The Framework contains only four recommendations, all of which are addressed to national regulators and none of which depart materially from the measures of leverage currently provided for under the UCITS and AIFMD regimes. This is in stark contrast to IOSCO's response to the FSB's request (also contained in the Policy Recommendations), to address the 'potential stability risk arising from liquidity mismatch in investment funds' and which resulted in 17 different liquidity risk management recommendations issued to managers of investment funds by IOSCO in February 2018.
The Framework's four recommendations are focussed on the collection and analysis of leverage data by national regulators under a proposed two-step approach to measuring and monitoring levels of leverage in funds. Perhaps unsurprisingly, IOSCO faced various challenges in addressing the FSB's request, ranging from the absence of a harmonised definition of leverage to the significant differences in the level of regulation of leverage across jurisdictions. As a result, IOSCO chose not to, at this time, introduce any new measure of leverage and instead proposes a two-step approach for regulators, which builds on existing measures of leverage used in a number of jurisdictions (principally the US and EU Member States).
A Two-Step Approach to the measurement and monitoring of leverage in funds
The two-step approach involves, firstly, the collection of data by regulators from investment funds based on existing measures of leverage, the analysis of which will allow regulators to determine the sub-set of funds which may present a leverage-related financial stability risk and thus require further risk-based analysis under the second step of the Framework.
UCITS management companies and AIFMs will be very familiar with the proposed measures of leverage recommended by IOSCO.
The first measure is a straightforward sum of the gross notional value of a fund's derivatives added to the value of the fund's remaining investments (Gross Notional Exposure or GNE). This is a blunt tool by which to measure leverage in a fund as it can significantly overstate a fund's exposure by taking no account of the types of derivatives in the fund's portfolio, their purpose or underlying exposures. While IOSCO acknowledges this, it regards GNE as a 'baseline measure' which 'may be useful for evaluating trends regarding potential leverage in funds'.
The second measure proposed is 'Adjusted GNE' which involves the calculation of GNE with a duration adjustment for interest rate derivatives (e.g. ten-year bond equivalent) and a delta adjustment for options.
IOSCO recommends that regulators collect GNE or Adjusted GNE broken down by asset classes, and long and short exposures, in respect of investment funds. Regulators may also consider collecting an additional net-exposure measure of leverage which could, at the regulator's discretion, take account of netting and hedging arrangements similar to that provided for under AIFMD.
The second step entitled 'analysing leverage-related risks in funds' allows each regulator to determine its own approach to defining risk-based measures to analysing any funds identified under step 1 as potentially presenting a significant leverage-related risk to the financial system. The Framework does not prescribe any risk-based measure of leverage but rather suggests which risks may be appropriate for a regulator to take into account (counterparty/market/liquidity risk) when analysing funds identified under step 1. IOSCO also highlights the risk-based measures of leverage which are currently used in various jurisdictions such as Value at Risk or VaR and which regulators may wish to consider in analysing funds under step 2 of the Framework. In the course of next year, IOSCO will commence aggregating the leverage data collected by regulators pursuant to its recommendations which it will publish on an annual basis from 2021 onwards.