Publication of the CSSF working paper “Liquidity Stress Test for Luxembourg Investment Funds: the Time to Liquidation Approach”

The CSSF presents in this working paper a liquidity stress testing framework applicable to Luxembourg investment funds.

The key characteristics of this liquidity stress testing framework are the following:

1. the estimation of a time to liquidation at the security level, whereby a dynamic dimension is integrated in the assessment of the fund portfolio liquidity;
2. a dual impact shock, by which shocks hit both the liability side with two types of shocks (redemption shocks derived from a macroeconomic model and from the distribution of historical redemptions) and the asset side (application of different levels of haircut to the liquidity of assets); and
3. a macroprudential perspective with the assessment of 1) the contagion risk via the estimation of the price impact of first-round sales and 2) an amplification risk via the estimation of potential second-round redemptions.

Scope of the LST exercise

The liquidity stress testing framework is applied to a sample of Luxembourg domiciled investment funds with different investment strategies (covering, among others, equity funds, global bond funds, high yield bond funds and emerging market bond funds). Overall, funds in the sample cover total net assets of EUR 1.1 trillion.

Output of the LST framework

The output of the liquidity stress testing framework can be considered from different perspectives:

• the time required for funds to meet/honor the redemption shocks;
• the proportion of funds, in terms of fund investment strategy and size, that can meet the shocks for a given time horizon; and
• the average time required to liquidate the assets per fund investment strategy and size.

The main findings of the application of the liquidity stress testing framework to the sample of Luxembourg funds are indicated in the following points.

• Based on the macroeconomic model (with shocks higher than the redemption levels observed at fund level during the March 2020 episode), 83% of the funds can meet the redemption shocks in 2 days and 96% in 5 days.
• The analysis of the results across fund strategies shows that high yield bond funds would have longer time to liquidation as only 87% of these funds can meet the macro redemption shock within 5 days. Some mixed funds would also need more than 5 days, as a result of their larger size. The results also show that, across all sectors, small and middle size well diversified funds are generally able to liquidate their portfolios more rapidly.
• The price impact estimated with the macro-based redemption shocks (contagion channel) is low at individual fund level, but the market-wide price impact would amount to a loss of EUR 12 billion (compared to a market size of around EUR 5 trillion).
• Similarly to the price impact, the potential amplification effect is limited with low level of second-round redemption rates at individual fund level.

The authors consider that this framework is a helpful risk management tool at individual investment fund level, but also an important supervisory tool for regulators, especially also for those funds with less liquid assets in their portfolio, such as emerging market and high yield bond funds. This paper also aims at contributing to the ongoing discussions on liquidity risk for open-ended funds taking place at international level (such as FSB, IOSCO and other international securities regulators).