Stress Simulation Framework for Investment Funds-ESMA
After its report on licensing FinTech companies, The European Securities and Market Authority-ESMA has now developed a framework to be used for stress simulators for investment funds. The methods introduced by ESMA are included in its Economic Report along with a case study where it is applied to 6.000 UCITS bond funds.
The chair of ESMA, Steven Maijoor supported that the stress simulation framework is a key element of the testing strategy ESMA follows, and it includes guidelines on liquidity stress testing as well as money market fund testing. He noted that the flexibility of the fund sector is significant as ″it accounts for an increasing part of the EU financial program″.
He continued by saying that this framework will be handy for supervisors to assess risks in the asset management industry since ESMA developed a methodology which is easily adaptable to the industry’s different sectors.
The fund industry’s development has provided retail investors with multiple investing opportunities. Between 2007 and 2018 the total net assets managed by EU-domiciled UCITS funds have increased impressively from €6.2tn to €9.3tn. it is thus of the utmost importance to ensure that the funds industry is flexible and able to absorb economic shocks.
Through the application of the stress simulation framework to the UCITS bond funds, ESMA has simulated a pure redemption shock, where multiple investors can request to reduce or withdraw their parts in the fund within a short timeframe. Most funds can cope with these extreme shocks, based on the results, since they have adequate liquid assets to meet the investors’ redemption requests. Regardless, pockets of vulnerabilities are identified, mostly for High Yield (HY) bond funds. Under the plausible assumptions of ESMA’s simulations, 40% of HY bond funds could experience a liquidity shortfall.
The impact of the funds’ liquidation on financial markets has been modelled and since funds need to sell assets to meet investors’ redemptions, they exert downward pressure on asset prices. Based on the results, the overall price impact is limited for most asset classes; sales by funds are a mere fraction of aggregate trading volumes. For asset classes with more limited liquidity, like HY bonds and Emerging Market (EM) bonds, funds sales can have a material impact which ranges from 150 to 300 basis points and generate material second-round effects.
ESMA proceeded to detailed discussions with the relevant national authorities to secure that this case study would benefit the daily supervision of the funds sector.
This stress simulation framework will be used by ESMA to monitor and identify risk and assess possible adverse scenarios which can possibly affect the EU fund industry.
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