The European Securities and Markets Authority (ESMA) recently published the results of the 2020 Common Supervisory Action (CSA) on UCITS liquidity risk management (LRM) (the “ESMA Report”). The ESMA Report incorporates the findings of the Central Bank’s own supervisory analysis and engagement with UCITS Fund Management Companies (UCITS Managers) on compliance with their LRM obligations. These were consistent with the overall findings of the other National Competent Authorities. In addition to its engagement with UCITS Managers where specific concerns were identified, the Central Bank has now issued a Dear Chair letter to all Irish authorised UCITS Managers including self-managed UCITS. The letter directs them to carry out a review of their activities in light of the findings of the ESMA Report.
Central Bank Dear Chair letter
In its letter, the Central Bank elaborates on some of the findings from the ESMA Report and highlights the following nine specific areas for attention which UCITS Managers should have regard to in their review:
1. Instances of LRM frameworks that were not clearly defined, adaptable and/or independent
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Instances identified whereby UCITS Managers were not able to provide a single cohesive documented LRM framework.
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UCITS Managers are expected to employ a cohesive, comprehensive, practical, live documented LRM framework accounting for all known dynamics relating to liquidity risk.
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Efforts must be made by UCITS Managers to understand the investor base in order to fully comprehend and manage liquidity risk and employ the correct liquidity strategy.
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A reminder that UCITS Managers must ensure that their LRM frameworks are not unduly influenced by external commercial matters, but are instead driven by, inter alia, the liquidity profile of the UCITS and profile of its investors.
2. A lack of formal documented pre-investment forecasting frameworks
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Instances identified of pre-investment forecasting being carried out in an ad-hoc and subjective manner without a clearly defined or documented methodology overseeing how it is being performed.
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UCITS Managers are required to ensure that a pre-investment forecasting framework is incorporated into their risk management policies and procedures and that it meets the standards for risk management policies set out in the Irish UCITS Regulations.
3. A lack of formal liquidity escalation policies
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A number of UCITS Managers were identified who did not have clearly defined and documented escalation procedures in respect of liquidity risk.
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A formal process must be put in place with quantitative measures supported by qualitative judgements and clear responsibilities for the identification and escalation of liquidity issues and/or concerns to the board.
4. Cases where no pre-investment forecasting performed
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Cases were identified where UCITS Managers did not perform pre-investment forecasting, instead relying on the presumption of liquidity for each investment.
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UCITS Managers are required, where appropriate, to formulate forecasts and perform analyses concerning their individual investment’s contribution to the UCITS portfolio composition, liquidity and risk and reward profile before carrying out the investment.
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Given the nature of securities not admitted to trading on a regulated market and their heightened liquidity risk, failure to perform pre-investment forecasting for such investments is not fully compliant with the relevant regulations.
5. Over-reliance on the presumption of ongoing liquidity
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Cases were identified where UCITS Managers placed an over-reliance on historical performance as a testament to the soundness of their LRM frameworks, instead of increasing preparedness for future liquidity events.
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UCITS Managers are required to conduct stress testing and scenario analysis, where appropriate and conduct stress testing for future hypothetical scenarios, including exceptional liquidity events, which enable the assessment of risk under such conditions.
6. Oversight of delegates below expectations
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Cases were identified where there was a lack of effective engagement with delegated investment managers.
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UCITS Managers are expected to have regular engagement with delegate investment managers through receipt of ongoing liquidity reporting and evidence of regular challenge and interaction with them.
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It is necessary that the board of the UCITS Manager exercise skill, care and diligence in its continuing oversight of delegates through the review of reporting from appropriately authorised personnel of the delegate.
7. Shortcomings in the role of the designated person for fund risk management
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UCITS Managers identified whose designated persons’ oversight and input into the relevant LRM frameworks was not at the expected standard.
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There was no evidence provided of constructive challenge, analysis or commentary on the liquidity reporting received by the designated person.
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Designated persons are required to approach information received from delegates with healthy scepticism, not necessarily accepting such information at face value and interrogating information received. Designated persons should constructively challenge delegates and follow up on issues raised to ensure they are concluded satisfactorily.
8. Cases of no liquidity reporting to the board of the UCITS Manager
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UCITS Managers identified whose board of directors did not receive liquidity reporting.
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The reporting of liquidity risk and the manner in which it is reported to the board of directors of the UCITS Manager is an essential part of a properly functioning and robust risk management policy.
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It is a requirement that the risk management policy of the UCITS Manager must state the terms, contents and frequency of reporting to the board of directors.
9. Shortcomings in internal control framework
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Failures identified with the internal control frameworks within UCITS Managers.
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UCITS Managers must ensure that compliance functions, and where appropriate and proportionate, internal audit functions, have sufficient input into and oversight of LRM frameworks to ensure they are operating effectively.
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UCITS Managers must establish, implement and maintain adequate internal control mechanisms designed to secure compliance with decisions and procedures at all levels of the management company.
The Central Bank emphasised that their letter should be read in conjunction with: (1) the ESMA Report; (2) the results of the implementation of the ESRB recommendations; and (3) the Central Bank letter issued to UCITS managers in the context of that exercise.
Action plan
UCITS Managers are required to conduct a specific review of their practices, documentation, systems and controls by reference to the findings in the ESMA Report, the Central Bank Dear Chair letter and the nine specific areas mentioned above. This review must be documented and include details of actions taken to address the ESMA Report and the Central Bank Dear Chair letter.
The review should be completed and an action plan discussed and approved by the board of each UCITS Manager by the end of Q4 2021.
The Central Bank Dear Chair letter demonstrates that LRM continues to be an area of supervisory focus by the Central Bank. As a result, UCITS Managers should commence the requisite review as soon as possible to ensure an action plan is put in place by Q4 2021.
If you would like to discuss the above or require assistance in conducting the review and preparing an action plan, please contact a member of our Investment Funds team.
The content of this article is provided for information purposes only and does not constitute legal or other advice.
