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Systemic risk spotlight on leverage

Systemic risk spotlight turns to leverage

Last month’s edition described the latest spate of regulatory outputs on liquidity management in open-ended funds, one of the key work streams within the systemic risk debate. The second main work stream is now up and running: the calculation of leverage.

Further to the Financial Stability Board’s recommendations of January 2017, IOSCO is consulting (PDF 574KB) on a standardised set of measures of leverage and a proposed supervisory framework. Comments are sought by 1 February 2019. The paper uses the generic term “investment fund” and refers in places to AIFMD, implying that both UCITS and AIFs are within scope. Separately-managed portfolios or accounts – such as defined benefit pension funds – are not mentioned.

ISOCO proposes a flexible two-step approach: an initial filter based on selected measures applied to all funds, then a risk-based analysis of a subset of funds with higher metrics. This flexibility is welcome, but fund managers might still need to perform different calculations and to provide different additional information in each jurisdiction. Within the EU, it is not clear how a consistent analytical framework for the second stage analysis will recognise the very different national markets. It is therefore not certain that the end result will be increased comparability of funds for investors or reduced operational costs for managers. Moreover, the European Systemic Risk Board (ESRB) has called for greater use of leverage limits, which could restrict professional investors’ investment options in EU-domiciled funds.

IOSCO’s proposals

IOSCO notes that rules relating to leverage in funds, and its measurement and monitoring, vary around the globe. Even where regulators require reporting of leverage data (notably, the EU and the US), different metrics are used, which creates challenges for the monitoring of potential systemic risks at global level. Comparability is also hampered by the wide variety of funds and investment strategies. Measures of leverage that are appropriate for one type of fund or strategy may be less appropriate or informative if applied to other types of funds or strategies.

Further, IOSCO acknowledges that there is an underlying tension between achieving precise leverage measures and arriving at sufficiently simple, robust metrics that can be applied in a consistent manner to the wide range of funds offered in different jurisdictions. It also recognises that a fund’s use of derivatives alone – which can increase certain measures of market exposure – should not be seen as solely synonymous with the amplification of risk and returns. Derivatives may reflect the use of hedging or cost-efficiency techniques.

IOSCO therefore proposes a two-step approach: reporting of leverage using a common set of measures; and a more thorough risk-based analysis by regulators of those funds that report higher levels of leverage. The goal is to exclude via step one those funds that are unlikely to pose risks to the financial system, allowing regulators to focus their attention on a subset of funds. IOSCO does not intend to prescribe which of the metrics or supplementary data a regulator may require in step one, or the form that the step two assessment should take. It believes that each jurisdiction should determine the most appropriate risk assessment given the type and nature of the funds under review.

This open approach allows much needed flexibility to accommodate the wide range of legal structures, strategies, asset class, portfolio compositions and efficient portfolio techniques used by funds, but it raises the question whether it will lead to improved comparability of data collection at global level. Fund managers might still need to produce a myriad of different reports and to perform different calculations for similar funds, which results in higher operational costs and added complexity for investors seeking to compare funds.

Meanwhile, the ESRB has already called for the Commission and the European Securities and Markets Authority (ESMA) to introduce more stringent requirements, including making better use of possibilities to impose a limit on leverage.

A bit more detail

The metrics proposed (summarised in the box below) have been chosen because IOSCO believes they can be applied across all types, strategies and leverage methods of funds; they avoid model risk; and they will facilitate the identification of funds that may pose a risk to financial stability.

Proposed leverage measures

Gross Notional Exposure without adjustment: The summation of the absolute values of the notional amounts (i.e. market values of equivalent positions) of a fund’s derivative positions and the value of the fund’s other assets.

Pros: relatively easy to calculate, uses simple data points, can be applied reasonably consistently across different funds and avoids model risk.

Cons: does not reflect why derivatives are being used, may overstate a fund’s exposure, does not reflect the volatilities of different asset classes and tends to overstate leverage.

Adjusted Gross Notional Exposure: The same calculation as above but with adjustments for interest rate derivatives (either by using the derivatives’ notional amounts in terms of ten-year bond equivalents, or relative to the fund’s target duration) and delta adjustments for options.

Pros: attempts to risk-adjust interest rate derivatives and options exposures, relatively simple to calculate and apply across different types of funds, uses simple data points and avoids model risk.

Cons: can still overstate certain exposures (although to a lesser extent), does not account for netting or hedging, and does not differentiate between asset types.

Net Notional Exposure: considers the extent to which exposures may be netted and the extent of hedging, and can be applied to either of the previous two measures. Two approaches to evaluating netting or hedging are considered: define the circumstances when positions can be netted or considered to be hedged (the approach taken in the UCITS and AIF regulations); or consider information that indicates possible netting or hedging relationships, without defining mechanistic rules.

Pros: accounts for some netting and hedging

Cons: can still overstate exposure (but to a much lesser extent), can understate leverage risk if netting or hedging has residual risks, may introduce model risk, not easy to aggregate values and does not differentiate between asset type.

Any of these metrics could be broken down by asset class within a fund (i.e. calculating not one single aggregate figure for a fund, but a figure for each asset class in which the fund invests), allowing regulators more meaningfully to compare funds across the market. 


IOSCO suggests that regulators could further refine the step one filter by considering other data points, such as portfolio composition, availability of assets to meet margin or collateral calls, measures of an investment’s volatility relative to the market or value at risk.

Step two is intended to mitigate the inherent limitations in the step one metrics by the use of risk-based analyses. Common risks identified are market and counterparty risk. For example, margin or collateral posted by a fund in connection with a derivative transaction reduces the risk the fund may pose to its counterparty.

In determining which funds to analyse in step two, it is suggested that regulators might consider the size and scope of the fund industry in their jurisdiction, the nature of the regulator’s focus and mission, and the extent to which other domestic regulations seek to address leverage-based risks.

Although a reasonable approach in theory, and one which a number of national regulators effectively already adopt, it is not immediately obvious how a common approach could be adopted across the EU given the wide diversity between national fund markets.

Questions for CEOs to ask:

  1. What would be the leverage figures for our funds if we have to use the proposed methodologies? Are those figures in line with our view of each fund’s strategy and portfolio – on a standalone basis, relative to other funds we manage, or relative to market peers? If not, what refinements do we believe should be made to the proposed methodologies?
  2. Might any of our funds fall into the second step (i.e. be subject to a fuller risk-based analysis by the regulator)? If yes, what other information do we believe should be provided to the regulator to inform that analysis?
  3. How should these figures be disclosed to investors? What narrative would we wish to provide to make those disclosures as meaningful and as useful as possible?
  4. If a maximum level of permitted leverage were imposed on AIFs, would this impact our fund offerings? In our view, would it unreasonably limit the legitimate investment aspirations of EU professional investors, or would it provide necessary and appropriate protection?

IOSCO suggest that regulators could further refine the step one filter by considering other data points, such as portfolio composition, availability of assets to meet margin or collateral calls, measures of an investment’s volatility relative to the market or value at risk.

 

Step two is intended to mitigate the inherent limitations in the step one metrics by the use of risk-based analyses. Common risks identified are market and counterparty risk. For example, margin or collateral posted by a fund in connection with a derivative transaction reduces the risk the fund may pose to its counterparty.

 

In determining which funds to analyse in step two, it is suggested that regulators might consider the size and scope of the fund industry in their jurisdiction, the nature of the regulator’s focus and mission, and the extent to which other domestic regulations seek to address leverage-based risks.

 

Although a reasonable approach in theory, and one which a number of national regulators effectively already adopt, it is not immediately obvious how a common approach could be adopted across the EU given the wide diversity between national fund markets.


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