As we all personally look forward to the start of a new year, the global financial services regulatory agenda for 2016 looks far less refreshing. Among other things, 2015 will be remembered as the year the International Monetary Fund (IMF) publically called for re-examining the asset management industry and its potential for posing a risk to global financial stability. Its reform proposals have called for better oversight and better use of data and risk factors. It also called for evaluation of existing risk management methodologies including Liquidity Risk. This has initiated sweeping reforms across the globe and the subject of liquidity risk management in particular has become a hot debate.
The inconsistencies in how the industry manages liquidity risk were the driving force behind the U.S. Securities & Exchange Commission’s (SEC) proposal of a new rule and amendments to its current rules and reforms. Their observation that asset managers are employing liquidity management programs to varying degrees with some firms unable to demonstrate any structured methodology for managing liquidity risks within their mutual funds is concerning. Issued in September 2015, the new framework will strengthen and promote effective liquidity risk management for open ended mutual funds and exchange traded funds that fall within the scope of the Investment Company Act. The proposal does not affect U.S. money market funds which are governed by a separate regime set to go live next year.
Money Market Funds (MMF) have also been very much in the liquidity spotlight during 2015 and here again we have seen reforms initiated at a global level. In September, the International Organisation of Securities Commissions (IOSCO), the global watchdog and standard setter for securities and futures markets, contributed by publishing the final report of the Peer Review led by the Australian regulatory body, ASIC, on the Regulation of Money Market Funds. The review focused primarily on the progress of reform within the U.S., France, Luxembourg, Ireland and China as the dominant players who collectively control up to 90 percent of the global AUM in the MMF market. The reform includes liquidity risk management and addresses risks that potentially affect a stable NAV.
The U.S. appears to have both the investment funds and money market reform well underway. In Europe, however, the reforms appear to be less active. While both the UCITS IV funds regime and the AIFMD (alternative investments) regime make provisions for having an effective liquidity risk management program in place, their effectiveness have yet to be properly tested. There has also been a call by Amundi, a Paris based firm and also one of the largest asset managers in Europe, for Stress Testing (a method commonly used within liquidity risk management) to be more prescriptive in order for regulators to have more visibility to judge market liquidity.
But it is the money market reform in Europe that has really not been successful. Luxembourg, which was tasked with the mandate for MMF reform in Europe at the start of its EU presidency in July, has made little progress to date. However, arguably it is unfair to expect Luxembourg to push reform for the $700bn market when it is home to a large proportion of that market. It is more likely that the responsibility for reform in Europe will change hands along with the presidency when the Netherlands takes over. They will have less of a conflict, but will they have space for this on their already planned agenda?
Moving away from the regulation and on to the market, the concern about liquidity risk in asset management goes beyond that of a mutual fund’s ability to match their assets with their liabilities. The notion that liquidity risk is under-priced by the market is certainly trending and was highlighted at the British Bankers’ Association International Banking Conference in London back in October. In a speech given by Sir Jon Cunliffe, Deputy Governor of the Bank of England, he voiced concerns that the price of liquidity risk is well below historic averages.
With these low prices, there is also evidence that increased competition drives trading and custody costs down – therefore risky assets are cheaper to hold. If you couple this with the added pressure of finding yield for your client, the market becomes exposed to the risk of holders of riskier assets who may not have the tolerance to bear the market drawdowns of those riskier assets – and in periods of stress this exacerbates the management of market liquidity. This issue was reinforced only last week when a U.S. fund management company was forced to liquidate one of its high yield mutual funds following a run on redemptions as investors tried to avoid the bond market turmoil during that same week.
We can expect 2016 to bring more visibility to global regulators on the subject of liquidity risk in mutual funds, Liquid Alts and Exchange Traded Funds in particular. Whether the reforms will be implemented in time and be enough to shield investors from any adverse market events during 2016 and beyond is yet to be determined.