“Since the global financial crisis in 2008, that resulted in nationalisation of a number of banks and recapitalisation of banks, policy-makers such as the Financial Stability Board (FSB) and International Organization of Securities Commissions, or Iosco, and others [have displayed] a recurring interest in the asset management industry,” said Geoff Radcliffe, managing director at Blackrock (Luxembourg), speaking at an Association of the Luxembourg Fund Industry (Alfi) conference on 20 September.
Similar roles for the FSB and Iosco
Thoreau Bartmann, chief counsel of investment management at the US Securities and Exchange Commission (SEC), indicated that the FSB is made up of several regulators and central banks from large countries across the world formed out of the 2008 crisis “to address many of the biggest financial stability issues that come up in the world.”
The FSB “doesn’t have legislative ability, but it has moral suasion […] and tries to set out guidelines and other rules that the member states will then follow and work to implement on key critical issues,” said Bartmann.
On the other hand, Iosco sets the standards for the securities market regulations and works with the FSB. Its members are the SEC, CSSF, Bafin, etc. “Iosco also sets up guidelines and best practices for applying strict regulations around the world,” noted Bartmann.
How are open-end funds generating systemic risk and financial instability
Radcliffe explained that policymaker’s perspective is that open-ended funds can collectively generate systemic risk and financial instability by a liquidity mismatch.
“Liquidity risk concerns are nothing new in the world,” said Georg Kiefer, head of division at the Luxembourg Financial Sector Supervisory Commission (CSSF). He noted that Iosco published recommendations in 2017 and 2018 on how to manage liquidity.
The recommendations included disclosure to investors, the availability and the use of liquidity management tools (LMT), liquidity stress testing and the reporting by entities on debt to regulators to better monitor liquidity risks through the lifecycle of a product.
Despite efforts by the regulators, Kiefer observed some instances of liquidity turbulences (covid, Russia’s war in Ukraine, LDI crisis in the UK last autumn) in the recent years. He thinks that it is one of the reasons why Iosco and FSB decided to revisit the topic and “came out with new enhanced provisions for liquidity risk management.”
Recommendations: the big picture
Radcliffe and Kiefer noted that the recommendations by the FSB and Iosco included the review of structural liquidity mismatch (illiquid assets versus liquid liabilities), first mover advantage (cost to be shared with fewer remaining investors), liquidity bucketing, greater inclusion and more consistent use of LMTs, in the stressed and unstressed market conditions.
Jessica Reyes, head of asset management policy at the French financial markets authority, or AMF, explained that the goal of these recommendations was to reduce the liquidity mismatch but also to limit the amplification of shocks.
Delving into some of the details
Recommendation three “was about making sure that managers offer liquidity to investors according to the liquidity of the underlying assets in the fund,” said Reyes. Elsewhere, recommendation five suggested anti-dilution tools to ensure fairness among investors. In total, the AMF “proposed five types of facilitation tools” while also giving Iosco guidance on tool calibrations related to timing and advice on governance and disclosure to investors.
The FSB is very focused on the inclusion of market impact […] [yet] some commentators even challenge the existence of market impact
Bartmann explained that under the FSB approach, open-ended funds invest in liquid assets under a three-bucket system. For the funds investing in illiquid assets (more than 30% of their assets), the proposal would be that “regulators would require longer notice periods, not redeem or subscribe on a daily basis, or other types of structural changes [such structuring illiquid funds] into closed-end funds.”
“For the funds in middle that invest in less liquid assets […] the proposals encourage the use, on a day-to-day basis of liquidity management tools, such as anti-dilution [tools] or the like,” said Bartmann. He thought that these “middle bucket funds” are the focus of the Iosco recommendations.
Market impact: a disputable concept
“The FSB is very focused on the inclusion of market impact […] [yet] some commentators even challenge the existence of market impact,” said Radcliffe. As evidence of the complexity of the concept, Reyes said she understands the challenges related to the complexity of the calculation, the cost to implement the model and relevant data to calculate the market impact.
Reyes acknowledged that it is a challenging concept to tackle but “we need to start from somewhere.” The FSB and Iosco are juggling with the “estimation of market impact,” the “best effort basis to make those estimations” and “the significant market impact.” She expects the concept to be further debated in the coming months.
Cash buffer: a sword with two edges
“At Iosco, we don’t think that the cash buffer in open-ended fund is a good thing,” said Reyes. She thinks that it can create a “first mover advantage” as some investors tracking the liquidity position of funds may run out quicker than others. Interestingly, Bartmann noted that the US does not have a cash buffer regime but has a similar requirement called “a highly liquid investment minimum.”
Liquidity management tools: what is required?
“The only prescription at the moment is to require an anti-dilution tool for all open-end funds,” said Reyes. On the other hand, asset managers can select one tool out of five options that is the most appropriate for their funds. Moreover, the asset manager should be the one to assess whether there is risk of material dilution.
Managing the fine cost-benefit balance
“Some of the proposals will require additional systems, additional advanced analytics, to calculate, for example, market impact or might not all be available,” said Kiefer. He thinks that the investment funds in Luxembourg are already well tooled to tackle these challenges.
Reyes reminded the audience that Iosco and FSB expect to publish a feedback statement together with a final report by the end of the year.
This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .