In the April edition, we highlighted that within a six-week period regulators had issued papers and made statements about a number of matters relating to systemic risk and market data, including stress testing of and reporting by money market funds (MMFs), hedge funds and the use of benchmarks and credit ratings.
To a large degree, asset managers and investment funds have proved resilient during the pandemic. Given ongoing uncertainty about its impact on the capital markets, though, it is understandable that liquidity risk management in open-ended funds has been a key area of focus, for both managers and regulators. That focus shows no signs of diminishing, from either an investor protection or systemic risk perspective, and the systemic risk debate is widening.
Sudden market falls and increased market volatility in response to the pandemic have re-ignited questions from some policymakers about whether computer-led trading strategies, short selling, MMFs and ETFs are exacerbating the problem. Other commentators, however, think these things are not to blame and that they make it easier for everyone to buy and sell at more accurate prices. (See Chapter 2 (PDF 2.11 MB) of the Evolving Asset Management Regulation Report 2020 for more information.)
The chair of the Financial Stability Board (FSB), Randal Quarles has thrown his hat into the ring in a letter to central bank governors and finance ministers. The letter observes that market volatility has decreased, but that it may return. A key theme of the letter is the need to reinforce resilient non-bank financial intermediation (NBFI): “understanding risk, risk transmission and policy implications for the NBFI sector is more important than ever”, it says.
The FSB is carrying out a “holistic review of the market turmoil in March” and is mapping the critical connections between the banking and non-bank sectors. Issues covered will include liquidity mismatches, leverage, interconnectedness and investor behaviour. The work will inform future steps in 2021 to improve the resiliency of the NBFI sector while preserving its benefits.
Analyses should consider the differences between apparently similar funds in different jurisdictions, the different rules to which managers are subject, the tools at their disposal, investor types and regulatory influences on investor behaviour.
An important subtext of the FSB's work is concerns about the fixed income markets and especially sovereign debt. During the initial height of the pandemic, several central banks undertook critical interventions in money markets to support their economies and government borrowing.
As with all policy debates, there is the “test tube” problem. We can observe what has happened with the current levels of asset management activity in capital markets and the volume and types of investment funds, but we cannot know for certain what would have happened if both were lower or more constrained by regulation. If more private investors held sovereign debt directly and not via investment funds, would there have been greater or lesser redemption activity? Might the regulatory disciplines around open-ended funds – in particular, diversity requirements and liquidity risk management tools, including deferred redemptions or “gates” – have helped to limit or smooth redemptions rather than have exacerbated volatility?
In whatever way the debate progresses, it is certain that the activities of asset managers and funds will be under closer scrutiny at global level, and the debate is likely to feed through to regional and national requirements.
In Europe, stress testing scenarios have joined the priority list and will be even more rigorous going forward. There are already calls, for example by the French regulator, for ESMA’s July 2019 guidelines on stress testing in MMFs to be reviewed to take into account recent market data. The use of leverage in alternative investment funds (AIFs) is also high on the agenda. ESMA is about to close its consultation on guidelines to encourage convergence among national regulators in assessing leverage risks and in designing, calibrating and implementing leverage limits. The guidelines include a common minimum set of indicators to be taken into account and set out the two-step assessment approach recommended (PDF 112.69 KB) by IOSCO in December 2019.
Questions for CEOs
Can we evidence that our investment process is subject to internal discipline and external challenge, and that we are not swayed by so-called “herd behaviour”?
Can we evidence how we monitor investor behaviour in times of stress and what we do to mitigate potential issues?
Are we reviewing all aspects of our liquidity management framework?
Are we enhancing our stress testing scenarios?
Do we have daily dealing funds in less liquid or illiquid assets? What extra measures can we take to minimise the risk of fund suspensions?
Have we considered how ESMA's proposals on leverage might impact our product offerings and disclosures?