What is expected from Liquidity Stress Testing models?
The ESMA Liquidity Stress Testing Guidelines require the building of Fund specific liquidity stress testing models. The Guidelines are clear in stating that Managers should not take a one size fits all approach in modelling liquidity stress testing but should rather analyse, identify and select appropriate scenarios for the Fund by considering its assets and liabilities profile.
The model should be able to stress both the assets and liabilities side of the Fund’s balance sheet on the basis of historical as well as hypothetical events and shall consider any liquidity management tools and/or internal liquidity risk limits applicable to the respective Fund. The Guidelines further require for the LST model to consider the liquidity profile of the Fund in normal conditions with the aim of identifying the severity of any liquidity concerns.
Stress Testing of the Fund’s Assets and Liabilities
The model shall be able to replicate how a historical event and a how a hypothetical event would impact its assets and liabilities.
Stress testing the asset side of a Fund’s balance sheet should involve modelling the impact of liquidity hits on a Fund’s portfolio or income stream. For funds of funds, the model shall consider the liquidity profile of each target fund in the portfolio when stress testing. The Manager is required to assess in detail the liquidity profile of target funds and reflect such information in the LST model utilised.
Stress testing the liabilities side of a Fund’s balance sheet requires stressing of the Fund’s liability obligations i.e. stressing amongst other things its redemption requests, its margin requirements and its capital commitments, with the aim of identifying whether such liabilities could be met in normal and stressed market conditions.
Stress Testing Aggregation
The model utilised shall be able to aggregate the asset and liability liquidity stress tests to assist the Manager in understanding the Fund’s overall liquidity risk. Where deemed appropriate, the stress testing model should also aggregate liquidity stress tests across more than one Fund under management. This shall be done where more than one Fund managed have similar strategies and exposures to ensure more accurate liquidation costs estimation and time to liquidate when stress testing.