ESMA releases framework for stress test simulations for investment funds

The European Securities and Markets Authority (ESMA) has released a framework to be used for stress simulations for the investment fund sector.

Its method has been detailed in the new Economic Report it has published, along with a case study where it was applied to 6,000 UCITS bond funds.

As the fund industry has developed it has given retail and institutional investors with a selection of investment vehicles available. Between 2007 and 2018, the total net assets managed by EU-domiciled UCITS funds increased significantly from €6.2 trillion to €9.3 trillion. This is why ESMA hopes to ensure the fund industry is resilient.

The stress testing simulation framework has tested a pure redemption shock where various large investors request to reduce or withdraw their parts in a fund within a short timeframe. It shows that most funds can cope with extreme shocks as there is enough liquid assets to meet redemption requests.

However, pockets of vulnerabilities are identified, particularly in high-yield bond funds. Up to 40 per cent of these bond funds could witness liquidity shortfalls, an instance where their holdings of liquid assets do not cover the redemptions assumed in the shock.

ESMA chair Steven Maijoor said, “The stress simulation framework is a key element of ESMA’s stress testing strategy, which also includes guidelines on liquidity stress testing and on money market fund stress testing. The resilience of the fund sector is of growing importance as it accounts for an increasing part of the EU financial system.

“This framework will be an important tool for supervisors to assess risks in the asset management industry, as the methodology developed by ESMA can be applied across the industry’s different sectors.”

The method outlined in the report can be implemented by regulators to simulate stress situations for different segments of the fund industry. Alongside this, ESMA has discussed the underlying data in detail with relevant national authorities, to ensure knowledge gained from this case study can benefit for the daily supervision of the sector.

 

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