FSB backs closed-ended funds in liquidity recommendations

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The Financial Stability Board has proposed more closed-ended funds to help address liquidity mismatch and stress testing individual funds in its latest policy recommendations for the asset management industry.

It says while traditionally asset management has not created financial stability concerns the increasing size and scope of the industry means risks have increased.

Global assets under management rose from $50trn in 2004 to $76trn a decade later, accounting for 40 per cent of global financial system assets. The FSB says $31trn is invested in open-ended mutual funds.

A document, Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities, outlines 14 policy recommendations to address risks in liquidity mismatch, leverage, operational risk and securities lending.

The recommendations that focus on liquidity mismatch suggest authorities could require funds with significant illiquid assets to be closed-ended or to impose restrictions on redemptions.

Following the UK’s vote to leave the European Union many open-ended property funds ended up being gated due to overwhelming redemptions that could not be granted due to the illiquid nature of the underlying assets.

In contrast, closed-ended funds continued to trade.

The FSB also suggest authorities provide guidance and requirements for stress testing at the individual fund level to address liquidity mismatch.

Other policy recommendations suggest authorities collect information on liquidity profiles of funds relative to their risks from a financial stability perspective and introduce measures that restrict first mover advantage.

Bank of England governor Mark Carney, who is chair of the FSB, says: “The growth in asset management activities provides new sources of credit and investment, and adds diversity to our financial system.

“The policy recommendations published today will enhance the resilience of asset management activities so that this form of market-based finance can help underpin strong, sustainable and balanced economic growth.”

The recommendations

  • Authorities should collect information on the liquidity profile of open-ended funds in their jurisdiction proportionate to the risks they may pose from a financial stability perspective. 
  • Authorities should review existing investor disclosure requirements and determine the degree to which additional disclosures should be provided by open-ended funds to investors regarding fund liquidity risk, proportionate to the liquidity risks funds may pose from a financial stability perspective. 
  • In order to reduce the likelihood of material liquidity mismatches arising from an open-ended fund’s structure, authorities should have requirements or guidance stating that funds’ assets and investment strategies should be consistent with the terms and conditions governing fund unit redemptions both at fund inception and on an ongoing basis (for new and existing funds), taking into account the expected liquidity of the assets and investor behaviour during normal and stressed market conditions.
  • Authorities should require and/or provide guidance on stress testing at the level of individual open-ended funds to support liquidity risk management to mitigate financial stability risk.
  • Authorities should promote (through regulatory requirements or guidance) clear decision-making processes for open-ended funds’ use of exceptional liquidity risk management tools, and the processes should be made transparent to investors and the relevant authorities.
  • While asset managers have the primary responsibility to exercise exceptional liquidity risk management tools regarding the open-ended funds they manage, authorities should provide guidance on their use in stressed conditions. 
  • Where relevant, authorities should give consideration to system-wide stress testing that could potentially capture effects of collective selling by funds and other investors on the resilience of financial markets and the financial system more generally.
  • IOSCO should identify and/or develop consistent measures of leverage in funds to facilitate more meaningful monitoring of leverage for financial stability purposes, and help enable direct comparisons across funds and at a global level.
  • Authorities should collect data on leverage in funds, monitor the use of leverage by funds not subject to leverage limits or which may pose significant leverage-related risks to the financial system, and take action when appropriate.
  • IOSCO should collect national/regional aggregated data on leverage across its member jurisdictions based on the consistent measures it develops.
  • Authorities should have requirements or guidance for asset managers to have comprehensive and robust risk management frameworks and practices, especially with regards to business continuity plans and transition plans, for example, to enable orderly transfer of their clients’ accounts and investment mandates in stressed conditions.
  • Authorities should monitor indemnifications provided by agent lenders/asset managers to clients in relation to their securities lending activities.