfolio management function on how the (typically delegated) portfolio managers carry out their ex-ante investment analysis.

Effectively, a liquidity risk monitoring dashboard (including early-warning signals, macro monitoring of liquidity conditions/pressures in the market, projective stress-testing, etc.) is needed to handle this requirement properly.

The salient importance of the risk management function is unchanged. In addition to proper stress testing frameworks, interactions between liquidity risk and other risk types (in particular market and reputational risks) must be considered in the risk management process.


Pillar III: Recurring testing of effectiveness

Contingency plans are needed for optimum effectiveness of the LRM framework as well as to ensure smooth functioning of all LMTs in place regardless of adverse internal or economic circumstances. These arrangements must be tested and validated on a periodic basis.

There are certainly a few questions worth asking:

Can your asset allocation be maintained during adverse market liquidity conditions?

How would you deal with illiquid portfolio assets in such situations?

Can redemptions be served to every investor in a fair and equitable manner?

What’s next?

It goes without saying that the regulatory spotlight is on robust liquidity management governance frameworks. To substantiate liquidity risk management, it is essential to demonstrate that there is a proper liquidity risk measurement environment. ManCos of open-ended funds will therefore have to formalize a robust LRM framework before substantiating its application and effectiveness in daily operations.

Regulator scrutiny for liquidity management is only set to increase, with 2020 as a major milestone. It will, therefore, be of essence for asset managers to revisit and strengthen their liquidity management framework and governance.

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