_This is the 10th episode of our COVID-19 webcast series. In this episode Partner Mark Shaw talks about some recommendations of the European Systemic Risk Board in the wake of the COVID-19 pandemic. They focus on real estate and debt funds, but as they are flagging issues relevant to all asset managers, the recommendations are worth considering in a broader context.
Transcription of the video:
You may have seen a communique from the CSSF last week relating to a previous announcement of the European Systemic Risk Board (the ESRB).
In early May, the ESRB discussed a set of policy measures to address the impact of COVID-19 on the financial system from a macro prudential perspective.
Their policy measures apply broadly to different sectors of the financial system, and are concerned with issues such as market illiquidity and downgrades of corporate bonds.
Here, the ESRB is focussing on aspects the investment fund sector. The ESRB is not a supervisory or regulatory authority, as such, it just has an oversight role, so the ESRB recommended that ESMA (being the ultimate European fund supervisory body) coordinates with national competent authorities to undertake supervisory engagement with those investment funds having significant exposures to corporate debt and real estate assets. On 14 May, ESMA issued a public statement in support of the recommendations and sharing the ESRB’s concerns, putting them in the regulatory crosshairs.
So we should expect ESMA to lead the NCAs in undertaking focused supervisory engagement with investment funds and their managers that have significant exposures to the less liquid asset classes of corporate debt and real estate.
Ahead of any direct contact from the CSSF or any other NCA, what should fund mangers be doing?
Going back to brass tacks:
- for UCITS, in addition to the eligible asset rules, the liquidity profile of the investments of the UCITS must be appropriate to the redemption policy laid down in the fund rules or prospectus;
- for AIFs, the investment strategy, liquidity profile and the redemption policy must be consistent.
These rules are complemented by ESMA’s guidelines on liquidity stress testing in UCITS and AIFs, requiring fund managers to regularly test the resilience of their funds to liquidity risk under normal and exceptional liquidity conditions.
Investment fund managers in Luxembourg must also ensure that they comply with Circular 19/733, which implements the latest IOSCO recommendations for liquidity risk management and puts them into Luxembourg regulation – there is a note on this on our website.
Back to the ESRB, and they want to enhance preparedness to respond to potential future adverse shocks that could lead to a deterioration in financial market liquidity. The ESRB identified corporate debt and real estate funds as particularly high-priority areas for enhanced scrutiny from a financial stability perspective. It should be noted that the ESRB has these fund categories in their crosshairs not because of the risks to the funds themselves, but because of the wider macroeconomic risks of their asset classes.
Looking at corporate debt funds first, and the ESRB is concerned because these funds hold a significant proportion of the outstanding corporate bonds in Europe.
Future redemptions pressures from open-ended funds could result in fund managers selling less liquid assets quickly, thereby contributing to a deterioration in liquidity conditions in corporate debt markets. This could have adverse spill-overs on other financial institutions with exposures to these assets or an adverse impact on the cost and availability of market-based financing for non-financial corporations.
The second segment identified by the ESRB is real estate funds. The slowing of real estate market transactions due to the pandemic has increased valuation uncertainty.
Real estate investment funds are estimated to account for approximately one-third of the EU commercial real estate market.
Again, redemptions causing widespread liquidations of real estate in an environment of low transaction volumes, could have adverse implications for other financial institutions with exposures to real estate (including through the use of real estate as collateral for lending).
So what we see here is a coordinated EU regulatory approach, with the ESRB looking at wider economic concerns arising from the COVID-19 pandemic and influencing ESMA and, by extension, the NCAs. They are not concerned about protection of investors in EU debt or real estate funds, but the knock-on consequences of crowded exits from these markets due to redemption pressures. There is no change in the rules or regulations applying to these fund classes, but managers should continue to be mindful of the liquidity risks that they face.