Liquidity stress testing: save time, resources and gain deeper insights

Jan De Spiegeleer of RiskConcile explains key challenges and regulatory requirements with regards to liquidity stress testing and how technology can help asset managers save time, resources and get more and better insights

What are the key objectives of ESMA’s liquidity stress testing guidelines for fund managers?

Fund managers employ similar quantitative or qualitative methods for portfolio composition, including balance sheet metrics or technical ratios like momentum and RSI. The rise of robo-advisors intensifies this trend, resulting in globally similar investment portfolios. This uniformity poses a risk during market downturns when investors panic, triggering widespread selling. Liquidity becomes scarce, akin to a friend on Facebook vanishing when needed. Regulators, prioritizing investor protection, emphasize liquidity oversight.

ESMA’s liquidity stress testing (LST) guidelines aim to enhance the quality and consistency of LST by fund managers. They advocate for unified supervision by National Competent Authorities (NCAs) and seamless integration into risk management frameworks.

How frequently should liquidity stress testing be conducted according to ESMA’s guidelines?

LST should be carried out at least annually, with quarterly testing recommended by the guidelines. Factors such as higher unit dealing frequency, a concentrated investor base, complex investment strategy, and a less liquid asset base may necessitate more frequent testing.

What are the key components and methods recommended by ESMA for liquidity stress testing?

ESMA suggests that LST should employ hypothetical, historical, and reverse stress testing scenarios while avoiding over-reliance on historical data. It should provide outcomes to ensure fund liquidity, strengthen the manager’s ability to manage liquidity in investors’ interests, and identify potential weaknesses in investment strategies. Additionally, the asset management company should aggregate liquidity stress tests across all funds it manages. Each fund might for example deliver a satisfying result for a LST, whilst the aggregate may tell a different story.

What are the challenges faced by fund managers in implementing ESMA’s liquidity stress testing guidelines?

For sure, fund managers understand the concept of liquidity. In front of an investor they will be confronted with a series of liquidity related questions: “How long will it take to sell all the assets in the fund and how much will this cost?”

Of course, the cost is much more than the expected brokerage fee. This question boils down to a pre-trade quantitative analysis where the risk department of the fund manager may encounter various challenges. Indeed, relying on metrics such as the daily average volume of an instrument or its issue size are far from good enough. For fixed income or hybrid instruments, traders often add other properties such as the credit rating or the number of market makers into the equation. All of this is to help estimate the expected impact of stress on the fund’s net asset value.

Why is RiskConcile well-equipped for liquidity stress testing?

Early 2019, we added TCALab (PRIIPS and MIFD Transaction Cost Analysis – Lab) to our suite of cloud-based regulatory software. TCALab provides for a calculation of implicit and explicit transaction costs for a fund. Meeting the PRIIPS-regulation implied transaction costs must be based on the slippage methodology where trades are assessed against the bid-offer prices in the market at the time the order is given. The difference between a so-called ‘Arrival-Price’, ie the mid-price and the traded price quantifies the implicit cost.

TCALab was the starting point for our data scientists and our software developers to tailor a liquidity module. This module addresses what the ESMA is looking for in terms of liquidity stress tests. Our application examines how the liquidity position of a portfolio would be affected by various stress scenarios, such as sudden redemptions by the investors. For each portfolio, our solution calculates the impact of such redemptions. The impact of parameters such as the liquidation time window can be easily simulated. On top, we also provide so-called reverse liquidity stress tests where we start from a maximum liquidation cost and then calculate how much of the assets can be liquidated or how long it would take.

Lastly, aside from liquidity, what do you consider to be key challenges in the regulatory landscape for asset managers?

Regulation constantly changes, so be prepared at all times! While ELTIF 2.0 and AIFMD 2.0 are big topics in product manufacturing, our clients are also preparing hard to be ready to calculate their PRIIPs and MIFID Transaction Costs using Slippage Method by 1 January 2025. Slippage poses multifaceted challenges, including correctly capturing order timestamps, sourcing tick-history, ensuring three-year backfill, accurate trade file compilation, and handling complex trades. Larger entities are proactively seeking solutions, yet we anticipate – just like in 2022 with the UCITS to PRIIPs transition – a surge of “latecomers” in Q4 2024, just ahead of the deadline on January 1, 2025.

*Jan De Spiegeleer is Founder and CEO at RiskConcile, a software and services firm headquartered in Leuven, Belgium with a focus on data, risk, and regulatory technology for the cross-border asset management industry. Established in 2015, the firm covers complex areas like PRIIPs, Transaction Costs (Slippage), SFDR, Solvency, and AIFMD Annex IV.

HAVE YOU READ?

THOUGHT LEADERSHIP

Innovative US companies are providing some of the solutions to the climate crisis and transition to a more sustainable economy. We see potential opportunities in areas including renewable energy and…
FIND OUT MORE
This white paper outlines key challenges impeding the growth of private markets and explores how technological innovation can provide solutions to unlock access to private market funds for a growing…
DOWNLOAD NOW

IRELAND SPOTLIGHT

Visit our dedicated Ireland channel for all the latest news and analysis on the country's investment industry.
READ MORE

PRIVATE MARKETS FUND ADMIN REPORT

Private_Markets_Fund_Admin_Report

LATEST PODCAST