FSOC Expresses Concerns with Fund Leverage and Redemptions
Calls on SEC to Study Potential Emerging Risks from Investment Funds
December 9, 2020
Not surprisingly, the 2020 annual report of the Financial Stability Oversight Council (FSOC) looks at the risk to the U.S. financial system through the lens of the unprecedented economic turmoil wrought by the COVID-19 pandemic.
According to the report, the pandemic “caused a contraction of economic activity at an unprecedented pace,” requiring extraordinary government measures. Although these measures succeeded in “arresting the decline in economic conditions,” the FSOC is concerned that a protracted virus outbreak can slow this fragile recovery or even “prolong the economic downturn.” That said, large financial institutions are better positioned today to weather a crisis than they were during the 2008 financial crisis, and the report recommends that financial regulators continue to require sufficient capital and liquidity to ensure the resiliency of these large institutions.
The report discusses regulatory actions during this period as well as the impact of the pandemic on financial stability in general, and specifically on corporate credit, short-term wholesale funding markets, residential real estate and nonbank mortgage origination and servicing, commercial real estate, large bank holding companies, investment funds, financial market structure, central counterparties, alternative reference rates, cybersecurity, data gaps and challenges, and financial innovation. The report includes a description of SEC regulatory actions taken in 2020 to address concerns related to the pandemic as well as rulemakings more generally geared towards expanding the exempt markets and reducing burdens on issuers and market participants.
This article focuses on the report’s observations relating to asset management and funds.
General observations on investment funds
In its discussion of the role of investment funds in the U.S. economy, the report states that the FSOC has “identified a potential vulnerability relating to redemption risk in certain open-end funds.” It concludes that the vulnerability is a function, among other things, of “the liquidity of the underlying assets, the effectiveness of the fund’s management of its liquidity, and the potential for an investor to enjoy a first-mover advantage.” Because some fixed income markets are less liquid than equity markets, even though funds holding both types of instruments offer daily redemptions, those holding mostly fixed income instruments are more vulnerable to the risk of runs. The report states that “[t]he Council has focused in particular on the question of whether the structure of open-end funds results in greater selling pressure than if investors held the fixed-income instruments directly.”
While the report credits the SEC for taking steps to address this potential vulnerability, including through adoption of the 2016 rule on liquidity risk management for funds, it points to historically high levels of outflows from bond funds and the necessary Federal Reserve and Treasury interventions as “demonstrat[ing] the need for additional analysis to assess broader market structure dynamics that may have contributed to the stress, including whether investors redeeming shares from bond funds may have affected the extent of selling pressure in the bond market differently than if those investors had held and sold bonds directly.”
The report also continues to raise concerns with leverage in investment funds, noting that, because leverage introduces counterpart risk, in a period of stress, forced sales can exacerbate price movements and contribute to systemic volatility.
Because of these concerns, the FSOC supports regulatory initiatives to address risk in investment funds, as well as data collection and “analytical” work by the relevant agencies to identify potential emerging risks. The report praises the SEC for several of its data collection efforts and new reporting requirements for funds. The report recommends that the SEC and other relevant agencies consider whether additional steps should be taken, including potentially through additional reporting requirements.
Discussion of specific types of funds
Money market funds. As market participants “shifted risk preferences” towards cash and other highly liquid instruments during the early period of the pandemic, there were rapid outflows from and substantial declines in assets of prime institutional money market funds. Some of these outflows were attributed to concerns by investors that these funds would impose redemption gates and liquidity fees. The SEC’s 2014 money market reforms gave money market fund boards the option to impose liquidity fees and gates if a fund’s weekly liquid assets fell below 30 percent of total assets. Following intervention by the Federal Reserve, money market fund assets regained roughly the amount lost in March. Despite the stress in the prime institutional market, money market fund assets in the aggregate grew significantly in 2020 – as of September – in large part because of their liquidity. The report also noted acceleration of the long-term trend towards consolidation in the money market fund sector, a trend that had slowed in 2019.
Mutual funds and ETFs. The net assets of mutual funds other than money market funds increased by only 0.5 percent in 2020, compared with an increase of 20 percent in 2019. Before the pandemic, bond funds saw consistent inflows while equity funds saw consistent outflows. In March, these flow patterns changed, with record outflows across the board. As of September, bond flows have stabilized but equities are still seeing outflows in the aggregate. ETFs are growing faster than mutual funds, and now account for 17 percent (up from 12 percent in 2019) of U.S. investment company assets. While bond ETFs had record outflows early in the pandemic, their flows have stabilized. Equity ETFs generally remained positive through 2020. The report notes that ETF management remains highly concentrated.
Alternative funds. The report notes that hedge funds saw outflows in the aggregate through September, but outflows were less than 2019 numbers. Event-driven funds and convertible arbitrage funds were the only strategy types with inflows in the first nine months of 2020. Hedge fund borrowings, which have been increasing dramatically over the past few years, also contracted in March 2020. Private equity funds appear poised to enter a more active deal-making period since they hold a record amount of uncommitted capital earmarked for buyouts. The report notes that the PE industry remains concentrated and that pension funds are the largest beneficial owners of funds managed by large private equity advisers – holding 29 percent of net assets.
Pension plans. The report also discusses pension funds, observing that it is hard to analyze the impact of the pandemic on defined benefit plans in the aggregate since their disclosure requirements differ depending on the type of plan. “[A]necdotal reports,” however, show that, “while some plans made substantial investment gains in the second quarter of 2020, annual returns have fallen short of longer-term targets.”
Derivatives markets. The report notes that asset managers, hedge funds, market makers, and other types of investors – including retail – “contributed to record levels of activity across multiple futures markets” in 2020. The report points to the higher volatility, increase in short-term trading activity, and significant hedging and investment needs to explain the activity.
Key Takeaways. While the pandemic has been an “extraordinary shock to the global financial system,” leading to significant economic disruption, conditions have improved largely due to policy actions. The report credits the FSOC with facilitating coordination and analysis of emerging systemic risks during 2020 as well as its earlier legwork in identifying potential systemic vulnerabilities with helping ensure that regulatory responses to economic fallout from the pandemic were “more coordinated, well-informed, and effective.” The global outlook for recovery is still uncertain, however, and regulators are urged to continue to assess the potential negative effects of leverage and elevated asset prices on the markets, including in connection with investment funds.
TAGS: Coronavirus, COVID-19, Derivatives, FSOC, ETFs, Hedge Funds, Mutual Funds