Liquidity Stress Test

In July 2020 the ESMA (European Securities and Markets Authority) released new guidelines on Liquidity Stress Testing in UCITS and AIFS. In the Netherlands, the AFM (Autoriteit Financiële Markten) has given notice that they will integrate these guidelines in their supervisory approach from 30th of September 2022 onwards. The guidelines apply to: Undertakings for Collective Investment in Transferable Securities (UCITS), ‘Alternatieve beleggingsfondsen’ (AIFs), Exchange Traded Funds (ETFs) and closed-end AIFs with leveraged financing.

In short, these guidelines set increased requirements for liquidity stress tests. This considers:

  • Methodology of liquidity stress tests.
  • The used stress scenarios.
  • The frequency at which the liquidity stress test needs to be executed.

Within RiskQuest we have developed different Liquidity Stress Tests methodologies that align with the ESMA guidelines on Liquidity Stress Testing. We did this for funds including, equity, bonds, and more exotic financial instruments, for example, asset-backed securities. Each stress tests developed consist of the same building blocks, namely:

  • A redemption model, i.e., a model that generates redemptions of the fund over a specific timeline.
  • A liquidation strategy, i.e., the strategy followed by the fund when a (large) redemption is requested by the client(s).
  • Measure of the fund’s liquidity, i.e. a quantity that represents the fund’s liquidity after redemptions and given a liquidation strategy.

We have developed two different redemption models. An expert-based and simulation-based redemption model. In the former we define stress scenarios based on expert judgement by the fund manager. The latter considers a (Monte Carlo) simulation, where the time between two redemptions and the size of the redemption are drawn from parametric distributions.

After the redemptions are known over time, we define how the fund manager should liquidate the assets to pay out the clients. We refer to this as the liquidation strategy. This strategy depends on expert input by the fund’s manager.

Given the redemption model and the liquidation strategy, we can assess the fund’s liquidity based on a quantity that measures any liquidity shortages over time.

The deliverables of these stress tests are periodic reports, where the liquidity risk of the fund is described and potential advice for the fund’s manager to improve the liquidity of the fund is given. Currently we have successfully delivered reports at multiple mutual funds in different asset categories. The AFM already reviewed and approved our methodologies.

If you would like to know more about this, read here about one of our projects. If you would like to work on liquidity stress tests, you can join our financial risk modelling team. Apply here if you are interested

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