ESMA publishes guidelines on stress test scenarios for money market funds

Rick Steves

The 2023 update of parameters notably mirrors the current systemic risks identified for the financial system, set against a backdrop of prolonged low growth, high inflation, and rising interest rates.

The European Securities and Markets Authority (ESMA), the EU’s key regulator and supervisor for financial markets, has issued its Final Report on the Guidelines concerning stress test scenarios under the Money Market Funds Regulation (MMFR).

The Guidelines on stress test scenarios under the MMF Regulation report offers a crucial update in the approach and methodology applied to stress testing in the financial sector, particularly within the context of money market funds (MMFs).

The Final Report is a synthesis of an updated methodology for implementing scenarios that simulate hypothetical changes in the liquidity levels of assets held in MMF portfolios, combined with the annual recalibration of risk parameters. This update reflects ESMA’s commitment to maintaining robust and relevant stress testing practices, considering the evolving market conditions and systemic risks.

New parameters that mirror the liquidity stress impacting the money market

Key revisions in the methodology, prompted by stakeholder feedback, include the introduction of parameters that mirror the liquidity stress impacting the money market. A notable addition is a new risk factor designed to simulate the extra impact of asset sales under stressed market conditions. This is represented as a price impact, quantifying the additional cost incurred when selling large volumes of securities in a market with limited buyers.

The 2023 update of parameters notably mirrors the current systemic risks identified for the financial system, set against a backdrop of prolonged low growth, high inflation, and rising interest rates. The stress test scenarios’ parameters, particularly those related to hypothetical interest rate movements, have seen a significant increase in severity compared to the 2022 Guidelines. Meanwhile, other scenarios are updated with a severity level similar to the previous year’s exercise.

In recalibrating these new risk parameters, ESMA has collaborated closely with the European Systemic Risk Board and the European Central Bank, ensuring a cohesive and informed approach to risk assessment in the financial sector.

As for the next steps, these updated Guidelines, along with the revised methodology and the new parameters for 2023, will be mandatory for the first reporting period following the start of the application of the updated Guidelines. This update is part of ESMA’s ongoing commitment to revising and refining the stress testing processes, ensuring they remain aligned with the latest market developments and systemic risk assessments.

Furthermore, the Guidelines pertaining to the common reference parameters of the stress test scenarios will continue to undergo annual updates, taking into account the latest market trends and developments.

Guidelines applicable two months after the translations’ publication

This initiative is grounded in Article 28 of the MMF Regulation, mandating ESMA to develop guidelines with common reference parameters for stress test scenarios. These guidelines are to be updated annually, reflecting the latest market evolutions. The latest update of these guidelines was published on 30 November 2022, and following a consultation paper issued in January 2023, the 2023 final report includes both updated guidelines on methodology and specifications for stress tests.

Looking ahead, the Guidelines in Annex II of this report will undergo translations into the official EU languages and be published on ESMA’s website. Following the publication of these translations, there will be a two-month period during which National Competent Authorities (NCAs) must notify ESMA of their compliance intentions with the guidelines. The updated guidelines, inclusive of the new 2023 parameters, will then become applicable two months after the translations’ publication. Post-application, managers will be required to report the results of these new parameters in their quarterly reports to NCAs, as stipulated in Article 37 of the MMF Regulation and detailed in Commission Implementing Regulation (EU) 2018/708. Until the application of the updated guidelines, managers are expected to use the 2022 Guidelines parameters and report results accordingly.

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