ESMA consultation on guidelines on Article 25 of AIFMD : Assessment of leverage-related systemic risk and leverage limits

Background

In response to a recommendation from the European Systemic Risk Board [1], ESMA has issued a consultation on proposed guidance aimed to improve assessment of leverage-related systemic risk and operationalization of risk limits by national competent authorities (“NCA”). The objective is to identify as early as possible and mitigate potential spill-over effects, such as the amplification of price movements, the contagion to the banking sector and the interruption in direct credit intermediation, resulting from the funds deleveraging during a financial crisis. Contributions can be submitted to ESMA until 1 September 2020.

Primary Change

While leverage data is already reported by AIFMs, the proposed guidelines promote a consistent approach to be taken by NCAs when assessing whether the conditions for imposing leverage limits are met. The guidelines under consultation include a common minimum set of indicators, of which calculation instructions are based on the currently reported data as well as qualitative and quantitative descriptions of the interpretation of the indicators. The guidelines also draw a macroprudential framework with a description of the leverage limits and the principles to be considered when calibrating and imposing leverage limits.

Key Points

• Assessment of leverage-related  systemic risk

The risk assessment should be performed by NCAs on a quarterly basis and follows the two-step approach described below;

• Leverage limits imposed by NCAs

When deciding to impose leverage limits, NCAs should consider

       I.          risks posed by funds according to their type and risk profile as defined by the risk assessment

      II.          risks posed by common exposure. Where a group of funds of the same type and similar risk profiles may collectively pose leverage-related systemic risks, NCAs should apply similar limits to all funds in that group

NCA should carefully implement leverage limits, both in terms of timing and phasing in and out. Limits should be:

       I.          maintained as long as the risks do not decrease

      II.          released when the change in market conditions or fund behaviour stop being procyclical, when measures have been implemented to limit the build-up of risks

    III.          implemented progressively in a way which avoids procyclicality

   IV.          cyclical limits, where appropriate, in order to dampen the build-up and materialisation of risks in the upswing and downswing of the financial cycle

When setting the level of leverage limits, NCAs should assess their effectiveness in addressing the relevant systemic risks

         I.          when risks are directly related to size, leverage limits should reduce the risks accordingly

       II.          when risks are partially related to size and leverage limits are not sufficient, NCAs should consider imposing other restrictions on investment policy, redemption policy or risk policy

      III.          when leverage limits may temporarily result in an increase of risks, NCAs should impose restrictions on the proportion of certain assets to avoid sales of lower risk assets to meet the new requirement. In order to address liquidity mismatches, NCAs should impose a reduction of the frequency of redemptions or impose notice periods

NCAs should evaluate the efficiency of leverage limits by taking into consideration the

         I.          proportionality of the limits to ensure that the sector remains able to provide valuable services to the economy

       II.          robustness to gaming and arbitrage

Practical considerations

The ESMA guidelines under consultation aim at providing NCAs enhanced supervisory tools 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, and impose macroprudential leverage limits on AIFs where and when needed to prevent leverage from contributing to procyclicality, especially in times of economic cycle-downturn or increase in market volatility.

On the one hand, cyclical limits could dampen the implementation of certain investment strategies and packages of measures could reduce the flexibility left to managers to adjust their fund strategies in case of supervisory intervention. On the other hand, the lack of visibility on the negative spill-overs which could result from leverage used by other AIFs may limit the ability of managers to anticipate systemic risks caused by collective behavior eventually detrimental to all financial market participants.

Fund managers employing leverage should carefully consider the criteria, indicators and methodologies to be used by NCAs for the purpose of imposing leverage limits. Notably they should integrate contingency plans in their investment policy, redemption policy and risk policy in order to retain control of the way they conduct their activities to the largest extent possible, should a leverage limit be imposed.

Read ESMA Consultation