As published on investmentweek.co.uk, Monday 30 March, 2020.
In a consultation paper published on Friday in response to the European Systemic Risk Board's April 2018 recommendations to address liquidity and leverage risk in investment funds, ESMA looked to set out "essential" proposals to put in place a harmonised approach to regulating and monitoring Alternative Investment Fund (AIF) leverage across the EU.
AIFs can employ both financial leverage and derivatives-linked synthetic leverage, which cannot be observed from balance sheets, as derivatives are accounted for at market value.
ESMA said that given the "rapid expansion of the investment fund sector and the higher risk-taking, in a context of low interest rates", it is of "utmost importance to implement a framework for [national regulators] to monitor the level of leverage and deleveraging process of highly leveraged AIFs".
It also warned that the deleveraging process of these funds may "further amplify systemic risks during a financial crisis, especially if the fund has short redemption periods".
The most notable aspect of the proposals is a requirement that regulators "should impose leverage limits" on funds or groups of funds that they consider "pose risks to financial stability".
Commenting on the proposals, CEO of independent fund depository and oversight business INDOS Financial Bill Prew explained that under the AIFMD regulation, AIFs are able to set leverage limits, but "regulators have not imposed limits since AIFMD was first introduced in 2014".
"Managers have been free to set the maximum level of leverage which they believe are ‘reasonable'," he added.
Prew warned that the proposals would not only focus on AIFs with "substantial leverage", but funds with greater than €500m of "regulatory AUM", as well as potentially other funds which fall below these thresholds.
He added: "The proposals do not address the findings of the ongoing IOSCO review of leverage nor any changes which may be implemented to the leverage measures as a result of the 'AIFMD 2' review.
"These should be addressed as soon as possible in order for regulators to compare apples with apples across funds and regulatory jurisdiction.
"The current AIFMD leverage measures are still, in several areas, subject to different interpretation across the industry leading to inconsistent reporting to national regulators."
Meanwhile, chair of ESMA Steven Maijoor said: "In situations when financial markets are under severe stress, highly leveraged alternative investment funds can further amplify systemic risk.
"Considering the size of the investment fund sector, achieving supervisory convergence in [national regulators'] approaches to monitoring and regulating the use of leverage by alternative investment funds is of the utmost importance
"Our proposed guidelines address the assessment of leverage-related systemic risk and aim at ensuring that [national regulators] adopt a consistent approach when assessing whether the condition for imposing leverage-related measures are met."
ESMA will close feedback to its proposals from 1 September 2020 with a view to finalising the guidelines for publication.