FSOC Updates Review of Asset Management Products and Activities
Commentary by Steven Lofchie
The Financial Stability Oversight Council ("FSOC") updated a report on potential risks to financial stability that may arise from certain asset management products and activities. In the report, FSOC focused on assessing whether asset management products or activities could "create, amplify, or transmit" risks to the financial system in ways that are broad enough to affect U.S. financial stability. FSOC examined the following areas: (i) liquidity and redemption, (ii) leverage, (iii) operational functions, (iv) securities lending, and (v) resolvability and transition planning.
In each of these areas, FSOC's analysis involved three components:
1. potential risks to financial stability and the materiality of such risks;
2. the extent to which market practices and regulations may or may not mitigate identified potential risks to financial stability; and
3. determining the next steps for addressing or better understanding potential risks to financial stability.
Liquidity and Redemption Risk in Pooled Investment Vehicles
FSOC recommended implementing the following safeguards and solutions:
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robust liquidity risk management practices for mutual funds;
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clear regulatory guidelines for addressing constraints on the ability of mutual funds to hold assets with very limited liquidity;
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enhanced reports and disclosures by mutual funds concerning their liquidity profiles and liquidity risk management practices;
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steps that would facilitate mutual funds' use of tools to allocate redemption costs more directly to investors who redeem shares;
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additional public disclosure and analysis of external sources of financing, and of events that trigger the use of external financing; and
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measures to mitigate the liquidity and redemption risks that are applicable to collective investment funds ("CIFs") and similar pooled investment vehicles offering daily redemptions.
Leverage Risk in Mutual Funds, Hedge Funds, CIFs and Separately Managed Accounts
FSOC examined the ways in which the use of leverage by investment vehicles could increase the potential for direct or indirect losses to counterparties and other market participants. Citing data that was reported on Form PF, FSOC observed an apparent concentration of leverage in a small number of large hedge funds, but noted that Form PF does not provide complete information on the economics and corresponding risk exposures of hedge fund leverage or potential mitigation associated with reported leverage levels. Consequently, FSOC is creating an interagency working group that will share and analyze relevant regulatory information in order to improve its understanding of whether certain hedge fund activities pose potential risks to financial stability.
Operational Risk
Securities Lending Risk
FSOC recommended enhanced and regular data collection, reporting, and interagency data sharing to address vagaries of scale regarding securities lending activities. The report urged regulators to continue to monitor cash collateral reinvestment vehicles and explore ways to gather information on reinvestment practices that occur beyond the regulatory perimeter.
Resolvability and Transition Planning
FSOC urged advance planning by asset managers for certain stress scenarios. FSOC said that the SEC is working to develop a proposed rule requiring registered investment advisers to create and maintain transition plans in order to address major disruptions in the investment adviser business.
SEC Chair Mary Jo White and CFTC Chair Timothy Massad issued statements of support for FSOC's review. Chair Massad acknowledged the challenge of measuring leverage in the regulation of derivatives, suggested the need to improve the data that is collected. He recommended a transition from the emphasis on quarterly data to "something closer to 'real-time' analysis of exposures across cleared and uncleared positions."
Commentary
According to FSOC, its review of asset managers focuses on "risks to financial stability rather than investment risk," which the report describes as a normal and necessary part of market functioning. By contrast, FSOC maintains, financial stability risk arises because the activities of individual market participants may affect the system more broadly, particularly during times of market stress.
Regardless of FSOC's distinction between the two kinds of risk, in the actual world, there essentially is no difference. Ultimately, almost all of FSOC's concerns have to do with market crashes that result in significant liquidations of assets and downward price spirals, which only trigger further asset liquidations. FSOC's report implies that these concerns may be mitigated by investors putting higher shares of their investments in what FSOC considers to be more liquid assets.
FSOC's solution is to threaten to impose more regulations. The biggest threat it wields is the assumption of significant regulatory control over the asset management industry. There is, however, an alternative view. FSOC should consider ways in which reduced regulation might increase financial stability. According to the report, "open-end [SEC-registered investment companies] provide liquidity transformation by allowing frequent (typically, daily) redemptions by investors while investing in less-liquid assets." During stress events, the price and liquidity of these assets may fall rapidly, since they cannot be transformed readily into cash, and sophisticated investors will be motivated to make it to the door before anyone else, which will trigger a run. However, hedge funds are unlike mutual funds and so are not subject to regulations that require them to provide daily redemptions; they require advance notice for redemptions and may impose lock-up periods. As a result, "hedge funds appear largely to match investor share liquidity and asset liquidity; funds with less-liquid assets typically have substantially longer investment horizons."
The problem that FSOC identified (investor runs of withdrawals of funds) is one that may be caused largely by regulation. The requirement that mutual funds provide the ability to be redeemed daily creates a mismatch between the redemption rights of investors and the liquidity of pretty much any securities portfolio (except perhaps the U.S. government's). By contrast, hedge funds, which are not subject to regulations governing redemptions, can match their redemption rights with the liquidity of the underlying assets. Their example shows that the answer to the problem might be to impose fewer rules instead of more; i.e., to remove the requirement that open-end funds offer daily liquidity. The regulatory construct that SEC-registered funds must offer either daily liquidity (in the case of open-end funds) or no liquidity (in the case of closed-end funds) is at odds with the goal of lowering systemic risk. Perhaps affording open-end funds greater latitude in offering redemption rights would help to reduce the problem identified by FSOC, and would do so by offering more rather than fewer choices to investors.