ESMA warns of potential risks in leveraged alternative investment funds

The European Securities and Markets Authority (ESMA), the EU’s financial markets regulator and supervisor, today (30 January) published a report on the EU alternative investment funds (AIFs)’ market and an article on the risks posed by leveraged AIFs in the EU.

ESMA highlighted in the statement the risks posed by real estate (RE) funds, in a context of declining volumes of transactions and falling prices in several jurisdictions.

Existing liquidity mismatches in AIFs are particularly heightened by the high share of open-ended RE funds, some of which offer daily liquidity. This vulnerability could be systemically relevant in jurisdictions where RE funds own a large share of the RE market.

Looking at the full sector and specifically at the risks posed by leveraged AIFs, ESMA found that:

• the size of the sector declined slightly (-3%) to EUR 6.8tn in 2022 and AIFs account for 36% of the EU fund industry,
• the fall in value was mainly driven by valuation losses for funds exposed to bonds and equities amid adverse market developments in 2022,
• RE funds face multiple risks related to leverage, market footprint, valuation discrepancies and liquidity mismatches
• leverage for hedge funds remains very high, and this may pose a risk of market impact. However, most of them also dispose of large levels of cash to address potential margin calls, which limits the risk of fire sales,
• NCAs have reported risks posed by the Liability-Driven Investment (LDI) funds, which gain leveraged exposures to the UK government bond market. Risks have remained elevated, and the limits set after the severe stress experienced in September 2022 remain appropriate.

In light of these findings, ESMA reported on the measure taken by authorities to address the risks identified, and will continue to work with the NCAs to meet ESMA’s financial stability objective.

The two documents contribute to ESMA’s financial stability objective. They are part of ESMA’s monitoring framework on AIFs, including market development and key risk metrics, such as leverage and liquidity. They foster a common supervisory approach of the data reported under AIFMD between ESMA and the NCAs.