Against the backdrop of ongoing uncertainty about the timing and shape of economic recovery, policymakers and securities regulators are reassessing the role of non-bank financial intermediation (NBFI). There is a focus on liquidity management in open-ended funds and asset valuations, with bond funds, money market funds (MMFs), exchange-traded funds (ETFs) and real estate funds all coming under increased scrutiny. Regulators are also determined to pursue issues that were already on their agendas, including a smooth transition to risk-free rates and access to market data.
The high volatility in capital markets in March 2020 was greater than during the 2008 crisis. Pinch points in the financial system contributed to a sudden demand for liquidity - "dash for cash" - which led central banks to intervene. Regulators recognize that the economic shock was caused by the pandemic, not by the financial services industry (unlike the 2008 crisis), and that its magnitude was such that the need for central bank interventions was unsurprising. There are concerns, though, about the precedents and incentives that the interventions may have set for the risk management of market participants, and about the potential for further market volatility and credit rating downgrades.
See below for more detail on:
Key considerations for firms
Fund managers should review all aspects of their liquidity risk management for open-ended funds, including whether they use liquidity management tools in an appropriately calibrated manner for each fund, and whether their disclosures to investors are clear.
Fund managers will need to evidence that they have critically analyzed experience during the 2020 market stress, and that their policies, processes, controls and documentation meet supervisory expectations.
Firms should review how their asset valuation processes work during periods of market stress and be able to evidence the pursuit of fair value, to regulators and investors.
Firms should review their risk management processes for derivatives, their use of leverage, and client disclosures.
Managers of open-ended funds invested in private and real assets should consider whether the funds' redemptions policies are appropriate for the illiquidity of the underlying assets and whether disclosures to investors are clear.
Firms should be progressing plans to transition to RFRs.
In the detail
Remarkable resilience and recovery
The asset management and investment funds industry has remained broadly resilient despite the most extreme market conditions in living memory. However, a small number of open-ended funds had to suspend dealing temporarily during 2020, in the face of heavy redemption activity and difficulties in selling assets in volatile and sharply falling markets. Suspensions are of concern to both managers and regulators, given the impact on investors and potential risk of contagion effects in the wider market.
Flows into funds have returned. For example, the European Securities and Markets Authority (ESMA) noted (PDF 3.8 MB) that the EU fund industry continued to expand in the second half of 2020, reflecting strong flows and valuation effects. In particular, and in contrast to the significant outflows experienced during the market stress, bond funds recorded the highest inflows. And the size and composition of EU MMFs remained stable, with liquidity buffers plateaued at high levels, substantially above regulatory requirements.
Despite the industry's remarkable story of resilience and recovery, regulators are concerned that lessons should be learned, by both fund managers and supervisors. Moreover, asset managers and asset owners - especially the USD 6 trillion sovereign wealth fund sector - are being called upon by governments to help repair damage caused by the pandemic on national economies. This could lead to a shift in focus away from global investment strategies towards domestic investments. Coupled with lower levels of retirement and long-term savings, or increased drawdowns, due to income loss or uncertainty (see chapter 7 of the main report), the investor universe could be reduced for some considerable time.
The industry is concerned that regulators should prioritize addressing the root causes that triggered the March 2020 stresses, such as the structure of bond markets, and only then consider necessary policy reforms for investment funds. As with all policy debates, there is the "test tube" problem. We can observe what happened with the current levels of asset management activity in capital markets and the current size and types of investment funds, but we cannot know for certain what would have happened if both had been different. If more private investors had held sovereign debt directly, not via investment funds, would there have been greater or lesser redemption activity? Might the regulatory disciplines around open-ended funds have helped to minimize or smooth asset redemptions, rather than exacerbate volatility?
The role of "non-banks"
The Financial Stability Board's (FSB's) November 2020 report to the G20 says that the interconnectedness within the NBFI sector and with banks, as well as greater reliance on market and funding liquidity to support market-based intermediation, reinforce the need to analyze the overall system. It notes that, "Absent central bank intervention, it is highly likely that the stress in the financial system would have worsened significantly" and that "The financial system remains vulnerable to another liquidity strain, as the underlying structures and mechanisms that gave rise to the turmoil are still in place".
The report suggests that some parts of the NBFI sector acted as propagators of the liquidity stress during March 2020. It highlights liquidity mismatches, the build-up of leverage in certain types of investment funds, and that large differences arose between certain fixed income ETF share prices and the estimated value of their assets. It also observes that open-ended funds invested in illiquid assets could amplify liquidity stress, but recognizes that fund structures, underlying assets, and availability and use of liquidity management tools vary across different jurisdictions. The FSB's 2021/22 work programme includes:
- Proposals to enhance MMF resilience, including with respect to the underlying short-term funding markets
- Examination of the availability and effectiveness of liquidity risk management tools for open-ended funds, including the experience of redemption pressures and use of tools in the March 2020 turmoil and their aggregate impact on the market
- Consideration of how to improve the structure of core funding markets, including the role played by hedge funds and other leveraged investors
- Analysis of whether existing policy tools are sufficient for dealing with the systemic risks posed by non-banks and the desired level of resilience of NBFIs
The International Organization of Securities Commissions (IOSCO) is also working on these issues. In addition, IOSCO will report in mid-2021 on the findings of its thematic review of the impact of the growth of passive investing on equity capital markets. It will provide an overview of the increase in passive investing and its drivers; examine the impacts, if any, of increased passive investing on market efficiency and corporate governance; and investigate the consequences of the interplay between passive and other types of funds for how investors collectively pay for efficient and effective equity markets.
At her first meeting as chair of the Financial Stability Oversight Council in March 2021, US Treasury Secretary, Janet Yellen said she has asked for an interagency assessment of the vulnerabilities posed by open-ended mutual funds and for recommendations on whether the council should take additional action. During 2021, the Division of Examinations of the Securities and Exchanges Commission (SEC) will review:
- Preferential treatment of certain investors by advisers to private funds that have experienced issues with liquidity, including imposing gates or suspensions on fund withdrawals
- Portfolio valuations and the resulting impact on management fees
- Adequacy of disclosure and compliance with any regulatory requirements of cross trades, principal investments, or distressed sales
- Conflicts around liquidity, such as adviser-led fund restructurings, including stapled secondary transactions where new investors purchase the interests of existing investors while also agreeing to invest in a new fund
In times of market stress, widely-held open-ended investment funds can encounter difficulties when redemptions suddenly increase, if underlying investments cannot easily be liquidated at prices close to valuations. MMFs and real estate funds were especially hit in certain markets during 2020, and there is ongoing concern about bond markets. Regulators are concerned about potential systemic risks arising from liquidity mismatches in funds and whether their access to and use of liquidity management tools has been effective. Many regulators had already reviewed their liquidity management requirements against IOSCO's 2018 recommendations but are revisiting the issue.
Luis de Guindos, Vice President of the European Central Bank (ECB) said in November 2020 that investment funds should hold more cash and liquid assets to ensure they can meet redemption requests in times of financial stress. He called for new rules to beef up fund's liquidity buffers and to ensure that redemption terms are closely aligned to the liquidity of the underlying assets. The ECB's long-held view that there should be a macroprudential framework for investment funds has been reinforced by the need for it to intervene in the euro money markets earlier in the year. The Vice President said that existing safeguards, such as fund suspensions or "gating", had not been enough to stem outflows.
In the same month, ESMA warned investment funds with less liquid assets to prepare better for market shocks. Its report found shortcomings in the liquidity management of real estate and corporate debt funds during the period of high market volatility. Only 0.4 percent of the funds under review suspended during that period, but this figure was double the percentage for all EU funds. In comparison, many UCITS1 in ESMA's sample used swing pricing to control or smooth redemption activity, where allowed by national rules, and only four suspended for up to 13 days due to valuation uncertainty and large outflows. The report contains analyses of which types of liquidity management tools are made available in each member state, with suspensions being the only commonly-available tool. ESMA set out five priority areas for fund managers and national regulators:
- Ongoing supervision of the alignment of a fund's investment strategy, liquidity profile and redemption policy
- Ongoing supervision of liquidity risk assessment, including consideration of the impact of margin calls and loan covenants in real estate funds
- Fund liquidity profile reporting
- Increase of the availability and use of liquidity risk management tools
- Supervision of valuation processes in a context of valuation uncertainty
Guidelines on liquidity stress testing in EU funds came into effect in September 2020. In March 2021, ESMA issued the findings of a common supervisory action on UCITS liquidity risk management (LRM), in which all 30 EU/EEA national regulators participated. Overall, they reported that most UCITS managers demonstrated they have implemented and applied sufficiently sound LRM processes, but shortcomings were identified in a few cases:
- Poor quality and documentation of LRM arrangements, procedures and methodologies
- Over-reliance on liquidity presumptions about listed securities, and application of liquidity presumptions to financial instruments not admitted to or dealt in on a regulated market
- The entity to which the portfolio management function is delegated also effectively performs the LRM function
- Lack of data quality checks and over-reliance on very few data providers
- Disclosures missing, inaccurate or unclear
- Insufficient governance, weak internal controls framework, and external controls not performed by the depositary and external auditors
National regulators are acting. In Sweden, for example, the Financial Supervisory Authority has reviewed the need for additional liquidity management tools for open-ended funds. It has concluded that managers of UCITS and other retail securities funds should be able to use swing pricing, anti-dilution levies, redemption gates and notice periods. Also, UCITS should be allowed to redeem every two weeks. The regulator recommends that the conditions for using these tools should be regulated.
In September 2020, the Spanish Comisión Nacional del Mercado de Valores (CNMV) began to subject local investment funds to stress testing using a methodology it describes as "somewhat more precise" than that developed by ESMA. The government has approved a royal decree that gives the CNMV additional powers in the supervision of funds in response to the pandemic. CNMV is now able to grant notice periods for fund redemptions without fund managers having to specify the exact length of this period or the level of requested withdrawals. It is expected to publish in 2021 technical guidelines on liquidity management and controls.
The Bank of England and the UK Financial Conduct Authority (FCA) issued in March 2021 the findings of their joint survey of liquidity management in UK authorized, open-ended investment funds, covering the period Q4 2019 to Q2 2020. Respondents managed 272 funds investing in less liquid assets - corporate bond funds (including high-yield bond funds), mixed bond funds and a small number of small and medium cap equity funds. All funds were daily dealing, and none had a notice period in place. Net outflows in March 2020 were much larger for funds with predominantly institutional or intermediated) investors than for those with direct retail investors. The authorities found that:
- Funds have a wide range of liquidity tools available to them (and used them more intensively during the stress period), but predominantly use swing pricing. However, tool selection and trigger points for their usage, and some pricing adjustment calculations, tended not to be fund-specific.
- Funds intensified and adapted their use of swing pricing during the stress period. There were large variations in how swing pricing was applied, which were not entirely explained by differences in primary strategies.
- Funds also held liquidity buffers in the form of cash and non-cash liquid assets, the two most common being units in MMFs and UK government bonds.
- Some funds adapted their liquidity management approaches and governance measures temporarily or permanently in response to the stress period.
- Managers of corporate bond funds may be overestimating the liquidity of their holdings, with some managers considering a large proportion of their holdings to be liquid in almost all market conditions, and most considering that the majority of their holdings have high valuation certainty.
MMFs and liquidity
A wide variety of investors - from non-financial corporations, public authorities and financial entities, to individuals - use MMFs as alternatives or complements to bank deposits. In some markets, MMFs tend to be institutional vehicles with large minimum subscriptions. In others, MMFs are used by retail savers.
According to the FSB's report (see above), at end-2019 MMFs accounted for approximately USD 7 trillion of assets under management. The FSB recognizes that the sector plays an important role in supporting the real economy, both as a liquid and diversified cash management tool for investors, and as a key source of funding for governments and financial and non-financial corporates. Also, the MMF sector is heterogeneous - with differing characteristics across jurisdictions, depending on fund type, structure and investor type - and that such differences are important in assessing the effect of pandemic-related market dislocations.
IOSCO's November 2020 report (PDF 636 KB) concurs that there is no common definition of MMFs. It observes that MMFs were severely tested in March and April 2020, when funds struggled to provide cash to investors rushing to redeem, while supplies of commercial paper were also drying up. Gaps exist in the accounting processes of EU-domiciled funds, making it difficult for funds accurately to conduct portfolio valuations, the report says. IOSCO suggests that funds offering a constant net asset value (CNAV) should be subject to measures designed to reduce the specific risks associated with a stable NAV and be forced to absorb the costs arising from those risks. Also, regulators should require CNAV funds to convert to variable NAV (VNAV) funds.
The US Securities and Exchanges Commission's (SEC's) December 2020 paper (PDF 550 KB) on experiences among US prime MMFs at the onset of the pandemic notes that, despite prior reform efforts to make MMFs more resilient to credit and liquidity stresses, investors redeemed USD 134 billion from prime and tax-exempt MMFs in March 2020, while government MMFs took in USD 838 billion. Although the overall MMF industry grew during this period, the large outflows from prime MMFs highlighted the remaining structural vulnerabilities in these funds, says the report. The SEC consulted (PDF 790 KB) until April 2021 on possible regulatory reforms:
- Removal of the tie between MMF liquidity and fee and gate thresholds
- Reform of conditions for imposing redemption gates to reduce their likelihood
- Imposing a minimum balance at risk that investors can redeem only with a time delay
- Liquidity management changes
- Countercyclical weekly liquid asset requirements
- Floating NAVs for all prime and tax-exempt MMFs
- Swing pricing requirement
- Capital buffer requirements
- Mandatory liquidity exchange bank membership
- New requirements governing sponsor support
ESMA issued updated guidelines on stress test scenarios for EU MMFs in December 2020 to reflect experiences in 2020. It is now seeking (PDF 527 KB) views by end-June 2021 on the EU Money Market Fund Regulation, to inform the review that the Commission must undertake by July 2022. The Regulation provides for three main types of MMFs: public debt CNAVs, low volatility NAV funds (LVNAVs) and VNAVs, which represent 7 percent, 48 percent and 45 percent of EU MMFs, respectively. ESMA notes that MMFs remain subject to a range of vulnerabilities, including liquidity of underlying markets, regulatory requirements and the role of credit rating agencies.
It is considering reforms in three broad areas, not all of which may apply equally to the three types of funds:
- On the liability side (e.g. swing pricing, redemptions in kind, holdbacks, minimum balance at risk, or removal of CNAVs)
- On the asset side (e.g. restrictions on asset holdings, increased liquidity buffers and/or making them usable/ countercyclical, decoupling regulatory thresholds from suspensions/gates)
- External to MMFs themselves (e.g. related sponsor support, enhance liquidity of underlying instruments in which MMFs invest, a liquidity exchange bank, enhanced MMF reporting to and stress testing by authorities)
ETFs - a growing market
At end-2020, assets under management in ETFs stood at around USD 8 billion, having doubled over the previous four years. Also, ETFs are being launched in an increasing number of jurisdictions. For example, 2020 saw the launch of new ETFs by fund managers in Saudi Arabia. The concept of ETFs is not new to the Kingdom, but fund managers are expanding their horizons in terms of the underlying assets in an ETF. Where predominantly the underlying securities used to be equities, there is now diversification towards sukuk and commodities, to cater for evolving market conditions and investor demand. There is also a growing interest in ETFs in Qatar, where banks are considering launching new funds.
As noted above, the FSB is concerned about differences between ETF share prices and estimated values of underlying assets. The 2021 priorities of the US SEC's Division of Examinations include reviews of ETFs and their managers. It is collecting publicly-disclosed data on trade quality, such as spreads, and private information about how the funds are being operated. The funds are required to monitor creation and redemption activity and trading activity on the exchange. The Division is reviewing compliance with exemptive reliefs provided against these obligations, including for the newly created non-transparent, actively-managed ETFs.
In times of market stress, otherwise automated asset valuation processes can require manual intervention, and sudden changes in asset valuations can lead to "passive" breaches to exposure limits. Several regulators are therefore reviewing the industry's valuation processes.
For example, in December 2020, the US SEC adopted a final rule that establishes a new framework for fund valuation. The rule lays out a process for how companies comply with requirements related to accounting, auditing and overseeing how value determinations are made. Major provisions in the rule include terms for how the fund's board of directors is involved in the valuation process and allowances for it to designate and oversee parties performing fair value determinations.
The Division of Examinations will review filings and reports to funds' boards for compliance with regulatory requirements and for valuation issues. In focusing on valuation and the resulting impact on fund performance, liquidity and risk-related disclosures, the Division will review for investments in market sectors that experienced, or continue to experience, stress due to the pandemic, such as energy, real estate, or products such as bank loans and high-yield corporate and municipal bonds. The Division will also review funds' and advisers' disclosures and practices related to securities lending.
Derivatives and leverage
Highly-leveraged funds are another focus area for policymakers. Sir Jon Cuncliffe, Bank of England commented (PDF 450 KB) on funds that undertake arbitrage trades on the price differences between the value of derivatives and the value of the cash instrument upon which the derivative is based. In “normal” market conditions, these trades are generally viewed as stabilizing market prices. However, various pressures meant that these funds had to undertake massive sales of government bonds (almost USD 90 billion during March 2020), causing further falls in bond prices.
The important function that derivatives can play is recognized by other regulators. The Saudi stock market launched an index futures product in 2020, which will allow investors to gain index exposure to Saudi equities included in the MSCI2 index. This marked the beginning of an exchange-traded derivatives market in Saudi Arabia and presents opportunities for fund managers to supplement and diversify portfolios.
In October 2020, the US SEC adopted a new rule to enhance the regulatory framework for derivatives use by registered investment companies, including mutual funds (other than MMFs), ETFs and closed-end funds. Then SEC Chair, Jay Clayton said, "Today's action provides for a comprehensive framework for funds' derivatives use that provides both meaningful protections for investors and regulatory certainty for funds and their advisers". Funds can now enter into a range of derivative transactions, provided they comply with certain conditions designed to protect investors and make additional filings. The conditions include adopting a derivatives risk management program and complying with a limit on the amount of leverage-related risk that the fund may obtain based on value at risk. A streamlined set of requirements apply for funds that use derivatives in a limited way.
Real estate funds
In its third annual report on EU alternative investment funds (AIFs), ESMA aired concerns over real estate funds and funds of funds regarding the mismatch between the potential liquidity of the assets and the redemption time frame offered to investors. Some member states require real estate funds to be closed-ended, but in aggregate just over half of EU real estate funds are open-ended, and 44 percent of commercial real estate funds, which are the largest category, offer daily liquidity to investors. The French Autorité des Marchés Financiers (AMF) is also concerned about the valuation and liquidity of real estate funds. Given current fears about the resilience of commercial property, the AMF will analyze the liquidity risk management systems of real estate fund managers.
There are about 20 UK retail funds described as property funds and that offer daily dealing, some of which are long-standing and have navigated various market crises. All funds invested in inherently illiquid assets have been subject to additional requirements since 2019, which include increased depositary oversight, standard risk warnings on financial promotions, increased disclosure of liquidity management tools and mandatory liquidity risk contingency planning. The FCA proposed in August 2020 that funds investing predominantly (more than 50 percent) in property, and that offer more frequent than monthly redemptions, should be subject to an additional notice period requirement:
- Each investor's redemption request would be received and recorded, then processed at the end of a notice period
- The investor would receive the value of their investment, based on the unit price of the fund at the first valuation point following the end of their notice period
- Redemption requests would be irrevocable, so investors could not place orders and withdraw them before the end of the notice period if market conditions change (to avoid the fund manager selling property to meet redemption requests that are subsequently cancelled)
No restriction will be imposed on daily subscriptions, the risk warning will no longer apply and there might be a reduced need for liquidity risk contingency planning. In May 2021, the FCA announced that it was deferring a decision on new rules while it is consulting on long-term asset funds (see chapter 8 of the main report).
The Central Bank of Ireland is reviewing the risks associated with investment funds investing in Irish property assets, specifically liquidity mismatch and leverage, which could result in funds needing to sell property assets over a relatively short period of time, amplifying price pressures in the commercial real estate market. Sharon Donnery, CBI Deputy Governor said "The growth of Irish property funds since the global financial crisis has brought with it many benefits, including the diversification of financing channels for commercial real estate away from domestic investors towards international investors." She added, however, that given the growth of Irish property funds in recent years, the resilience of this form of financial intermediation matters more today than it did a decade ago. The CBI is considering leverage limits and options to limit liquidity mismatches.
Moving to RFRs
Initial impact assessment: Modelling and systems analysis by all business units of: operational, legal and conduct risks; functional, economic and client impacts; and regional timings.
Strategic Planning: Based on economic impacts to existing portfolios and potential business opportunities: establish client communication and negotiation workflows; review contract structure; and evaluate profitability, cash-flows and hedging risk.
Governance & client outreach: Develop internal governance processes to approve changes to policies, systems, processes and controls; educate client-facing staff to guide clients transparently and fairly through the process.
Contract identification: Leveraging technology if possible, identify all products and business lines, including expected fall-backs, and the bilateral negotiations likely to be in scope.
IBOR exposures & risk management: Measure exposure by maturities beyond 2021, grouped by fund, portfolio and counterparty.
Transition to risk-free rates nears
Another imminent risk to capital markets stability is the likely demise of the widely-used London inter-bank offer rate (LIBOR) at the end of 2021 and the challenge of transitioning to risk-free rates (RFRs). The FSB's roadmap includes a smooth transition away from LIBOR to more robust benchmarks. The pressure is on firms to implement transition plans, as the UK FCA has confirmed that LIBOR will end in its present form for all currencies apart from USD at the end of 2021.
The US SEC has noted that the discontinuation of LIBOR could have a significant impact on the financial markets and may present a material risk for certain market participants, including registered investment advisers, broker-dealers, investment companies, municipal advisors, transfer agents and clearing agencies. Preparation for the transition away from LIBOR is essential for minimizing any potential adverse effects associated with LIBOR discontinuation
Market data: cost and access
IOSCO consulted (PDF 137 KB) until end-February 2021 on the cost of and access to market data, and the need for consolidated market data. Several jurisdictions, including Australia, the EU and the US, are contemplating whether regulatory changes are necessary. IOSCO intends that the findings of its consultation will provide useful information for jurisdictions considering their supervisory and regulatory approach.
Also, by end-2021, IOSCO will report on the findings of its thematic review of conduct-related issues in relation to index providers. The review will explore issues related to the role of asset managers in relation to indices and index providers, and the role and processes of index providers in the provision of indices (including the potential impact of administrative errors on funds and identifying potential conflicts of interest that may exist at index providers in relation to funds).
European authorities are seeking to improve reporting standards, with harmonization, effectiveness and efficiency being strong themes. The new reporting requirements under the EU Securities Financing and Transaction Regulation (SFTR) commenced in October 2020 for investment funds and some in-scope third-country entities, and in January 2021 for non-financial counterparties. As part of the review of the Markets in Financial Instruments Regulation (MiFIR), ESMA has consulted on the transparency regime and the reference data and transaction reporting obligations. The objective is to simplify the current reporting regimes and enhance the quality of reported data, by ensuring consistency among various reporting and transparency requirements. Also, changes introduced to MiFIR by the new Investment Firms Regulation (see chapter 5) will require annual reporting to ESMA by third-country firms providing investment services into the EU.