The G-20’s Financial Stability Board (FSB) on January 12, 2017 issued Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (Recommendations), covering four areas of concern: (i) liquidity mismatch; (ii) leverage; (iii) operational risk; and (iv) securities lending activities. The FSB will look to the International Organization of Securities Commissions (IOSCO) to review IOSCO’s existing guidance and, as appropriate, enhance this guidance in light of the Recommendations. As discussed below, the U.S. Securities and Exchange Commission (SEC) either has adopted or proposed rules covering many areas addressed by the Recommendations.
Potential for Future Asset Management G-SIFI Designations
The FSB continues to plan to revisit whether there are residual entity-specific sources of systemic risk that cannot be addressed effectively by market-wide activities-based policies that would support global systemically important financial institution (G-SIFI) designations of asset managers or investment funds.
It remains to be seen what approach U.S. representatives on the FSB (the Treasury Department, Federal Reserve Board (FRB) and SEC) under the Trump Administration will take in regard to any future FSB asset management G-SIFI designation initiatives. It also remains to be seen how U.S. regulatory bodies, including the Financial Stability Oversight Council (FSOC), the FRB and the SEC, would respond to any final asset management G-SIFI designation statements by the FSB during the Trump Administration. Republican members of Congress have already gone on record that the FSB has no binding authority in the United States.
FSB’s View of the Risks Related to the Asset Management Sector
Since the FSB’s initial January 2014 proposal regarding G-SIFI designation of asset managers and funds, the FSB has recognized the limited empirical support for the argument that the asset management sector poses a threat to financial stability. In that proposal, the FSB observed that from 2000 to 2012, even when viewed in the aggregate, no mutual fund liquidations resulted in a systemic market impact.
In the Recommendations, the FSB noted that, apart from money market funds and the collapse of Long Term Capital Management, there was little historical evidence of systemic risks arising from investment funds. In this regard:
- FSB acknowledges that open-end funds generally have not created financial stability concerns in recent periods of stress and heightened volatility.
- Nevertheless, the FSB suggests a scenario in which investment funds could pose a threat to financial stability, noting that growth in the asset management sector has been accompanied by increased investment in particular asset classes, including in less actively traded markets, through open-end funds that offer daily redemptions.
- The FSB suggests that if market prices were to drop sharply, investors in less-liquid asset classes of open-end funds could experience greater and more sudden losses than expected, which could result in a significant number of investors seeking to exit these asset classes; this, in turn, could amplify and increase the potential for contagion across asset classes.
Comments by the asset management industry in response to the FSB’s three prior proposals regarding the asset management industry have clearly had an important impact on the FSB’s view of the asset management sector, as the FSB acknowledges in the Recommendations that:
- Asset managers and funds pose very different structural issues (with dissimilar risk profiles) than banks and insurance companies, since asset managers act as agents on behalf of clients rather than as principals.
- Distress at the asset manager level should generally pose less of a risk to the financial system than distress across an asset manager’s funds, since asset managers usually do not rely on their balance sheets in transactions between their clients and the market to engage in transactions as a principal, and their balance sheets are generally small relative to the size of their assets under management.
Perhaps most significantly, the FSB expressly acknowledges that the operations of the asset management sector fundamentally reflect choices of individual investors who select particular investment vehicles and move their funds among alternative investment vehicle options. In this regard, the FSB states that: “Clients make many key investment decisions, for example, selecting the asset manager(s) and, in many cases, determining the type(s) of funds, investment strategies and asset classes in which to invest and when to redeem from various investments.”
The FSB provides 14 formal recommendations, and suggests that relevant national authorities review their existing regimes and consider making adjustments, as appropriate, to ensure that potential financial stability risks are addressed in a forward-looking and internationally consistent manner. The FSB notes that some of its Recommendations already may have been implemented in certain jurisdictions. The Recommendations include calls for the following:
- Collection of information as to the liquidity risk profile of open-end funds proportionate to the risks such funds may pose from a financial stability perspective, and requiring liquidity-related disclosures to investors.
The SEC has recently adopted rules that provide for increased liquidity and redemption-related disclosures to fund investors, as well as reporting on these matters to the SEC.
- Adoption of requirements or issuing guidance to make funds’ assets and investment strategies consistent with conditions governing fund unit redemptions, both at inception and on an ongoing basis, taking into account the expected liquidity of the assets and investor behavior during normal and stressed market conditions.
- Permitting open-end funds to use liquidity risk management tools (e.g., swing pricing, redemption fees and other anti-dilution methods) to reduce first-mover advantage, in order to increase the likelihood that redemptions are met even under stressed market conditions. Regulators should provide guidance on stress testing for open-end funds to support liquidity risk management.
The SEC has recently adopted rules (Liquidity Risk Rules) that, among other things, require registered open-end investment companies to: implement a liquidity risk management program; classify the liquidity of fund assets into one of four categories; maintain a minimum percentage of highly liquid assets; and limit the acquisition of illiquid assets to 15% of a fund’s assets. The rules permit, but do not require, “swing pricing” – this would adjust the net asset value of a fund’s shares to effectively pass on the trading and other costs associated with purchases or redemptions of fund shares to the purchasing or redeeming shareholders. The SEC has also indicated that it plans to propose new requirements for stress testing by large asset managers and large investment companies.
- Promoting decision making processes for open-end funds to use exceptional liquidity risk management tools that are transparent to investors and authorities, taking into account the costs and benefits of such action from a financial stability perspective.
The Liquidity Risk Rules provide that, before a fund can utilize swing pricing, it must establish policies and procedures governing how the fund would utilize this option.
- IOSCO’s consideration and/or development of consistent measurements of leverage in funds for financial stability purposes, as well as more risk-based measures, in order to enhance the regulators’ understanding and monitoring of risks that leverage may create.
- Monitoring the use of leverage across various types of investment funds and taking action when appropriate.
- Adoption of requirements or issuing guidance for asset managers to have comprehensive and robust risk management frameworks and practices (especially with regard to business continuity plans and transition plans), to enable orderly transfer of their clients’ accounts and investment mandates in stressed conditions.
The SEC has issued a proposed rule that would require registered investment advisers to implement a business continuity and transition plan. The plan would involve policies and procedures reasonably designed to address operational and other risks related to a significant disruption in the adviser’s operations.
- Monitoring of indemnifications provided by agent lenders/asset managers to clients in relation to the asset managers’ securities lending activities, in order to discover the occurrence of material risks or regulatory arbitrage that may adversely affect financial stability.