Key Takeaways
- • On 27 March 2020, ESMA launched a public consultation on draft guidelines assessing leverage risk in the EU alternative investment fund (AIF) sector, with comments due by 1 September 2020.
- • The draft guidelines address leverage limits under Article 25 of the AIFMD and would let national competent authorities (NCAs) impose limits on AIFs posing risks to financial stability, a practice NCAs have traditionally not used.
- • NCAs would perform quarterly two-step assessments, with AIFMs managing over EUR 500 million in AUM and using any leverage, not only substantial leverage, likely to be identified in Step 1.
- • The guidelines respond to ESRB recommendations from April 2018 and aim to promote supervisory convergence across member states, while remaining without prejudice to future IOSCO work and the AIFMD review.
Summary
The European Securities and Markets Authority (ESMA) launched a public consultation on 27 March 2020 on draft guidelines for assessing leverage risk in the alternative investment fund (AIF) sector, according to a client advisory from Akin Gump. The draft focuses on the principles for setting leverage limits under Article 25 of the Alternative Investment Fund Managers Directive (Directive 2011/61/EU). The consultation remains open until 1 September 2020, after which ESMA intends to finalise the guidelines. The work responds to recommendations from the European Systematic Risk Board (ESRB) issued in April 2018 on liquidity and leverage risks in investment funds, and aims to promote supervisory convergence in how national competent authorities (NCAs) assess leverage-related systemic risk and design and implement leverage limits.
The background to the proposal is that AIFMs are required under Article 24 to report leverage information for AIFs they manage or market, and Article 25 requires NCAs to use this data to identify whether leverage contributes to systemic risk, disorderly markets, or risks to long-term growth. Akin Gump notes that NCAs have traditionally not imposed leverage limits, though the draft suggests this may change. ESMA cited the rapid expansion of the investment fund sector and higher risk-taking in a low interest rate environment, and warned that deleveraging can amplify systemic risk in crises, particularly where funds have short redemption periods. ESMA stated that risks from unleveraged funds cannot be mitigated through leverage limits and are therefore outside the guidelines' scope.
The draft guidelines propose common minimum indicators, calculation instructions based on Article 24 reporting data, and interpretive descriptions. The assessment is a two-step process performed quarterly. Step 1 identifies AIFs using leverage on a substantial basis, non-substantial-leverage AIFs with at least EUR 500 million in AUM, and other AIFs with unusually high leverage relative to their own history and to peers of the same type, such as hedge, private equity and real estate funds. Step 2 evaluates systemic risks including market impact, fire sales, spillovers to financial institutions and disruption of credit intermediation, using the Table 2 indicators. NCAs must report results to ESMA at least annually and whenever a risk is identified.
On limits, the guidelines say NCAs should consider fund type and risk profile, as well as common exposures across groups of similar funds. Limits should be phased in progressively to avoid procyclicality, maintained while risks persist, and released when fund behaviour is no longer procyclical. Where limits could push risk up temporarily or be circumvented, NCAs should consider other management restrictions, and the guidelines also weigh proportionality and robustness against gaming and arbitrage, including for AIFs managed by non-EU AIFMs.
Akin Gump says the guidelines bring welcome clarity to leverage calculation under AIFMD and a more consistent NCA approach. Its view is that AIFMs with over EUR 500 million in regulatory AUM using any leverage will likely be flagged in Step 1 and may face leverage limits and enhanced supervision. ESMA noted the guidelines are without prejudice to IOSCO's leverage work, the AIFMD review and future recalibration of indicators. Comments must be submitted online at www.esma.europa.eu using the dedicated response form by 1 September 2020.
The background to the proposal is that AIFMs are required under Article 24 to report leverage information for AIFs they manage or market, and Article 25 requires NCAs to use this data to identify whether leverage contributes to systemic risk, disorderly markets, or risks to long-term growth. Akin Gump notes that NCAs have traditionally not imposed leverage limits, though the draft suggests this may change. ESMA cited the rapid expansion of the investment fund sector and higher risk-taking in a low interest rate environment, and warned that deleveraging can amplify systemic risk in crises, particularly where funds have short redemption periods. ESMA stated that risks from unleveraged funds cannot be mitigated through leverage limits and are therefore outside the guidelines' scope.
The draft guidelines propose common minimum indicators, calculation instructions based on Article 24 reporting data, and interpretive descriptions. The assessment is a two-step process performed quarterly. Step 1 identifies AIFs using leverage on a substantial basis, non-substantial-leverage AIFs with at least EUR 500 million in AUM, and other AIFs with unusually high leverage relative to their own history and to peers of the same type, such as hedge, private equity and real estate funds. Step 2 evaluates systemic risks including market impact, fire sales, spillovers to financial institutions and disruption of credit intermediation, using the Table 2 indicators. NCAs must report results to ESMA at least annually and whenever a risk is identified.
On limits, the guidelines say NCAs should consider fund type and risk profile, as well as common exposures across groups of similar funds. Limits should be phased in progressively to avoid procyclicality, maintained while risks persist, and released when fund behaviour is no longer procyclical. Where limits could push risk up temporarily or be circumvented, NCAs should consider other management restrictions, and the guidelines also weigh proportionality and robustness against gaming and arbitrage, including for AIFs managed by non-EU AIFMs.
Akin Gump says the guidelines bring welcome clarity to leverage calculation under AIFMD and a more consistent NCA approach. Its view is that AIFMs with over EUR 500 million in regulatory AUM using any leverage will likely be flagged in Step 1 and may face leverage limits and enhanced supervision. ESMA noted the guidelines are without prejudice to IOSCO's leverage work, the AIFMD review and future recalibration of indicators. Comments must be submitted online at www.esma.europa.eu using the dedicated response form by 1 September 2020.
Go deeper than the headline
Research every firm in this story, track the ones that matter and get the daily briefing — free for 7 days.