On April 18, 2016, the Financial Stability Oversight Council (FSOC or the Council) issued an update1 on its review of potential systemic risks arising from asset management products and activities.
The FSOC’s review—including its December 2014 notice seeking public comment on asset management-related issues—has focused on five areas: liquidity and redemption, leverage, operational risk, securities lending, and resolvability and transition planning.
In conducting its analysis, the FSOC utilized publicly available data, confidential data reported on the Securities and Exchange Commission’s (SEC) Form PF, input from member agencies with supervisory authority, academic studies, and submissions in response to the request for public comment.
Liquidity and redemption risk
The FSOC believes that financial stability concerns may arise from liquidity and redemption risks in pooled investment vehicles, specifically where investor redemption rights and underlying asset liquidity may not match.
The analysis finds two features of these vehicles that raise concerns: liquidity transformation and first-mover advantage.
With respect to liquidity transformation, the FSOC notes that some vehicles, specifically open-end funds, allow frequent, often daily redemptions while investing in less liquid assets. Investors may require a lower liquidity premium than investors purchasing the underlying assets directly, which may increase the price of the underlying assets. During a stress event, the FSOC cautions that the price of assets held “may fall rapidly if large redemptions occur.”2
Although the FSOC acknowledges that the “magnitude of potential spillover effects from liquidity transformation in mutual funds is uncertain”3 and that existing SEC guidelines limit mutual funds’ acquisitions of certain illiquid assets to 15 percent of net assets, it notes that this limit does not take into account the size of a fund’s position or lengthy settlement times, which could delay the ability to convert securities into cash. In addition, certain less liquid securities are not subject to this limit.
Further, the FSOC notes that hedge funds are not subject to liquidity guidelines and may invest in assets of varying liquidity profiles. Currently, large hedge funds (i.e., those with at least $1.5 billion in assets under management) report that 13 percent of their advised fund shares can be redeemed in seven days or less and 26 percent can be redeemed in 30 days or less.
The FSOC also warns that redemption options and pricing methods by pooled investment vehicles may create an advantage for the first investors who redeem options if the costs of meeting such redemptions are borne by remaining investors in the fund. In turn, the FSOC believes this dynamic could create incentives for investors to redeem shares ahead of other investors, a scenario that could be amplified under a stress scenario.
Moreover, the FSOC contends that first-mover advantage amplified liquidity transformation risk such that investors in funds with larger holdings of less liquid assets may have a greater incentive to redeem during stress periods.
Accordingly, the report sets forth six recommendations to mitigate risk in these areas:
The FSOC also notes that, although exchange-traded funds (ETFs) are not subject to the same types of liquidity and redemption risks as other open-end funds, it will continue to monitor financial stability risks posed by ETFs.
The Council also examined the ways in which the use of leverage by investment vehicles could increase the potential for losses to counterparties and other market participants, and the extent to which these risks may have financial stability implications. Although the FSOC recognizes that leverage is “not a perfect proxy for risk,”4 it maintains that there is ample evidence that the use of leverage can contribute to financial stability risks.
To complete its analysis, the Council used several metrics for measuring leverage at hedge funds based on Form PF data, including:
The FSOC finds that “many hedge funds use relatively small amounts of leverage,” but that large funds, as measured by GAV, tend to be “more leveraged than smaller hedge funds.”5 Specifically, the analysis shows that, as of Q2 2015, the weighted averaged of all qualifying hedge funds for the three ratios were 1.8x, 5.5x, and 0.7x, respectively. By comparison, the ratios for the 10 largest funds were 6.1x, 23.3x, and 4.6x.6
Although the Council acknowledges that these funds’ leveraged positions “generally appear to be offsetting,”7 it calls for further analysis, noting the difficulty in fully assessing the potential for the liquidation of leveraged assets by a distressed fund—or several funds pursuing similar strategies—to disrupt financial markets.
Addressing potential risks posed by leveraged mutual funds, the FSOC asserts that, notwithstanding the statutory limitation on these funds’ borrowings to 50 percent of net assets, certain funds’ current practices “enable them to obtain a higher degree of leverage than was contemplated under previous SEC guidance,”8 specifically at non-traditional bond funds and leveraged ETFs.
With respect to data limitations, the report notes that, although Form PF has increased transparency, it does not provide complete information on the economics and corresponding risk exposures of hedge fund leverage or potential mitigants associated with reported leverage levels.
In addition, the Council warns that no single regulator has all the information necessary to evaluate the complete risk profiles of hedge funds, noting that major counterparties are overseen by various regulators across jurisdictions.
The Council believes that further analysis is necessary, and is creating an interagency working group to share and analyse relevant information to better understand hedge fund activities and assess potential risks with respect to leverage.
Among other things, it group will consider “potential enhancements to and the establishment of standards governing the current measurements of leverage, including risk-based measures of leverage.”9
The working group expects to report its findings to the Council by Q4 2016. If it identifies financial stability risks, the Council will consider what actions regulators can take using existing authorities, as well as whether additional authorities may be needed.
Operational risk, securities lending, resolvability
Although these three areas were not the primary focus of the Council’s analysis, the report notes that (1) continued analysis is required with respect to operational risk in light of the growing reliance on service providers, (2) more comprehensive information is necessary to fully assess the materiality of potential risks in securities lending, and (3) there may be potential resolvability risks, particularly under stress scenarios.
Statements from Treasury, SEC, and CFTC
Treasury Secretary Jack Lew noted10 that the SEC is engaged in several initiatives affecting the asset management industry, including pending proposed rules on data reporting, liquidity risk management, and the use of derivatives, as well as forthcoming proposals on transition planning and stress testing. However, he maintained that the FSOC has a “clear mandate to look across the system for potential threats to financial stability.” As the SEC’s rulemaking process continues, the FSOC intends to monitor the effects of any regulatory changes and their implications for financial stability.
SEC Chair Mary Jo White expressed11 support for the update, noting that the FSOC’s work on asset management-related issues is “complementary” to the regulatory reforms the SEC is currently undertaking. She stressed, however, that the updated should “not be read as an indication of the direction that the SEC’s final asset management rules may take.”
CFTC Chairman Timothy Massad also supported12the update, including the suggestion that regulators further examine the implications of leverage with respect to hedge funds. However, he emphasized that regulators do not have a good metric for leverage and have not yet “connected the dots” between the leverage metrics cited and the amount of underlying risk it represents. For example, he noted that the GNE metric includes derivatives, but “not in a manner that accurately measures risk” given that it does not take into account certain factors that affect risk, such as product type, offsetting positions, whether a transaction is cleared, or whether margin is collected.
What does this mean for institutions?
Although the FSOC is continuing its analysis of potential financial stability risks arising from asset management products and activities and has not specifically proposed additional regulatory requirements, covered firms should carefully analyze the FSOC’s findings.
In addition, covered companies should closely monitor the SEC’s pending proposed rules on data reporting, liquidity risk management, and derivatives, the finalization of which will be significant to the Council’s further analysis.
Importantly, this update further illustrates the FSOC’s commitment to taking an “activity-based” approach to analyzing potential asset management-related financial stability risks. Although the FSOC previously designated four nonbank financial companies, including three insurance companies, as “systemically important financial companies”—and retains the statutory authority to make such designations—it appears that the Council will continue to focus on the activities of asset managers rather than subject individual firms to heightened supervision and regulation.
As significant developments occur, Deloitte will issue additional updates as appropriate.
1 Financial Stability Oversight Council, “Update on Review of Asset Management Products and Activities,” April 18, 2016 available at https://www.treasury.gov/initiatives/fsoc/news/Documents/FSOC%20Update%20on%20Review%20of%20Asset%20Management%20Products%20and%20Activities.pdf
2 Id, at 5.
3 Id, at 6.
4 Id, at 15.
5 Id, at 16.
7 Id, at 17.
8 Id, at 19.
9 Id, at 20.
10 Treasury Secretary Jacob Lew, Remarks at a Meeting of the Financial Oversight Council, April 18, 2016, available at https://www.treasury.gov/press-center/press-release/Pages/jl0430.aspx
11 SEC Chair Mary Jo White, Statement on Financial Stability Oversight Council’s Review of Asset Management Products and Activities, April 18, 2016, available at https://www.sec.gov/news/statement/white-statement-041816.html
12 CFTC Chairman Timothy Massad, Satement on the Financial Stability Oversight Council’s Update on its Review of Asset Management Products and Activities, April 18, 2016, available at http://www.cftc.gov/PressRoom/SpeechesTestimony/massadstatement041816