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European watchdog warns of investment fund ‘fire sales’

Mismatches between the liquidity of open-ended investment funds’ assets and their redemption profiles could lead to “fire sales” to meet redemption requests in times of market stress, the European Systemic Risk Board (ESRB) has warned.

The ESRB is also concerned about the impact liquidity mismatches could have on other financial market participants holding the same or correlated assets.

Leverage may amplify the impact of negative market movements, the board warned.

In reaching its conclusions, the board said it had considered a number of risks that may stem from the increasing role played by investment funds in financial intermediation and could result in the “amplification of any future financial crisis”.

Recommendations – liquidity

The ESRB made a series of recommendations to the European Securities and Markets Authority (Esma) and the European Commission.

“Additional liquidity management tools, further supervisory requirements and tighter liquidity stress-testing practices can address risks from liquidity mismatches,” the board said.

It recommended making a diverse set of liquidity management tools available to fund managers to help them deal with redemption pressures when market liquidity is low.

Such tools, it said, could include the ability to impose redemption fees and to temporarily suspend redemptions. In order to mitigate or prevent excessive liquidity mismatches at open-ended alternative investment funds (AIFs) holding a large amount of less liquid assets, such funds should be required to show supervisors that they would be able to maintain their investment strategy under stressed market conditions.

To reduce liquidity risk and strengthen the ability of entities to manage liquidity in the best interests of investors, the ESRB also recommended that Esma develop further guidance on how fund managers should carry out liquidity stress tests.

Recommendations – leverage

“Risks from leverage can be addressed by creating a harmonised reporting framework and by making better use of existing possibilities to set leverage limits,” the board said.

It also recommended establishing a harmonised reporting framework across the EU for undertakings for collective investment in transferable securities (Ucits) to make it easier for authorities to monitor such funds and assess any risks to financial stability.

Additionally, it suggested that Esma develop guidance to help supervisory authorities both assess leverage risks in the AIF sector and design, calibrate and implement macroprudential leverage limits.

Such guidance would facilitate the implementation of Article 25 of the EU Alternative Investment Fund Managers Directive, which provides an existing macroprudential tool to limit leverage in AIFs, the ESRB said.

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