As presented in a recent post, the European Securities and Markets Authority (ESMA) has published a Consultation Paper on the Money Market Funds Regulation (MMFR) and represents a first stage in the development of technical advice of the MMF framework. In the previous post we covered the key regulatory requirements in regard to liquidity and credit quality, and in this post we continues by reviewing requirements for credit quality assessments, reporting standards and stress testing compliance.
Credit quality assessment
To ensure that the credit quality assessment methodologies are prudent, systematic and continuous ESMA points out that they shall be subject to validation by the manager of an MMF. The quantitative part of the assessment incorporates bond pricing information, credit default-swap pricing information, default statistics of instrument issuers, financial indices and financial information about the issuer. The qualitative part of the assessment incorporates analysis of any underlying assets, relevant markets, structural aspects of relevant instruments, credit ratings and ratings outlook of the issuer and securities related research.
Technical standards of reporting
The reporting template that MMFs are required to send to their competent authority shall include e.g. the characteristics, portfolio indicators, assets and liabilities of the MMF as well as results of stress tests.
According to ESMA, one of the first key principles of the required reporting template would be to rely on work already done on the establishment of the reporting template within the AIFMD (Alternative Investment Fund Managers Directive) framework, since AIFMD has several similarities with the MMFR. The main goal is to avoid requesting/expressing/providing the same information in different and/or repeating ways in the context of AIFMD and MFF reporting. Hence, the AIFMD framework can be a good inspiration for the establishment of the reporting standards of the MMF framework.
ESMA is of the view that a combination of different stress tests definitions is appropriate, i.e. MMF managers should combine various risk factors in their stress testing. Stress tests can be performed via historical scenarios or via hypothetical scenarios. Because future crises do not need to be similar to past crises and the fact that there often is a lack of data, it would not be appropriate to completely focus on historical scenarios. One option is to use hypothetical scenarios, i.e. predicting a future crisis by setting its parameters. This often requires a compilation of all risk factors, correlation matrices and probabilistic scenarios based on implied volatility.
ESMA points out several possible parameters to consider in the stress tests, e.g.;
- the gap between the bid and ask spread, trading volumes or the number of counterparties in the market
- changes in liquidity levels of the assets held by the MMF
- changes in interest and/or exchange rates
- levels of redemption
- the downgrade or default of particular portfolio security positions.