RECOMMENDATION OF THE EUROPEAN SYSTEMIC RISK BOARD

of 7 December 2017

on liquidity and leverage risks in investment funds

(ESRB/2017/6)

(2018/C 151/01)

THE GENERAL BOARD OF THE EUROPEAN SYSTEMIC RISK BOARD,

Having regard to the Treaty on the Functioning of the European Union,

Having regard to Regulation (EU) No 1092/2010 of the European Parliament and of the Council of 24 November 2010 on European Union macroprudential oversight of the financial system and establishing a European Systemic Risk Board (1), and in particular Article 3(2)(b), (d) and (f) and Articles 16 to 18 thereof,

Having regard to Decision ESRB/2011/1 of the European Systemic Risk Board of 20 January 2011 adopting the Rules of Procedure of the European Systemic Risk Board (2), and in particular Articles 18 to 20 thereof,

Whereas:

The investment fund sector has grown strongly over the past decade, both in the Union and globally, and consequently investment funds now account for a greater overall component of securities markets. The role of investment funds in financial intermediation is expected to increase further in an environment of low interest rates and balance sheet constraints in the banking sector, coupled with changes resulting from the development of the Capital Markets Union. Regulatory authorities have welcomed this development as the diversification of financing sources may help to enhance the efficiency as well as the resilience of the financial system as a whole.

However, there are concerns that increased financial intermediation by investment funds may result in the amplification of any future financial crisis. Mismatches between the liquidity of open-ended investment funds' assets and their redemption profiles may result in fire sales in order to meet redemption requests in times of market stress. Such fire sales could adversely affect other financial market participants that own the same or closely correlated assets. Furthermore, leverage can amplify the impact of negative market movements as it creates exposure in excess of the assets of an investment fund. In addition to such channels of indirect contagion, an investment fund can spread risk through interconnectedness, e.g. interconnections with its investors, which is a direct channel through which shocks can be transmitted to other financial institutions.

Investment funds are also susceptible to changes in market dynamics and structure. For instance, in a low interest rate environment, the search for yield may encourage a greater proportion of investment in less liquid assets. There is a risk that macro-level shocks, such as a reversal in risk premia, could lead to widespread redemption requests by investment fund investors. This may be particularly pronounced in investment funds which hold a large proportion of highly leveraged and less liquid assets in their portfolios.

In addition, unless this risk is appropriately managed, some investors may make use of a ‘first mover advantage,’ i.e. investors who redeem prior to, or in the early stages of, a stressed market situation do not bear the full impact of such a stressed market situation, leaving the remaining investors to assume the burden.

The current legislative framework in the Union includes measures designed to reduce the amplifying effects of the investment fund sector in a financial crisis and to strengthen the resilience of investment funds. The legislative framework comprises Directives 2009/65/EC (3) and 2011/61/EU of the European Parliament and of the Council (4) .

Directives 2009/65/EC and 2011/61/EU both contain liquidity management requirements. Alternative investment funds (AIFs) are required to have redemption policies that are consistent with the liquidity profile of their investment strategy and to conduct regular stress tests under both normal and exceptional liquidity conditions. Undertakings for collective investment in transferable securities (UCITS) are subject to detailed eligibility rules that govern the types of assets in which they are allowed to invest and must conduct stress tests where appropriate.

To address leverage related systemic risks, Directives 2009/65/EC and 2011/61/EU currently provide a legal basis for limiting the build-up of leverage in investment funds. Article 51(3) of Directive 2009/65/EC specifies an investment limit on the exposures of UCITS to derivative instruments and Article 83(2)(a) of the same Directive specifies a 10 % temporary borrowing cap. Article 25(3) of Directive 2011/61/EU allows national competent authorities (NCAs) to impose leverage limits or other restrictions on the management of AIFs. In addition, Article 25(7) of Directive 2011/61/EU provides a role for the European Securities and Markets Authority (ESMA) in determining that the leverage employed by an alternative investment fund manager (AIFM), or by a group of AIFMs, poses a substantial risk to the stability and integrity of the financial system and ESMA may issue advice to NCAs specifying the remedial measures to be taken, including limits on the level of leverage.

The application of consistently high standards in respect of fund managers' capacity to manage risks across the Union is warranted to ensure that regulation will mitigate systemic risk. There is evidence that the current regulatory framework provides for effective risk management by investment funds at the microprudential level. However, its efficacy from a macroprudential perspective is largely untested. The purpose of this Recommendation is to address systemic risks related to liquidity mismatches and the use of leverage in investment funds. This will enhance the macroprudential framework in the Union as it applies to the asset management sector.

Recommendation A is designed to address the risks that may arise when fund managers do not have adequate liquidity management tools in place such as redemption fees, redemption gates, or the ability to temporarily suspend redemptions. In the absence of such tools, redemption pressures during times of declining asset prices could cause system-wide liquidity stress and exacerbate asset price falls, which could lead to risks to financial stability. The availability of a diverse set of liquidity management tools in all Member States would increase the capacity of fund managers to deal with redemption pressures when market liquidity becomes stressed. In addition, Recommendation A calls for further clarification of the suspension of redemptions by NCAs.

Recommendation B is designed to mitigate and prevent excessive liquidity mismatches in open-ended AIFs. Some open-ended AIFs hold a large proportion of their investments in inherently less liquid assets. This includes investment funds that invest in real estate, unlisted securities, loans and other alternative assets. There is a need for such investment funds to demonstrate their capacity to NCAs during both the approval process, and/or after approval, to maintain their investment strategy under stressed market conditions.

Recommendation C is designed to promote coherent liquidity stress testing practices at the investment fund level. Stress tests are tools that help the fund manager identify potential weaknesses of an investment strategy and assist in preparing an investment fund for a crisis. If used correctly, as a risk management and decision-making tool, a stress test should reduce liquidity risk at the investment fund level and contribute to lowering liquidity risk at the financial system level. Guidance on fund managers' liquidity testing practices is expected to reduce liquidity risk, at both investment fund and system level, and strengthens the ability of entities to manage liquidity in the best interests of investors, including the avoidance of surprises and resulting emergency reactions during unexpectedly high redemption periods.

Recommendation D is designed to establish a harmonised UCITS reporting framework across the Union. Although many jurisdictions within the Union have reporting obligations for UCITS, reporting practices differ widely in terms of the reporting frequency, the UCITS covered, and the data reported. The lack of a harmonised reporting framework prevents monitoring and a comprehensive assessment of the potential contribution of UCITS to risks to financial stability. A harmonised UCITS reporting framework will also reduce existing reporting inefficiencies for both NCAs and industry.

Recommendation E is designed to facilitate the implementation of Article 25 of Directive 2011/61/EU, which provides for a macroprudential tool to limit leverage in AIFs. There is a need to clarify the use of this tool by developing a common approach to ensure that NCAs are able to use the tool in a harmonised manner. Therefore, guidance on a framework to assess leverage risks and on the design, calibration and implementation of leverage limits should be developed.

This Recommendation advocates a proportionate framework for managing the systemic risks that may arise in, or be propagated by, the investment funds sector, while maintaining the key redemption features that attract investors to open-ended investment funds and facilitate collective investment.

This Recommendation takes into account ongoing international and European initiatives on macroprudential policies to mitigate risks from liquidity mismatches and leverage in investment funds and, in particular, the work of the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO). On 12 January 2017, the FSB published recommendations to address structural vulnerabilities from asset management activities arising from liquidity mismatches and the use of leverage in investment funds (5) . To supplement the FSB's work, IOSCO has been tasked with implementing the FSB's recommendations. This process is currently ongoing.

In order to implement the macroprudential elements of the current regulatory framework for investment funds and to ensure that NCAs act consistently, this Recommendation is addressed partially to ESMA, with regard to its facilitation and coordination role.

In order to tackle other risks posed by investment funds, it is recommended that the European Commission should propose additional legislative measures. It is recognised that the Commission has already placed legislative reviews in this area on its agenda. These will provide an opportunity to address the macroprudential issues referred to in the recommendations.

Recommendations of the European Systemic Risk Board (ESRB) are published after the General Board has informed the Council of the European Union of its intention to do so and provided the Council with an opportunity to react,

HAS ADOPTED THIS RECOMMENDATION:

SECTION 1

RECOMMENDATIONS

Recommendation A — Liquidity management tools for redemption

The Commission is recommended to propose that Union legislation incorporates a common Union legal framework governing the inclusion of additional liquidity management tools (a-LMTs) in the design of investment funds originating anywhere in the Union so that the decision on which a-LMTs to incorporate in the constitutional documents of or other pre-contractual information on investment funds is made individually by each entity responsible for management.

The Commission is recommended to propose that Union legislation includes further provisions specifying the NCAs' role when using their powers to suspend redemptions in situations where there are cross-border financial stability implications.

The Commission is recommended to propose that Union legislation sets out ESMA's general facilitation, advisory and coordination role in relation to the NCAs' powers to suspend redemptions in situations where there are cross-border financial stability implications, in line with Recommendation A(2).

Recommendation B — Additional provisions to reduce the likelihood of excessive liquidity mismatches

The Commission is recommended to propose that Union legislation includes measures to limit the extent to which the use of liquidity transformation in open-ended AIFs could contribute to the build-up of systemic risks or the risk of disorderly markets.

Recommendation C — Stress testing

In order to promote supervisory convergence ESMA is recommended to develop guidance on the practice to be followed by managers for the stress testing of liquidity risk for individual AIFs and UCITS.

Recommendation D — UCITS reporting

The Commission is recommended to propose that Union legislation requires UCITS and UCITS management companies to regularly report data, especially regarding liquidity risk and leverage, to the competent authority, and to provide such data to the relevant NCA if it is not the competent authority for UCITS reporting purposes.

The Commission is recommended to propose that the data mentioned in Recommendation D(1) is reported, within a reporting framework, at least on a quarterly basis by a sufficiently relevant proportion, from a financial stability perspective, of all UCITS and UCITS management companies. As a minimum, a sufficient subset of the data set should be reported annually by a representative proportion of all UCITS and UCITS management companies.

The Commission is recommended to propose that NCAs make the data mentioned in Recommendation D(1) available to the NCAs of other relevant Member States, ESMA and the ESRB.

Recommendation E — Guidance on Article 25 of Directive 2011/61/EU

ESMA is recommended to give guidance on the framework to assess the extent to which the use of leverage within the AIF sector contributes to the build-up of systemic risk in the financial system.

ESMA is recommended to give guidance on how NCAs should notify ESMA, the ESRB and other NCAs of their intention to implement macroprudential measures under Article 25(3) of Directive 2011/61/EU.

ESMA is recommended to use the information received from NCAs pursuant to Article 25(3) of Directive 2011/61/EU to benchmark and share knowledge with national macroprudential authorities and the ESRB on practices on the use of leverage limits and the imposition of other restrictions on the management of AIFs.

SECTION 2

IMPLEMENTATION

1. Definitions

‘undertaking for collective investment in transferable securities’ (UCITS) means an undertaking as defined in Article 1(2) of Directive 2009/65/EC that has been authorised in accordance with Article 5 of that Directive;

‘leverage’ means any method by which an investment fund increases its exposure over and above the assets of the fund whether through the borrowing of cash or securities or leverage embedded in derivative positions or by any other means;

‘entity responsible for management’ means: (i) a management company as defined in Article 2(1)(b) of Directive 2009/65/EC; (ii) a UCITS constituted as an investment company that has not designated a management company as provided for in Directive 2009/65/EC; (iii) an AIFM as specified in Article 4(1)(b) of Directive 2011/61/EU; and (iv) an internally managed AIF constituted as an investment company that has not designated an AIFM referred to in Article 5(1)(b) of Directive 2011/61/EU;

‘alternative investment fund managers’ (AIFMs) has the same meaning as in Article 4(1)(b), subject to the exclusions set out in Article 2(3) and the exemptions set out in Article 3, of Directive 2011/61/EU;

‘additional liquidity management tools’ (a-LMT) means tools that assist open-ended AIFs and UCITS as well as their managers to manage requests for redemption appropriately and effectively at all times and especially in stressed market conditions. These tools should include post-event measures, such as: suspensions of redemptions or deferred redemptions (‘gates’/extendable notice periods), and pre-emptive measures such as allocation of trading costs to subscribing/redeeming investors (‘swing pricing’/anti-dilution levies);

Annexes I and II form an integral part of this Recommendation. In the event of conflict between the main text and the Annexes, the main text prevails.

2. Criteria for implementation

due regard should be paid to the principle of proportionality, taking into account the objective and the content of each recommendation;

an assessment of the functioning of the actions undertaken having regard to the objectives of this Recommendation;

information on the substance and timeline of the actions undertaken, including any actions undertaken in relation to the European supervisory authorities, where applicable;

Addressees are requested to report to the ESRB and to the Council on the actions undertaken in response to this Recommendation, or adequately justify any inaction. The reports should as a minimum contain:

3. Timeline for the follow-up

Addressees are requested to report to the ESRB and the Council on the actions taken in response to this Recommendation, or adequately justify any inaction, in compliance with the following timelines:

By 31 December 2020, the Commission is requested to deliver to the ESRB and the Council a report on the implementation of Recommendations A(1), A(2) and A(3).

By 31 December 2020, the Commission is requested to deliver to the ESRB and the Council a report on the implementation of Recommendation B.

By 30 June 2019, ESMA is requested to deliver to the ESRB and the Council the guidance referred to in Recommendation C.

By 31 December 2020, the Commission is requested to deliver to the ESRB and the Council a report on the implementation of Recommendations D(1), D(2) and D(3).

Starting on 31 December 2019, ESMA is requested to provide the national macroprudential authorities and the ESRB, at least annually, with the information referred to in Recommendation E(4).

By 30 June 2019, ESMA is requested to deliver to the ESRB and the Council the guidance referred to in Recommendations E(1), E(2) and E(3);

4. Monitoring and assessment

verify the follow-up by the addressees, provide assistance at their request, and submit follow-up reports to the General Board via the Steering Committee.

assist the addressees, ensuring the coordination of reporting and the provision of relevant templates, and detailing where necessary the procedure and the timeline for the follow-up;

The General Board will assess the actions and justifications reported by the addressees and, where appropriate, may decide that this Recommendation has not been followed and that an addressee has failed to provide adequate justification for its inaction.

(1) OJ L 331, 15.12.2010, p. 1.

(2) OJ C 58, 24.2.2011, p. 4.

(3) Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) (OJ L 302, 17.11.2009, p. 32).

(4) Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (OJ L 174, 1.7.2011, p. 1).

(5) Financial Stability Board, ‘Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities’, January 2017.

(6) Commission Delegated Regulation (EU) No 694/2014 of 17 December 2013 supplementing Directive 2011/61/EU of the European Parliament and of the Council with regard to regulatory technical standards determining types of alternative investment fund managers (OJ L 183, 24.6.2014, p. 18).

(2) Commission Delegated Regulation (EU) No 231/2013 of 19 December 2012 supplementing Directive 2011/61/EU of the European Parliament and of the Council with regard to exemptions, general operating conditions, depositaries, leverage, transparency and supervision ( OJ L 83, 22.3.2013, p. 1 ).

the practices, if any, in relation to the use of leverage limits and the imposition of other restrictions on the management of AIFs using information received from the NCAs pursuant to Article 25(3) of Directive 2011/61/EU.

The guidance issued by ESMA should enable the NCAs to notify ESMA, the ESRB and other relevant NCAs. In particular, this guidance should include, but not be limited to, an efficient working procedure and templates for notification letters and reporting requirements on the NCAs' assessment of the need to implement macroprudential measures pursuant to Article 25(3) of Directive 2011/61/EU.

a set of principles to be taken into account by the NCAs when considering the imposition of leverage limits, as a minimum covering all of the following: (i) principles for a balanced approach between rules-based versus discretionary limit setting; (ii) principles relating to the interaction with other policy measures; (iii) principles for coordination among Union authorities.

a set of principles to be taken into account by the NCAs when calibrating leverage limits. As a minimum such principles should include all of the following: (i) a statement that provides for leverage limits to be based on the leverage measures set out in Directive 2011/61/EU, (ii) criteria for applying leverage limits, and (iii) principles regarding the periodic review of leverage limits;

be operable and sufficient for NCAs to inform ESMA, in connection with its advice under Article 25(6) of Directive 2011/61/EU and the principles laid down in Article 112 of Commission Delegated Regulation (EU) No 231/2013 (2) , whether the conditions for imposing leverage limits or other restrictions on the management of AIFs have been met.

facilitate assessment of the main channels through which systemic risk may materialise, i.e. fire sales, direct spillovers to financial institutions, and the interruption of credit intermediation; and

qualitative and, where feasible, quantitative descriptions of the interpretation of the indicators in the context of the assessment framework.

The Commission's proposed changes to Union legislation should include an obligation for the information mentioned in Recommendation D(1) to be made available to the NCAs of other relevant Member States, ESMA and the ESRB in order to ensure the harmonisation of UCITS data reporting with data sharing practices under Directive 2011/61/EU. In this context, the Commission should also take into account reporting requirements under Regulation (EU) 2017/1131.

the total assets under the management of the management company and the assets under management by individual UCITS funds should be taken into account when setting the scope for reporting, thus ensuring that a sufficient part of the industry will be covered by the reporting, in order to address risks to financial stability.

the data mentioned in Recommendation D(1) is reported as a minimum on a quarterly basis to enable effective monitoring of financial stability risks while also addressing proportionality aspects in relation to the entities required to report;

The Commission's changes to Union legislation should furthermore include a provision stating that if the NCA of the UCITS manager is different from the NCA of the UCITS itself, the UCITS manager must, upon request, also provide the reported information to the NCA of the UCITS.

The Commission should propose, where appropriate, a harmonisation of overall reporting requirements on investment funds and their managers, particularly between the recommended UCITS reporting and the measures already implemented for reporting under Directive 2011/61/EU. In this respect, the Commission should also take into account the reporting requirements under Regulation (EU) 2017/1131 of the European Parliament and of the Council (1) . Such harmonisation should enable the use of existing reporting platforms, achieve synergies and avoid undue burdens on asset managers.

The Commission's proposed changes to the relevant Union legislation should include reporting obligations that cover both manager and fund-specific data while also reflecting the specificities of UCITS. The reported data should allow for sufficient monitoring of potential vulnerabilities that may contribute to systemic risk, and should cover, as a minimum:

Such guidance should be based on the stress testing requirements set out in Directive 2011/61/EU and how market participants carry out stress testing.

the discretion to impose transitional provisions for AIFMs of open-ended AIFs specifying the time allowed to comply with the legislation when assets are added to the list of inherently less liquid assets under point B(a), and when internal limits are breached, where useful, in order to avoid any unintended, harmful effects.

a requirement for AIFMs of open-ended AIFs whose objective is to invest significantly in assets included in the list of inherently less liquid assets under point B(a), to demonstrate to the NCAs their capacity to maintain their investment strategy under foreseeable market conditions. The assessment should include, inter alia, tailored redemption policies, the implementation of a-LMTs and/or internal limits of assets included in the list of inherently less liquid assets under point B(a). Such internal limits, if used, should then be disclosed to the NCAs at the inception of the relevant funds and reported thereafter whenever these limits change. Disclosure to investors should also be implemented based on guidance to be developed by ESMA;

granting powers to ESMA to prepare and to update a list of inherently less liquid assets, on the basis of ESMA's own analysis, after taking into account the ESRB's opinions in relation to macroprudential issues and those of the European Banking Authority and the European Insurance and Occupational Pensions Authority in relation to cross-sectoral consistency issues. In compiling this list, ESMA should consider, as a minimum, real estate, unlisted securities, loans and other alternative assets that appear to be inherently less liquid. The analysis should take into account, inter alia, the time it would take to liquidate those assets under stressed market conditions;

The Commission's proposed changes to the relevant Union legislation should include an obligation for ESMA to ensure that it fulfils a general facilitation, advisory and coordination role in relation to the NCAs' powers to suspend redemptions where there are cross-border financial stability implications.

an obligation for the NCAs, when exercising the powers to direct the suspension of redemptions for cross-border financial stability purposes, to notify other relevant NCAs, ESMA, and the ESRB, prior to exercising such powers.

clarification of the respective roles of the NCAs and cooperation between them with regard to suspending redemptions for cross-border financial stability purposes, where the AIF or UCITS is established in one Member State but has an AIFM or UCITS management company established in another Member State, i.e. cross-border implications;

The guidance should take into account the necessary contingency planning that should apply in advance, as required under point A(1)(c), to enable such a-LMTs to be activated promptly and effectively.

the level of transparency in relation to investors when a-LMTs are activated and during their use.

the European Securities and Markets Authority (ESMA), after taking into account the opinion of the European Systemic Risk Board (ESRB) in relation to macroprudential issues, to develop guidance on:

AIFMs of open-ended AIFs and UCITS management companies to report to the national competent authorities (NCAs) on the implementation and use of a-LMTs in stressed market conditions;

AIFMs of open-ended AIFs and UCITS management companies to ensure that the necessary operational capacity and contingency planning is available for the timely activation of any a-LMT which they may use;

AIFMs of open-ended AIFs and UCITS management companies to include, as a minimum, the power to suspend redemptions, particularly in stressed market conditions, in the constitutional documents or other pre-contractual information of the funds they manage;

alternative investment fund managers (AIFMs) of open-ended AIFs and UCITS management companies to assess all available a-LMTs and specifically to assess which of them are suitable for the investment strategies of the funds they manage and should be included in their constitutional documents or other pre-contractual information in order to be exercised both in normal and in stressed market conditions and to provide investors with sufficient transparency in relation to such tools;

Union legislation should allow for a wide range of additional liquidity management tools (a-LMTs) to be legally available at Union level while recognising that asset managers should bear the primary responsibility for activating and implementing a-LMTs and that some of the tools will not be suitable or necessary for all types of open-ended funds. The a-LMTs should support open-ended alternative investment funds (AIFs) and undertakings for collective investment in transferable securities (UCITS), as well as their managers, to manage requests for redemption appropriately and effectively at all times and especially in stressed market conditions.

ANNEX II

ECONOMIC RATIONALE AND ASSESSMENT

TABLE OF CONTENTS

List of abbreviations 12

I. Introduction 13

II. ESRB Recommendation on liquidity and leverage risks in investment funds 17

II.1 Recommendation A – Liquidity management tools for redemption 17

II.1.1 Economic rationale and intended effects 17

Recommendation A(1) – Availability of additional liquidity management tools 17

Recommendations A(2) and A(3) – Further provisions on NCAs and on ESMA's role in relation to NCAs' suspension of redemptions with cross-border financial stability implications 21

II.1.2 Unintended effects 22

II.2 Recommendation B – Additional provisions to reduce the likelihood of excessive liquidity mismatches 22

II.2.1 Economic rationale and intended effects 22

II.2.2 Unintended effects 30

II.3 Recommendation C – Stress testing 31

II.3.1 Economic rationale and intended effects 31

II.3.2 Unintended effects 34

II.4 Recommendation D – UCITS reporting 35

II.4.1 Economic rationale and intended effects 35

Recommendation D(1) – Reporting obligations for UCITS and UCITS management companies 35

Recommendation D(2) – Frequency and coverage of reporting obligations for UCITS and UCITS management companies 38

Recommendation D(3) – Harmonised reporting and information sharing 39

II.4.2 Unintended effects 39

II.5 Recommendation E – Guidance on Article 25 of Directive 2011/61/EU 40

II.5.1 Economic rationale and intended effects 40

Recommendation E(1) – Assessment of leverage-related systemic risk 40

Recommendation E(2) – Macroprudential leverage limits 45

Recommendation E(3) – Notification procedure 48

Recommendation E(4) – Benchmarking 48

II.5.2 Unintended effects 48

References 49

Appendix 52

List of abbreviations

a-LMT additional liquidity management tools AIF alternative investment fund AIFM alternative investment fund manager AuM assets under management CESR Committee of European Securities Regulators CIS collective investment scheme CLMT countercyclical liquidity management tool CRE commercial real estate CSD central securities depository EBA European Banking Authority ECB European Central Bank EEA European Economic Area ELTIF European long-term investment funds ESCB European System of Central Banks ESMA European Securities and Markets Authority ESRB European Systemic Risk Board EU European Union EUR euro FSB Financial Stability Board FVP fair value pricing IOSCO International Organization of Securities Commissions ITS implementing technical standards MMF money market fund NAV net asset value NCA national competent authority OTC over-the-counter RTS regulatory technical standards SEC Securities and Exchange Commission UCITS undertakings for collective investments in transferable securities VaR value at risk

This Annex provides background material for the ESRB recommendations in order to support their implementation in the EU. In particular, each recommendation is discussed in detail below, and the economic rationale and assessment that accompany each recommendation are set out, including possible intended and unintended effects and potential market impact. For the analysis, extensive use is made of research and policy papers, national regulations and results of ESMA, ESRB and IOSCO surveys (e.g. of the availability and use of liquidity management tools, of the use of fund leverage under Directive 2009/65/EC of the European Parliament and of the Council (1) and Directive 2011/61/EU of the European Parliament and of the Council (2), and of fund managers' stress-testing practices).

I. Introduction

Structural considerations

The Union's investment fund sector has grown considerably in recent years. Since 2008 total net assets of EU investment funds have more than doubled, growing from EUR 6,2 trillion to stand at EUR 15,3 trillion in the third quarter of 2017. (3) It should also be noted that, in the same period, European AIFs more than tripled in size, increasing from EUR 1,6 trillion to EUR 5,8 trillion. (4) As the investment funds sector becomes a larger part of the total financial market, so managing systemic risk in that sector becomes more pertinent.

Investment funds show a particularly complex range of potential behaviours in reaction to market stress. Investment funds are just one of a number of major types of investor in financial markets – others include banks, insurance companies, pension funds, retail investors, family offices, sovereign wealth funds and intermediaries of various kinds. Each type has its own specific behavioural characteristics. One characteristic typical for investment funds is that they gather funds from a wide variety of end-investors and channel that investment into the markets through a collective investment structure. This feature, combined with the fact that most investment funds are ‘open-ended’ (i.e. end-investors can withdraw their investment from the fund prior to the maturity of the underlying assets), means that under market stress investment funds show a particularly complex range of potential behaviours. One notable possibility is that an investment fund, or a subsector of an investment fund, might, in response to market stress and resulting investor redemption behaviour, sell assets on a significant scale into a falling market, thus exacerbating the market shock and contributing to financial instability.

Investment funds tend to maintain their investment strategy in the presence of market shocks. With the exception of some AIFs, investment funds typically use low levels of leverage. (5) In this case, funds which are not experiencing redemptions pressure tend to keep their assets and may even opportunistically seek to purchase assets as prices fall, thereby producing a countercyclical impact.

Sources of risk

The main reason for funds possibly acting differently and selling into a falling market during a market shock would be an unexpectedly high level of redemption demand. While this has not been the historical pattern, there have been a few cases of high levels of redemption demand during times of market stress. Furthermore, the past pattern of an investment fund's behaviour is not necessarily indicative of its future behaviour. For this reason, we cannot be certain that those cases of high levels of redemption demand will continue to be rare or isolated occurrences. One reason why there might be high levels of redemption demand during times of market stress is the fact that investment funds do not act merely as vehicles for unleveraged, long-term equity investments. Instead, funds are sometimes used by investors who have shorter-term perspectives and the proportion of such investors can vary significantly, depending on other influences on the market. This creates the potential for significantly greater systemic risk within the sector than would be the case if high levels of redemption occurred only rarely or as isolated instances. As the sector becomes larger, this fact, in turn, becomes a more important feature of systemic risk overall.

The second major source of systemic risk is the fact that there are incentives to trade liquidity off against yield, or to increase leverage so as to deliver a yield that will be attractive to investors. The more an investment fund is leveraged the less it is likely to show resilience in periods of market stress. In addition, the more an investment fund trades liquidity off against yield, the less well placed it might be to deal with spikes in redemption demand in an orderly fashion. This behaviour might be exacerbated if the trade-off is unclear to potential investors, either because the assets invested appear to be liquid although the liquidity is not resilient, or because the leverage is embedded in derivative instruments and its scale is not transparent.

The third source of systemic risk is the way the redemption mechanism works. Open-ended investment funds may give rise to ‘first mover advantage’, whereby redeeming investors do not bear the full cost of redeeming early, which is instead passed on to the remaining unit holders. For fund managers there is also a related reputational issue which can lead them to be reluctant to suspend redemptions, even when it would be in the interests of investors to do so, while also managing a balancing act between providing liquidity to investors who have requested redemptions as long as there is liquidity in the fund and determining that circumstances are sufficiently exceptional to warrant a suspension.

The fourth source of systemic risk is that the operation of the redemption mechanism depends on market liquidity. For many of the instruments that investment funds invest in, liquidity has traditionally been dependent on market makers and has been variable across time and instruments. Recent developments – including reductions in volatility, increased reliance on electronic trading, the fragmentation of sources of liquidity, and smaller holdings of assets by traditional market makers such as banks and broker-dealers, as well as cyclical factors such as monetary policy – indicate that the structure of liquidity provision can change over time (although ongoing research has not yet found unanimous evidence of reduced liquidity at this time). These changes can affect how robust liquidity provision proves to be when markets come under stress. The significance of these changes in the structure of liquidity is difficult to predict and, as a consequence, investment funds may find themselves relying on levels of liquidity which are less resilient than expected.

There are important interactions between the leverage, liquidity and redemption features of investment funds. Leveraged investment funds that are experiencing higher margin calls, withdrawals of funding, or increased haircuts can make rapid adjustments if they hold assets that can be liquidated quickly. If, however, a highly leveraged fund holds smaller amounts of liquid assets and is subject to potential short-term redemptions or changes in lending terms, it may have to sell assets quickly in less liquid markets (selling at a discount) in order to honour its obligations. Although, in the event of margin calls, investment funds may be able to suspend redemptions in the interests of the investors, the fund will have to raise cash quickly via emergency funding and/or asset sales to avoid liquidation, which could potentially cause significant counterparty risk and have a great impact on asset prices.

Central banks, markets and securities regulators have raised concerns over the potential for investment funds to amplify systemic risks. (6) At a global level, the FSB has ascertained that investment funds' liquidity mismatches and use of leverage give rise to potentially significant structural vulnerabilities in the fund management sector. Subsequently, the FSB has stressed how important it is to examine and address potential structural vulnerabilities associated with liquidity mismatch and the use of leverage by investment funds that could pose financial stability risks. The FSB recommends, for instance, authorities to monitor the use of leverage by funds and to take action when appropriate. (7)

The current regulatory framework for investment fund liquidity and leverage

In Europe, the regulatory framework governing investment fund liquidity and leverage management consists of Directives 2009/65/EC and 2011/61/EU. This forms the basis of how investment funds in Europe are required to manage their liquidity and leverage positions, and serves as a starting point for assessing systemic risks from investment fund liquidity mismatch and the use of leverage.

UCITS are highly regulated investment funds. UCITS are investment funds that invest in eligible assets, such as cash and cash-like deposits, bonds, equities, money-market instruments and other investment funds (see Box 1a). Theoretically, UCITS are less prone to liquidity mismatches since both their assets and their liabilities are supposed to be traded in a short timeframe. They may only invest in transferable securities or in other liquid financial assets whose eligibility rules are detailed in a specific Directive (8). UCITS are obliged (subject to the possibility that the investment fund could be suspended) to redeem an investor's share on receipt of a request from the unitholder: this means that UCITS must permit redemptions at least twice a month, although many UCITS permit redemptions on a daily or weekly basis. Regarding leverage, UCITS operate under regulatory leverage limits. UCITS may only use financial leverage via unsecured cash borrowing against up to 10 % of their assets and on condition that such borrowing is only temporary (see Box 1b). As a result, UCITS using both cash borrowing and securities financing transactions or derivatives can leverage up to a maximum of 2,1 times their NAV.

AIFs are investment funds which are permitted to invest in assets similar to those in UCITS but are not subject to such detailed restrictions on diversification, liquidity or leverage. AIFs may also invest in financial instruments that are not eligible assets for UCITS, such as private equity, venture capital, real estate, physical commodities and other alternative assets. However, managers are required to put in place liquidity management procedures if they manage open-ended AIFs or closed-ended AIFs that are leveraged. This includes aligning the investment fund's investment strategy, liquidity profile and redemption policy, as well as setting appropriate liquidity management limits and stress tests (see Box 1a). It should be noted that AIFMs operating below certain thresholds (9) may not be subject to the same requirements, in which case they will not be able to benefit from the passport available under Directive 2011/61/EU for marketing in other Union jurisdictions. Regarding leverage, AIFs operate without any regulatory leverage limits. AIFs' funds are only required to report their use of leverage (see Box 1b).

Box 1a: The current regulatory framework for investment fund liquidity Directive 2009/65/EC – UCITS Dealing frequency. UCITS must provide facilities so that units can be repurchased or redeemed at the request of fund investors. This means that UCITS must allow redemption requests at least twice a month (10), although many UCITS permit redemptions on a daily or weekly basis (11). Dealing procedures. Directive 2009/65/EC does not specify the dealing procedures to be followed by UCITS. In practice, a dealing deadline for the receipt of applications will be set at a time before the valuation point – which could be hours or days later. Furthermore, UCITS will generally pay out redemption monies in line with the settlement procedures detailed in the fund documentation, which could specify a time of three to five days after the valuation point (12). In line with these dealing procedures, there is a period of time between the cut-off time for receipt of applications and the deadline for payment of redemption monies. This gives the UCITS management company time to sell investments and generate cash to pay redemption monies if this is necessary. Eligible assets. UCITS are subject to detailed eligible assets rules and are therefore obliged to invest predominantly in liquid assets. These include: listed liquid transferable securities and money market instruments; exchange traded-derivatives; and bank deposits which are repayable on demand or include withdrawal rights and which mature in no more than 12 months. (13) To provide further support to liquidity, criteria are stipulated governing the markets on which eligible assets must be listed or traded (14). Pre-investment due diligence. Before an UCITS management company makes an investment, it must analyse, inter alia, the investment's contribution to the UCITS fund's portfolio composition, liquidity, and risk and reward profile. (15) Risk management. As a part of its risk management processes, an UCITS management company must follow an appropriate liquidity risk management procedure to ensure that each UCITS it manages is able to comply, in all foreseeable circumstances including stressed conditions, with its obligation to redeem units if requested to do so by a unitholder. Where appropriate, an UCITS management company must conduct stress tests to assess the liquidity risk of the UCITS under exceptional conditions. (16) Netting of subscriptions and redemptions. Where an UCITS fund receives subscription and redemption orders for the same dealing day, it will match the unit transactions and use the subscription monies received to pay some or all of the redemption requests. This reduces or removes any need to sell underlying investments to generate cash to pay out redeeming investors. Directive 2011/61/EU – AIFMD Dealing procedures. As is the case for UCITS, Directive 2011/61/EU does not specify the dealing procedures to be used for AIFs. An AIFM will design dealing procedures which are appropriate for its AIFs under management and which provide sufficient time for it to sell investments so it can generate cash to pay redemption monies. Risk management. Article 15 of Directive 2011/61/EU contains similar provisions to those covering pre-investment due diligence in Directive 2009/65/EC (explained above). The Article requires, as part of AIFMs' risk management, risks associated with each investment position of the AIF and their overall effect on the AIF's portfolio to be properly identified, measured, managed and monitored on an ongoing basis, including through the use of appropriate stress-testing procedures. Directive 2011/61/EU furthermore requires an AIFM to ensure that the investment strategy, liquidity profile and redemption policy are consistent for each AIF it manages. (17) An AIFM must have appropriate liquidity management systems in place to monitor the liquidity risk of the AIF and ensure that the liquidity profile of the investments of the AIF complies with its underlying obligations. Furthermore, an AIFM must regularly conduct stress tests, under both normal and exceptional liquidity conditions, to assess and monitor the liquidity risk of the AIFs. (18) These obligations are supplemented by detailed Level 2 rules on liquidity management. (19) Netting of subscriptions and redemptions. As is the case for UCITS, an AIFM can net subscription and redemption orders in an open-ended AIF.

Box 1b: The current regulatory framework for investment fund leverage Directive 2009/65/EC – UCITS Borrowings. UCITS may utilise financial leverage by borrowing up to a maximum of 10 % of their assets, provided that any such borrowing is only temporary. Such borrowing may be used if there is a temporary mismatch of cash flows, e.g. when redemption monies need to be paid out in advance of monies to be received into the UCITS following the sale of investments. Use of synthetic leverage. With regard to the use of synthetic leverage via derivative exposures, UCITS may create synthetic exposures – as calculated under the commitment approach – up to an amount equal to their total NAV. As a result, UCITS may use both borrowing and derivatives to leverage up to a maximum of 2,1 times their NAV. Under Directive 2009/65/EC, NCAs may also allow UCITS to calculate their global exposure by using a value-at-risk (VaR) approach or other advanced risk measurement methodologies instead of the commitment approach. For these funds, the use of leverage is only indirectly restricted via limitations on the fund's market risk, as explained in CESR Level 3 guidelines (20). So, funds that use the absolute VaR approach are limited to an absolute VaR which is not greater than 20 % of NAV (over a 20 day period). In turn, funds applying the relative VaR approach are limited to no more than double the risk of loss under a given VaR model of a similar, but unleveraged, portfolio. Importantly, these VaR approaches potentially allow for significantly higher leverage than would be allowed under the commitment approach, depending on the volatility of the underlying assets. Survey responses for 11 jurisdictions within the Union indicate that the subset of UCITS funds applying VaR approaches to calculate global exposure could represent between 27 % and 50 % of the Union's UCITS sector in NAV terms. Directive 2011/61/EU – AIFMD Borrowings and use of synthetic leverage. AIFs operate without any regulatory leverage limits. Under Directive 2011/61/EU, funds are only required to report their use of leverage. Notwithstanding this, Directive 2011/61/EU allows competent authorities to impose limits on the level of leverage that fund managers may employ in their AIFs, as well as other restrictions to risk management, in order to ‘limit the extent to which the use of leverage contributes to the build-up of systemic risk in the financial system or risks of disorderly markets’. So far, no authority has implemented this tool, and no EU-level framework supporting a harmonised implementation of macroprudential leverage requirements has been developed.

II. ESRB Recommendation on liquidity and leverage risks in investment funds

II.1 Recommendation A – Liquidity management tools for redemption

II.1.1 Economic rationale and intended effects

Recommendation A(1) – Availability of additional liquidity management tools

The regulatory framework governing investment fund liquidity management in the Union needs to be broadened. The provisions concerning liquidity management in the Directives 2009/65/EC and 2011/61/EU have been generally adequate in the past. However the continued growth of the investment fund sector, combined with an increase in its liquidity transformation activity, could lead to increased financial stability risks that need to be addressed.

Appropriate liquidity management tools could smooth liquidity mismatches occurring in UCITS and open-ended AIFs, thus reducing financial stability risks under stressed market situations. Liquidity mismatch is especially relevant for open-ended funds that offer frequent redemption opportunities but invest in assets which, in certain cases, cannot be sold off quickly without a material impact on their market price. Many open-ended funds offer daily redemptions, but not all. Under the provisions of the Directives 2009/65/EC and 2011/61/EU, fund managers are responsible for determining the redemption frequency (see Box 1a). There is a set of a-LMT which can help to mitigate liquidity risks for open-ended funds by reducing the first-mover advantage (21) in stressed market situations (ex ante) and the occurrence of a liquidity spiral (ex post).

Ex ante tools can be used to mitigate first mover advantage and systemic risk. In principle these tools can be used under either normal or stressed market conditions. The purpose of ex ante tools such as swing pricing and anti-dilution levies is to treat customers fairly, ensuring that the remaining investors are not disadvantaged by the actions of the redeeming investors. This should remove any incentive for investors to redeem before others in order to benefit from lower costs. Nevertheless, if investors are determined to liquidate their fund positions they will do so regardless of the associated cost. The tools therefore only mitigate first mover advantage, but not necessarily selling pressure in the underlying asset markets.

Ex post tools allow fund managers to manage investment fund liquidity by controlling or limiting outflows. These tools typically relieve managers from the obligation to immediately sell assets (at or below market prices) in response to redemption requests by investors. They can therefore act, to some extent, as a kind-of circuit breaker and can mitigate the occurrence of a liquidity spiral. Ex post tools are typically employed under stressed market conditions.

The availability and implementation of a-LMT for investment funds varies significantly across jurisdictions. While the suspension of redemption by the fund manager or by the NCA is explicitly allowed under Directives 2009/65/EC and 2011/61/EU, the latter do not stipulate any other a-LMT. Thus, there are differences in the availability of as well as the specific procedures governing the use of a-LMT across jurisdictions. A survey conducted by IOSCO (22) and also a recent survey of Union Member States conducted by ESMA (23) show that in some Member States a set of a-LMT tools is available, including swing pricing and an anti-dilution levy. However, in most Member States fewer tools are available.

The most commonly available tools in Union Member States are:

— redemption fees;

— redemption gates;

— redemptions in kind;

— side pockets;

— suspension of redemptions.

The only tool common to all participating jurisdictions is the suspension of redemptions. After that, the most commonly available tool is redemption-in-kind, which is available in 17 Member States.

In most Member States fund managers are solely responsible for the activation of liquidity management tools – regulators play only a minor role in the process and cannot activate the tools. Fund managers do not need regulatory authorisation to activate most a-LMT. Only three Union Member States require authorisation for some tools, and only one for the use of the power to suspend redemptions. However, liquidity tools, and the circumstances under which they can be used, must typically be listed in the constitutional documents of the investment fund, which are subject to authorisation in EU Member States. Regulators are not usually allowed to activate tools. The general exception to this is the suspension of redemptions, which may be imposed by the regulator if it is deemed to be in the public interest which, presumably, also includes financial stability factors. In a number of jurisdictions NCAs are granted the power to activate redemption gates.

The availability of the tools is, in some cases, restricted to certain types of investment funds and/or to exceptional circumstances. The option of using a-LMT varies under normal conditions. In some Member States certain tools can be used under normal circumstances, usually on the condition that their possible use has been previously stipulated in the fund documents. In other Member States the use of certain tools is restricted to extraordinary circumstances. In all Member States the use of the power to suspend redemptions is restricted to extraordinary circumstances only.

The guidance provided by regulators on the use of a-LMT is heterogeneous and differs for each individual tool. A maximum time limit is not always set governing the application of suspension of redemption, and three Member States do not provide any guidance on the use of suspension of redemption. With regard to the other a-LMT, formal definitions rarely exist, although Member States usually have a general understanding of the tools. In most cases, there are no specific regulatory provisions in the national legislation or guidance by the NCAs as to the use of the tools.

The FSB identified liquidity mismatch as a potential structural vulnerability for open-ended investment funds and suggested that liquidity risk management tools should be more widely available. The availability of a diverse set of ex ante and ex post liquidity management tools in all Member States would improve capacity to react to stressed liquidity situations and would, therefore, reduce risks to financial stability. NCAs and investment fund managers also indicated, in their responses to a consultation carried out by the Commission, that they would welcome the wider availability of liquidity management tools. (24)

Cross-border effects emphasise the need for a more harmonised regulatory framework. Since UCITS and AIFs often invest and operate on a cross-border basis, the potential impact of liquidity problems is not limited to the jurisdictions in which the respective UCITS and AIFs are domiciled. Contagion could therefore contribute to liquidity spirals with cross-border effects. A homogeneous set of liquidity management tools should, as a consequence, be available across the Union. This will provide investment funds with a common set of a-LMT which fund managers should assess and, as appropriate, include in the investment funds' constitutional documents to mitigate cross-border liquidity risks. All AIFs and UCITS should have the power to suspend redemption under stressed market conditions routinely included in their constitutional documents.

The recommendation aims to make it easier to activate liquidity management tools in addition to enhancing their availability. Fund managers might be reluctant to use certain liquidity management tools for a number of reasons, including reputational concerns or contagion. Activating a tool could lead to spill-over effects that impact on other investment funds managed by the same fund manager. In some cases, even investment funds managed by different fund managers but with a similar portfolio concentration might be affected. Thus, the insertion of a-LMT into an investment fund's constitutional documents may not be enough to effectively reduce the liquidity risks associated with the investment fund if the manager is reluctant to apply the a-LMT in practice. Fund managers should therefore ensure that the necessary operational capacity and contingency planning is in place for the timely activation of a-LMT. Each investment fund's prospectus or the pre-contractual information disclosed to investors should therefore describe all a-LMT included in the constitutional documents, their purpose and a description of how they are used. This will provide clarity and will familiarise investors with tools that are not commonly used.

The aim of the recommendations is to encourage a consistent approach to the use of liquidity management tools across Member States. To ensure the consistent application of a-LMT across Member States, the legislative proposal should oblige ESMA to develop high-level guidance on how a-LMT should be implemented in an investment fund's liquidity management process and the transparency and reporting requirements that should be established. In order to reach a better understanding of the effects of a-LMT on financial stability, the ESRB should collaborate with ESMA on macroprudential issues. Fund managers should report to the NCA regarding the implementation and use of a-LMT. To avoid burdensome reporting of any a-LMT in regular or constant use, reporting could comprise the use of tools under stressed market circumstances only.

Ex ante liquidity management tools could be used to mitigate the build-up and impact of systemic risk, while ex post liquidity management tools could be activated under stressed market conditions when investment funds face considerable outflows. Both types of instruments would therefore help to address financial stability risks arising from liquidity mismatches for investment funds. It is therefore recommended that both types of instruments be available at Union level. Box 2 further explains the different instruments while recognising that some of the tools will not always be suitable or necessary for all types of open-ended investment funds.

Box 2: Liquidity management tools Ex ante/hybrid (25) liquidity management tools (26) Swing pricing is aimed at protecting existing investment fund shareholders from adverse price effects caused by transactions executed by other investors. Swing pricing can be used to adjust the price of shares in an investment fund in order to make a contribution to the cost of fund transactions resulting from investor activity. (27) In practice, the NAV of the investment fund is adjusted downwards (upwards) in the case of large outflows (inflows) so that the transaction costs are borne by the investors buying or selling the shares rather than the existing investors. These price changes, if understood by investors, should incentivise investors to adjust their redemption and subscription behaviour in a way that helps to stabilise investment funds' net flows. Swing pricing can either be applied to all subscriptions and redemptions by investors (full swing pricing) or to just subscriptions and redemptions beyond a certain threshold (partial swing pricing). In the case of partial swing pricing a swing threshold is determined, and whenever net outflows exceed the threshold the NAV of the investment fund is adjusted downward, and vice versa. Thresholds may be variable, so the mechanism can be adjusted to match market/liquidity conditions, thus limiting investor optimisation behaviour (i.e. preventing investors from anticipating the use of swing pricing and taking appropriate action). Under conditions of full swing pricing the NAV is adjusted continuously, depending on whether there are net inflows or outflows. Swing pricing is a tool that can effectively influence investors' redemption and subscription behaviour, stabilising fund returns, and reducing the probability that first mover advantages and the associated fire sales will occur. Nevertheless, investors who are determined to exit a fund will do so, even if they incur a resulting cost from ‘swung’ prices. Since there may be multiple NAVs, employing the swing-pricing tool could be quite complex and cost intensive, and it may not be feasible for small investment funds to use it. Similarly, anti-dilution levies involve investors paying an extra charge to the investment fund when they subscribe to or redeem investment fund shares. Subscriptions to and redemptions of an investment fund can have an impact on the value of the investment fund. This is especially the case when shares in investment funds are not simply being transferred between matched buyers and sellers, but an imbalance between buyers and sellers requires the fund manager to purchase or sell underlying assets. This will involve transaction fees, related taxes and liquidity costs that impact the NAV of the investment fund, giving rise to dilution. An anti-dilution levy covers these dealing costs. Swing pricing and anti-dilution levies disincentivise procyclical behaviour, although only the former incentivises anticyclical behaviour. In contrast to swing pricing, anti-dilution levies do not incentivise investors to act in a countercyclical manner (i.e. subscribing in a redemption phase) since in this case investors do not benefit from the more favourable sales or redemption price created by swing pricing. Neither anti-dilution levies nor swing pricing generate extra costs for the investment fund – they only change the way costs are passed on to investors. Ex post liquidity management tools Redemption gates (deferred redemptions) temporarily delay redemptions. A redemption gate is a temporary deferral of the right of shareholders to redeem their shares. This deferral may be full, so that investors cannot redeem their shares at all, or partial, so that investors can only redeem a certain portion of their shares. Redemption gates can also be designed in such a manner that when redemption requests exceed a certain threshold (for example 10 % of NAV for an investment fund offering daily or weekly dealing), a fund management company can decide to carry forward any redemption requests over that threshold to the next dealing period. Under stressed market conditions, redemption gates give fund managers more time and flexibility to react to investor redemptions and to ensure the orderly sale of underlying assets. This can decrease the risk of fire sales. Redemption-in-kind frees the fund manager from the need to liquidate large amounts of assets in the event of large-scale redemptions. A fund manager may decide to meet a redemption request by transferring securities, instead of cash, to the redeeming unitholder. Since a large ad hoc sale of assets might generate significant market impact, redemption-in-kind may protect investors remaining in the investment fund against the high liquidation costs which might otherwise arise. This mechanism may be suitable for redemption orders from institutional investors. However it is generally less suitable for redemptions by retail investors because it might not be feasible to redeem single shares of the investment fund in kind and to do so might also entail high operational and reputational costs. Although investors can sell assets redeemed in-kind in the same way as fund managers, they would then be obliged to internalise the costs of such sales, rather than spreading them across all investors in the investment fund. The impact on the market (and therefore on financial stability) might, however, be the same, regardless of whether it was the investment fund itself or the investors selling the underlying assets. ‘Side pockets’ allow illiquid investments to be separated from remaining liquid investments of the investment fund. This approach has two advantages. First, investors needing liquidity can still cash in the liquid part of the investment fund's investments at, presumably, little liquidation cost. Second, the approach protects the interests of investors who wish to remain in the investment fund, since the fund manager is not forced to liquidate assets at or under market prices if faced with high redemption demand. Side pockets are therefore especially suitable whenever a fund has diverging investor interests, i.e. when some investors wish to remain invested in the fund while others want to redeem their shares. Practices vary across Member States as to the rules governing the circumstances under which side pockets can be created. Notice periods provide fund managers with additional flexibility to manage their liquidity. A notice period refers to the period of advance notice that investors must give to fund managers when redeeming their investments. Notice periods are often already stipulated in the constitutional documents of an investment fund and give fund managers more time to meet redemption requests without having to sell assets immediately at a discount. Suspension of redemption is an instrument of last resort during a liquidity crisis. Suspensions function as circuit breakers, giving the fund managers additional time, in situations of financial distress, to liquidate assets in an orderly manner. Instead of having to make hasty decisions and to liquidate at any price, the fund managers are granted extra time to find the optimum solution. Moreover, this additional time may allow the fund managers and supervisors to better communicate the reasons for the stress to investors, potentially avoiding panic. Suspensions are, therefore, widely regarded as an important tool for managing large-scale redemptions in a crisis. However, suspensions may impose high welfare costs on investors by preventing them from cashing in their investments. Furthermore, there are concerns that sophisticated investors might be able to predict a suspension of redemption and could seek to redeem their shares ahead of others (in contrast to the initial objective of the tool which is to mitigate first-mover advantages), possibly even triggering a run.

Recommendations A(2) and A(3) – Further provisions on NCAs and on ESMA's role in relation to NCAs' suspension of redemptions with cross-border financial stability implications

Suspension of redemptions is the only tool available across all Member States. In principle, the decision to suspend redemptions is, first and foremost, the responsibility of, and at the discretion of, the fund manager (see Box 2). Suspension of redemption can, however, also be ordered by the NCAs for both UCITS and AIFs, if it is in the interests of the unitholders or the public.

Fund managers might not suspend redemptions if they fail to internalise the effect of large scale redemptions on the stability of the financial system. A run on an individual investment fund alone may be enough to cause general panic among investors and large-scale withdrawals from other funds. As a consequence, investment funds may also face severe liquidity stress and may be forced to sell substantial amounts of assets. If the size of the affected investment funds is large relative to a market or sector, considerable declines in asset prices may result, leading to a downward spiral. Hence, the prevention of runs and consequent large-scale fire sales is of great importance to overall financial stability.

Fund managers might not suspend redemptions because they are concerned about reputational risk. One of the main obstacles to the use of a suspension of redemption is a potentially negative impact on the fund manager's reputation. Since the need for a suspension could easily be attributed to poor liquidity management on the part of the fund manager, there may be a lasting loss of confidence in the professionalism of the fund manager. Consequently, fund managers may refrain from using suspension of redemption even if it would be in the collective interests of all investors in the investment fund. In some other cases fund managers may also decide not to order the suspension of redemptions if they believe that this would not be in the best interests of the investors in their investment funds. In these cases, where the suspension of redemption is not used by fund managers but is nevertheless warranted from a macroprudential perspective, NCAs should use the power to require the suspension of redemption.

Passporting arrangements in the Union mean that roles and responsibilities should be assigned to NCAs for ordering suspensions. Passporting regimes allow AIFMs and UCITS management companies to market units or shares across borders to investors within the EEA. They also allow cross-border management activities by the managers of these investment funds. If an investment fund is established in one Member State but the AIFM or the UCITS management company is based in another, it might not be clear which NCA is responsible for managing the suspension of redemptions or when an authority should intervene with suspension powers. Lack of clearly assigned responsibilities might lead to insufficient or delayed reactions during stressed and rapidly changing market conditions. Shared responsibilities and/or responsibility lying with the less well informed authority could therefore have unintended negative consequences. To avoid this, the Commission is recommended to propose that the relevant Union legislation clarify the roles and responsibilities of the NCAs involved.

Other relevant authorities, including ESMA and the ESRB, should be notified before the responsible authority exercises its power to order the suspension of redemption if there are cross-border financial stability implications. Since passporting allows funds to be marketed on a cross-border basis within the EEA, ordering the suspension of redemption might directly affect the investors and markets of other relevant authorities. Ordering the suspension of the redemption of a certain investment fund might also, therefore, have consequences for the financial markets and investor trust in other jurisdictions. If the relevant authorities are not informed, such market reactions might come as a surprise and could inhibit appropriate regulatory action. So that potential risks to financial stability may be mitigated, the Commission is recommended to propose including the obligation to provide prior information to relevant authorities in the appropriate Union legislation. This obligation should, however, be formulated in such a way that it does not prevent NCAs from acting immediately in the event of a crisis.

ESMA should seek to provide advice and should facilitate and coordinate NCAs' use of their powers to suspend redemptions if there are cross-border financial stability implications. Taking national characteristics into consideration, ESMA should adopt a coordinating and advisory role to provide a level playing field for NCAs to use their powers to suspend redemptions, with the goal of mitigating risks to financial stability. This coordinating role should include taking a lead on the general practicalities that NCAs need to consider when using their powers to suspend redemptions. Furthermore, there is currently no homogeneous and precise definition of the public interest. ESMA should promote a shared understanding among NCAs of how the relevant provisions in Directives 2009/65/EC and 2011/61/EU relate to financial stability and systemic risk, without making regulators predictable and generating moral hazard. These provisions will not only facilitate a more harmonised approach to the suspension of redemptions but will also support the idea that the suspension of redemptions should become a functional tool to help mitigate risks to financial stability.

II.1.2 Unintended effects

There is a risk that well-informed institutional investors might anticipate the activation of a certain tool. This could reduce or counter the effectiveness of a tool, since investors would try to act before the tool had actually been activated. Under certain circumstances the anticipation of the activation of a tool could even lead to run scenarios, thus triggering the emergence of a liquidity spiral. For that reason, guidance should avoid any kind of automaticity and prescriptiveness.

Liquidity management tools may be of value when stressed market conditions are persistent. Depending on the market circumstances, ex post tools might only defer the liquidity problem given that they only defer redemptions for a limited amount of time (e.g. redemption gates). They do not eliminate the problem when stressed market conditions persist and cannot, therefore, replace structural measures such as those aimed at addressing excessive liquidity mismatches.

II.2 Recommendation B – Additional provisions to reduce the likelihood of excessive liquidity mismatches

II.2.1 Economic rationale and intended effects

Investment funds managing assets that are inherently less liquid do not necessarily create financial stability concerns. Providing access to a variety of asset classes increases market efficiency as it offers more investment opportunities and improves access to financing for the issuers of such assets. From an economic policy perspective, allowing investment funds to invest in less actively traded asset classes, such as private equity, unrated corporate bonds or loans, also contributes to the diversification of funding in the economy. This coincides with rising investor demand for more investment opportunities in the context of a prolonged low-yield environment.

Financial stability risks arise when there is a large mismatch between the liquidity of these assets and the liquidity offered to investors through fund redemption policies. Compared with investment funds that invest in liquid assets, where only a large number of redemptions would have an impact on market prices, the obligation (subject to the possibility that the fund could be suspended) to sell even a small amount of less liquid assets could rapidly lead to large amplifications of market falls. The availability of frequent redemption points is particularly problematic if this leads investors to overestimate the liquidity of the assets held by the investment funds they have invested in. This might result in forced sales by, for example, leveraged investors.

Ensuring that the redemption policy of an open-ended investment fund is structurally aligned with the liquidity profile of its assets should reduce risks associated with fire sales. Managers have several options when investing heavily in less liquid assets. For example, on the asset side, setting limits to the proportion of less liquid assets a manager can invest in would improve the capacity of the fund manager to redeem, even under stressed market conditions. By making sure that sufficient liquid assets are available, this would reduce first-mover advantage and the risk of a run. While addressing excessive liquidity mismatches at an individual fund level, it would also reduce the magnitude of collective selling and the risk of fire sales. Finally, it would reduce the likelihood and severity of a systemic event.

Improving an investment fund's capacity to honour redemptions under stressed market conditions also reduces the likelihood of a suspension of redemptions. Increasing the structural resilience of investment funds would avoid over-reliance on a-LMT since a part of the media commentary specifically refers to a potential unintended effect of the suspension tool itself (28).

On the liability side, managers could implement redemption policies and reduce the frequency of redemptions offered by an investment fund, and/or impose notice periods for investors wishing to redeem from an investment fund. In the event of abnormal levels of outflows, restricting redemptions would provide the fund manager with more time to liquidate assets to meet redemption requests. It would also provide more time for the market to find a solution to the underlying concerns, or for the concerns to dissipate naturally over time (e.g. in the case of UK property funds). In some cases, it could allow for some form of broad intervention from authorities, which could help to alleviate the immediate underlying stress. In the case of notice periods, knowing the due date in advance would allow investors a degree of planning in terms of their own liquidity positions which suspension of redemptions does not permit.

Real estate funds are one example of funds that may present high liquidity mismatches. Real estate funds typically invest in less liquid underlying assets and are prone to significant liquidity mismatches if they have an open-ended structure. Systemic risks could arise from a combination of liquidity mismatches and the use of leverage. Early redeemers may benefit from first-mover advantage, thus starting a run, since these investment funds hold few liquid assets on hand to meet redemptions. Because of leverage these redemption requests could force the manager to sell off a larger proportion of the portfolio, with a concomitant impact on asset prices. Eventually, these investment funds might amplify and spread risks through the rest of the financial system. (29) In the case of UK property funds, suspensions helped to avoid widespread, rapid sales of CRE in the wake of the UK referendum on membership of the European Union (see Box 3). However, as has been pointed out by the Bank of England, there is still an underlying vulnerability that could emerge from liquidity mismatches between the investment funds' assets and liabilities. Future shocks to the CRE market could trigger cycles of redemptions, suspensions and discounted sales.

Box 3: Real estate funds – the case of UK property funds The characteristics of Union real estate funds differ. Real estate funds typically invest in less liquid assets such as property, property rights and equity interests in property companies. In some jurisdictions, only closed-ended real estate funds are permitted, in which case investors may only redeem units at predetermined maturities and, normally, only on the investment fund's expiry date. In other jurisdictions, the investment fund rules and the offering documentation of open-ended structures give investors the right to request redemption of their fund units more frequently. This can lead to large-scale liquidity transformation, especially if these investment funds offer weekly or daily redemptions. An example of the concerns relating to real estate funds was seen in the United Kingdom following the 23 June 2016 EU referendum. Between July and December 2016, several of the United Kingdom's 19 authorised CISs (30) investing in direct property applied some form of special liquidity measure. The UK property market had been experiencing declining values and investment fund redemptions for around eight months prior to the referendum, and the vote to leave triggered an increase in redemption demands from investors. Some 15 investment funds offering daily dealing experienced cumulative redemptions of 4,1 % of NAV, reaching 8 % of NAV in one case. At the same time, ten investment funds made fair value pricing (FVP) adjustments ranging from 4 % to 15 %. The affected investment funds adopted different approaches to using liquidity management tools. In the first week of July six daily-dealing investment funds, representing about GBP 14,6 billion, suspended redemptions (three of them had also applied FVP adjustments). One investment fund resumed dealing with an anti-dilution adjustment in place to reflect the discount required to sell a number of properties rapidly. The other fund managers kept their investment funds suspended until they judged there was sufficient clarity regarding asset valuations. The UK Financial Conduct Authority (FCA) rules require a fund manager to review the justification for a suspension at least every 28 days, but do not set a maximum period for which the suspension may be kept in place. Levels of redemption demand began to revert to normal from mid-July onwards. Those investment funds that had suspended redemptions gradually began to resume dealing, the last of these doing so in mid-December. Investment funds offering monthly or quarterly liquidity either did not experience higher than usual levels of redemption requests, or were able to ensure that sufficient levels of cash and other liquid assets were available to meet demand. This episode had an impact on some unit-linked investment funds, but no contagion spread to other asset classes. The suspension of dealing affected some unit-linked investment funds that had invested in CIS to gain exposure to property as an asset class. Of these investment funds, 59, with total AuM of GBP 2 billion, had invested in the CIS that had suspended dealing. In some cases, this affected their ability to meet their non-contractual obligations, including surrenders or transfers, although there was no impact on the paying out of benefits either on maturity or on the death of insured persons. The Bank of England highlighted contagion risks in its Financial Stability Report of July 2016 (31). However, the nature of the market event reduced the risk that it might have a systemic impact. The shock was not a widespread credit event, but primarily a UK-specific event affecting property prices. In addition, the impact from redemptions of daily-dealing investment funds was well contained through the use of the tools already available to investment funds. Moreover, the value of the investment funds affected was small: in terms of AuM, authorised property CIS represented about 2,7 % of UK open-ended investment funds (GBP 949,7 billion). On aggregate, all open-ended investment funds hold approximately GBP 35 billion in commercial property, i.e. less than 10 % of the market (GBP 683 billion).

Another example is when bond funds invest in non-investment grade or unrated securities, which can present significant liquidity mismatches. In December 2015 a large US high-yield bond fund announced that it was liquidating its portfolio and suspending redemptions. The fund manager considered that investor requests for redemption, in the context of a general reduction of liquidity in the fixed income markets, meant it was not practicable to raise sufficient cash to pay redemption requests without selling assets at a discounted price, thereby disadvantaging the remaining shareholders. This was a consequence of the intrinsic low liquidity of the holdings of the investment fund, such as corporate bonds rated CCC and below or that were unrated (also known as distressed securities), coupled with a low level of cash and other liquid assets.

There are no large liquidity mismatches in most investment funds in the Union. For instance, equity funds are viewed as engaging in limited liquidity transformation (32) since most listed shares are deemed liquid even under stressed conditions. Similarly, evidence for bond funds seems to point to a trade-off between liquidity and maturity transformation. (33) Investment funds focusing on less liquid corporate debt generally invest in securities with a shorter than average maturity, while investment funds investing in more liquid sovereign bonds tend to invest in longer-term assets. An investment fund investing in long-term liquid assets is generally able to sell these at any time, while a fund investing in short-term less liquid assets should be able to roll over its portfolio frequently, thus limiting its liquidity transformation. (34)

By contrast, the largest maturity mismatches occur for open-ended AIFs investing in inherently less liquid assets. Real estate funds, in particular, account for 5 % of investment funds in Europe (EUR 658 billion), of which the majority are open-ended and exposed to liquidity mismatches as reflected in the ESRB Shadow Banking Monitor (Tables 1 and 2). The real estate fund sector has also become more important in recent years, as AuM have increased by 34 % over two years (to the fourth quarter of 2016) compared with 19 % for the rest of the fund industry. The ESRB Shadow Banking Monitor also shows that hedge funds (EUR 436 billion) engage in liquidity transformation, depending on their strategy. In comparison, loan funds are still a nascent industry (EUR 26 billion).

Table 1

Liquidity transformation by investment funds

Fund type Bond Funds Hedge Funds Real Estate Funds Exchange Traded Funds Private Equity Funds Colour coding: = pronounced engagement; = medium engagement; = low engagement; = unlikely or insignificant engagement





Table 2

Euro area investment funds' assets (EUR trillions)

Dec-14 Jun-15 Dec-15 Jun-16 Dec-16 Mar-17 Apr-17 Bond funds 3,06 3,31 3,19 3,32 3,36 3,51 3,54 Equity funds 2,55 2,89 2,82 2,70 2,95 3,15 3,17 Hedge funds 0,42 0,48 0,47 0,49 0,42 0,43 0,44 Mixed funds 2,24 2,57 2,64 2,71 2,81 2,93 2,97 Real estate funds 0,48 0,50 0,57 0,61 0,64 0,66 0,66 Total 9,30 10,37 10,38 10,62 11,12 11,64 11,77

A pattern observed over the last few years has been for some Union bond funds including UCITS to shift their asset allocation from higher to lower-rated debt securities, resulting in exposure to longer maturities and higher credit risk. In particular, high-yield investment funds represent 19 % of bond fund assets, and, depending on structural and cyclical factors of market liquidity, as mentioned before, it cannot be excluded that investment funds could eventually become exposed to liquidity mismatches, at least temporarily. However, in the absence of harmonised data at Union level, it is difficult to measure the materiality of this issue and the potential contribution of UCITS to financial stability risks (see Box 4).

Box 4: Potential exposure of UCITS to liquidity mismatches Directive 2007/16/EC requires UCITS to invest predominantly in liquid assets. However, the liquidity of some eligible assets could decline under stressed market conditions, temporarily exposing them to liquidity mismatches. This is especially the case for high-yield bond funds. Reacting to this, IOSCO has recently launched a consultation on whether funds, including UCITS, should have additional mechanisms for managing liquidity. (35) Union bond funds: average rating of fund holdings (percentage of total assets; last observation: Q4 2016) Sources: Thomson Reuters Lipper, ESMA and Standard & Poor's. A common pattern observed since 2009 has been for some Union bond funds to shift their asset allocation from higher to lower-rated debt securities, while, at the same time, increasing the duration of their portfolios. Although this shift in investment patterns has slowed over the past few years, it still means that these funds are now more exposed to changes in bond yields. Less liquid portfolios and lower cash holdings could make it more difficult for bond funds to rebalance portfolios following large redemption requests, i.e. without causing spillovers to the bond markets. Despite evidence of increased risk-taking against a backdrop of reduced liquidity in the bond markets (36), a lack of granular information on UCITS assets (e.g. liquidity) and liabilities means that the risk to financial stability cannot be comprehensively assessed. Reporting obligations for UCITS management companies, as foreseen by Recommendation D, are required to assess the materiality of this risk. This implies collecting and exchanging granular and harmonised data. If there is, however, analytical evidence showing that parts of the UCITS fund sector are exposed to significant liquidity mismatches, it might be necessary to review the scope of Recommendation B to include some specific UCITS products.

The FSB advises (37) that investment funds' assets and investment strategies should be consistent with the terms and conditions governing investment fund unit redemptions both at investment fund inception and on an ongoing basis (for new and existing investment funds). This should take into account the expected liquidity of the assets and investor behaviour under both normal and stressed market conditions.

Additional provisions in that area would be consistent with the existing framework under Directive 2011/61/EU, which already requires the alignment of the investment strategy, liquidity profile and redemption policy of the investment fund, and sets appropriate liquidity management limits and stress tests. In particular, under the current regulatory regime AIFMs should be able to demonstrate to their NCAs that appropriate liquidity management systems and effective procedures are in place. However, based on recent evidence the ESRB has observed that some AIFs are still performing a high level of liquidity transformation. (38) Therefore, making this demonstration mandatory for investment funds investing in less liquid assets would contribute to achieving the goals of Directive 2011/61/EU by ensuring a more consistent implementation of the Directive. It would promote the use of specific measures for investment funds investing in less liquid assets, such as, for example, the use of internal limits on less liquid assets.

Substantial liquidity transformation should be avoided. Some Member States have incorporated bespoke regimes into their national legal frameworks to establish the conditions under which AIFs may manage assets deemed to be less liquid, such as real estate or loans. In its opinion to the European Parliament, the Council and the Commission (39), ESMA argued that loan-originating AIFs should be set up as closed-ended vehicles without the right to redeem units on a regular basis. Other jurisdictions have adopted structural measures to remove the risks of fire sales posed by massive redemption requests. For instance, if a non-negligible part of the portfolio is illiquid, the closed-ended form is required owing to the intrinsic nature of the assets held by the CIS. The option to request repayment during the life of the AIF should only be offered by the fund manager to investors if certain conditions have been fulfilled. This should take place at fixed intervals, e.g. as stipulated by Regulation (EU) 2015/760 of the European Parliament and of the Council (40).

This recommendation advises ESMA to define a list of inherently less liquid assets. There is currently no definition of liquid or less liquid assets in the regulations (see Box 5), although the objective is not to propose such a definition but instead to promote a consistent approach to the implementation of the aforementioned provisions of Directive 2011/61/EU. The term ‘less liquid’ also acknowledges the fact that assets are rarely, or never totally, illiquid.

In view of the need for cross-sectoral consistency, ESMA should consult with the EBA and EIOPA when preparing the list. The labelling by any regulator of an asset as liquid or less liquid sends a signal to market participants. Moreover, regardless of who is selling the asset (regulated, unregulated, bank or non-bank), the pool of buyers is generally the same under stressed market conditions. Consistency of regulatory approaches is therefore desirable. (41)

The list of inherently less liquid assets should include assets that cannot be easily and rapidly converted into cash with little loss of value during market stress. The analysis of asset liquidity should consider, inter alia, the time required to liquidate those assets under stressed market conditions without having to accept a large discount. In compiling this list, ESMA should, in particular, consider real estate, unlisted securities (including private shares), loans and other alternative assets. Assets that, under normal market conditions, can be sold without having to accept a large discount should not be on the list, since this recommendation aims to address structural issues posed by inherently less liquid assets.

Where an investment fund offers exposure to less liquid assets, the fund manager may have access to provisions it can introduce to address liquidity risk. (42) Managers would then need to demonstrate to the relevant NCAs, both at the inception of the investment fund and on an ongoing basis (i.e. during the approval process and after approval for investment funds subject to an approval procedure), that they can follow their investment strategy under any foreseeable market conditions. Having taken into account any regulation applying to the investment fund and following their investment policy, fund managers have different ways to ensure consistency between their investment strategy and the investment fund's redemption profile, both during the design phase and on an ongoing basis. (43) These include:

— the type of vehicle (e.g. closed-ended investment fund, ELTIF);

— redemption policies;

— investment policy including internal limits for assets included in the list, liquid asset buffer, diversification (exposures or counterparty) and limits on the size of the investment fund relative to the underlying market;

— implementation of a-LMT;

— liquidity risk management processes including, for example, defining relevant thresholds, classifying assets into liquidity buckets, monitoring the concentration of investors and expected redemption patterns.

The use of internal limits in particular should be disclosed to the NCAs at the inception of the relevant investment funds, notified thereafter whenever these limits change and also available upon supervisors' request. Disclosure to investors should also be implemented based on guidance that should be developed by ESMA.

In some cases, it could be unduly burdensome for small funds' managers in particular to show they can stick to the investment funds' investment strategies. Therefore, some discretion should be left to NCAs in designing a mechanism that allows AIFMs to show they can stick to the investment funds' investment strategies. The NCA assessment could, for example, take stress test results into account.

There is no single definition of market ‘liquidity’ across Union legislation on the basis of which a list of less liquid assets could be compiled. Each piece of legislation approaches the issue of liquidity in a different way, according to its purpose (see Box 5). An example of approaches followed at national level is given by the FCA consultation paper on illiquid assets and open-ended investment funds (44), which identifies a number of characteristics shared by illiquid assets:

— they are not traded on an organised market;

— there may be a significant imbalance between supply and demand;

— it is likely to take time for the buyer and seller to negotiate the price and the other terms of the transaction;

— valuing the asset is a complex process;

— physical assets are typically bought and sold in their entirety;

— owing to these factors, and other possible complications such as restrictions on the free transfer of title, transactions often take a long time to conclude.

Box 5: Liquidity in Union legislation Directive 2007/16/EC regarding eligible assets requires UCITS to invest predominantly in liquid assets, and sets out specific rules covering the eligibility of transferable securities, money market instruments and derivatives. In general, transferable securities and money market instruments may be considered liquid if they are admitted to or traded on a regulated market. Less liquid assets are not explicitly defined but are seen as ineligible investments under Directive 2009/65/EC. This is particularly the case for physical commodities and real estate assets. The concept of liquidity is mentioned in several other Union legal acts, as listed below. — Regulation (EU) No 909/2014 of the European Parliament and of the Council (45) stipulates that a CSD must invest in cash or highly liquid financial instruments with minimal market and credit risk. However, Regulation (EU) No 909/2014 does not explicitly define liquidity, recommending instead that ESMA, the EBA and the ESCB should develop draft RTS detailing the financial instruments that may be viewed as highly liquid. — Regulation (EU) 2017/1131 of the European Parliament and of the Council (46) on money market funds includes liquidity thresholds for assets which may be viewed as providing daily and weekly liquidity, although liquidity is not explicitly defined. Regulation (EU) 2017/1131 is based on the reasoning that an early maturity date for assets helps to ensure that investors get their money back. — Directive 2014/65/EU of the European Parliament and of the Council (47) includes discussions of the methodology used to calculate liquidity in non-equities such as bonds. ESMA considers two alternative methods for calculating liquidity, i.e. the instrument-by-instrument approach (IBIA) and the categories of financial instruments approach (COFIA). ESMA eventually adopted the IBIA in its RTS for the calculation of bond liquidity. — Regulation (EU) No 575/2013 of the European Parliament and of the Council (48) defines liquid assets for the purposes of credit institutions' liquidity buffers as the only freely transferable assets that can be converted quickly into cash in private markets without significant loss of value. The Regulation differentiates between assets of extremely high liquidity and credit quality (Level 1 assets), and assets of high liquidity and credit quality (Level 2 assets). Level 1 assets include cash, deposits at the central bank, Union government or government guaranteed bonds and covered bonds that meet certain conditions. Level 2 assets include third-country government bonds and bonds issued by public entities, and both covered and corporate bonds on the basis of their credit quality. They also include high quality securitisations