Esma’s stress tests catching out asset managers

By Emma Olsson | 30 October 2020

The European Securities and Markets Authority’s (Esma) new stress tests expose a lack of preparation among asset managers, highlighting the importance of regtech providers in risk assessments.

“The industry has been relying heavily on independent regtech providers who offer solutions as well as expertise to perform gap-analysis, design liquidity risk frameworks, draft policies, assess fund liquidity risks and construct stress scenarios,” said Alan Kelly, global head of risk platform, Torstone Technology in an email.

The liquidity stress testing (LST) regulation went live on September 30, requiring Alternative Investment Funds (AIFs) and Undertakings for the Collective Investment in Transferable Securities (Ucits) to stress test the assets and liabilities of the funds they manage. Guidelines state that the LST must be specific to the individual AIF or Ucits rather than a one-size-fits-all solution, which creates difficulties for regtechs rolling out solutions at scale.

“From the technology perspective, it will therefore be challenging to build generic off-the-shelf software products that everyone can use,” said Kelly.

“Regtech providers that can offer liquidity risk management monitoring solutions that include liquidity calculations, limit monitoring, investor dealing activity, stress testing scenario analysis and risk assessment will be best placed to help firms achieve and demonstrate compliance.”

He said the level of preparedness for the tests has varied between firms, referencing a Bloomberg report from earlier this year which found that only 49 percent of firms have an independent liquidity risk management process in place.

Managing liquidity risk has been a focus for regulators since the 2008 financial crisis, but the pandemic has further highlighted its importance, according to Panayiotis Antoniou, head of risk management services, Complyport.

“Before the outbreak of coronavirus, Esma initiated the research and drafting of a new regulation aimed at fostering financial stability by mitigating liquidity risk and promoting supervisory convergence across EU-domiciled funds and fund managers by setting a minimum standard for LST. While this new LST regulation was formulated before the current crisis, the recent market disruptions have further highlighted its importance,” he said in an email.

“During the past years, uncertain market conditions and financial crises have contributed to a more challenging liquidity management environment. The positive correlation between liquidity risk and other types of risk … revealed the need for funds to focus on their liquidity risk management practices and procedures.”

A 2019 Esma consultation paper reported that 93 percent of managers already undertake stress tests, leaving seven percent with a complicated task. According to Kelly, many financial institutions regularly perform market risk tests, but LST increases complexity by adding the liquidity dimension.

“The primary challenge is around identifying ways to capture liquidity in the tests, which come from key funding and asset liquidity risks. This might include using liquidity buckets with specific liquidity calculations and calibrating them according to the organisation in question,” he said.

Liquidity risk remains prevalent in the current climate, as portfolio managers have depressed asset prices and decreased liquidity.

“One would expect firms to capture both the financial crisis of 2007/8 and coronavirus as specific historical LST scenarios to be applied routinely going forward,” said Kelly.

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