Regulators and standard-setters, domestic and international, are worrying about the potential for investment funds to pose risks to financial stability. The Bank of England has been especially vocal on this issue, sounding the alarm (most recently in its July 2023 Financial Stability Report) about the urgent need to increase globally the resilience of investment funds along with other sectors of market-based finance. We expect the macroprudential regulation of funds to be an iterative process, each successive step prompted by a crisis which the previous regime had failed to prevent.
In this blog post, we consider the drivers of evolving regulation in the UK and internationally, including the impact of the global financial crisis and more recently the situation with liability-driven investment funds, and what the future holds.
Threats to financial stability
Once upon a time systemic risks were thought to lie mainly in the banking system, and these risks were addressed primarily through the regulation and supervision of banks, with the backstop of central bank lender of last resort (LOLR) facilities. Investment funds might from time to time pose a credit threat to their bank lenders and counterparties (for example, Long Term Capital Management in 1998 and, more recently, Archegos in 2021). But this credit risk could, in principle, be addressed like any other credit risk by the traditional tools of banking prudential regulation – capital requirements, limits on concentrated exposures etc.
However, the global financial crisis (GFC) of 2007-2008 and subsequent events have accelerated the recognition that investment funds might pose systemic risks quite distinct from credit risk to banks. And that these risks might need to be addressed directly by regulation and supervision of these funds.
Money market funds
The problem came to the fore when liquidity problems in money market funds (MMFs) – particularly those investing in private sector debt - were an important contributor to the GFC. MMFs are in important ways functionally equivalent to specialist banks: they receive deposit-like funds from investors and use them to purchase short-term debt securities, aiming to earn an interest-like return from the maturity mismatch. But with maturity mismatch comes liquidity mismatch and the possibility of a run, the characteristic risk of banking, when a loss of confidence in the future capacity of the fund to repay on demand triggers a rush for the exits, and a flood of redemption requests threatens to overwhelm the fund’s capacity to find cash to meet them.
The GFC showed how problems in one MMF could be indicative of (and exacerbate) problems across the whole sector, due to MMFs’ similar asset portfolios, the substantial proportion of these asset classes that are typically held by MMFs and the limited secondary market for them (even in good times). The fact that many of the issuers of these assets were financial institutions made for rapid transmission of stress to the wider financial system, as the disappearance of buyers made it difficult for financial institutions to fund themselves.
Similar problems arose more recently in the “dash for cash” at the beginning of the Covid 19 crisis in March 2020.
Liability-driven investment funds
The “dash for cash” and more recent events in the UK have demonstrated that investment fund risks are not confined to the risk of a run, and that they are also to be found in funds other than MMFs.
In the UK in autumn 2022 many liability-driven investment (LDI) funds got into trouble. These funds take leveraged long positions in long-dated gilts (either direct holdings funded by repo borrowing, or synthetically through derivatives) as a hedge against the value of UK defined benefit (DB) pension schemes’ long-term liabilities. In the days immediately following the announcement of the government’s growth plan, long-dated gilts prices fell sharply. LDI funds were faced with having to meet large margin and collateral calls, and with potentially having to sell large quantities of gilts into an increasingly illiquid market. Worse, some funds were at risk of falling to a negative net asset value and defaulting on their repo or derivatives contracts, likely to result in counterparties selling gilts collateral and hedges. The Bank of England worried that a self-reinforcing spiral would be set off, “threatening severe disruption of core funding markets and consequent widespread financial instability”. The situation was only stabilised when the Bank intervened to stand in the market on a short-term basis as a buyer of the relevant asset classes.
The LDI episode was concerning because financial stability risks had appeared not in the banking sector, nor even in shadow banking (MMFs), but simply from the holding of leveraged positions in a fund structure which made it difficult to raise new capital rapidly. Rapid deleveraging, and the threat of defaults likely to result in the liquidation of collateral, could destabilise a sensitive market just as effectively as a run on an MMF.
National and international regulatory responses
The regulatory response to these threats has been gradual and is still evolving, with initiatives being taken at both national and international level.
There is an international aspect to most investment funds. A fund may be established in one jurisdiction, managed in another, and have investors and invest in markets based in others. Regulatory failures in one jurisdiction can have cross-border consequences. For these reasons, there have been increasing attempts at international coordination of the regulatory response, with the standard-setting effort being led by the Financial Stability Board (FSB) together with the International Organization of Securities Commissions (IOSCO).
This need for coordination is mirrored at national level, as funds are typically regulated by securities regulators rather than by the bodies with primary responsibility for financial stability. A somewhat fragmented regulatory environment can also present problems of coordination and diffused responsibility. To take the UK LDI market as an example, pension funds are regulated by The Pensions Regulator (TPR), LDI fund managers are regulated by the Financial Conduct Authority (FCA), the LDI funds themselves are typically established and regulated outside the UK, and investment consultants to pension funds are typically not regulated at all.
Recent regulatory history
In the immediate aftermath of the GFC, there were changes to MMF regulation in the US and the EU in 2010, and other reforms were subsequently adopted elsewhere. The focus at this stage was largely on MMFs’ assets: imposing requirements related to their maturity, quality and liquidity. The US reforms also specifically enabled a fund to suspend redemptions in certain circumstances.
The first set of international recommendations was published by IOSCO in 2012 and related specifically to MMFs. These recommendations were part of a wider FSB plan to tackle the risks of non-bank financial intermediation, and followed a slow motion run on US MMFs in 2011. They included recommendations on asset quality and maturity, asset valuation (particularly restrictions on use of the amortised cost method) and liquidity management, among other issues. IOSCO explicitly recognised that its recommendations might be implemented differently in different jurisdictions “depending on local conditions and circumstances, as well as according to the specificities of the existing domestic legal and regulatory structures”.
In 2017, the FSB turned its attention to investment funds more broadly, publishing a set of policy recommendations to address four particular structural vulnerabilities: liquidity mismatch in open-ended funds, leverage within funds, operational risks, and securities lending practices. Regarding leverage, the FSB recommended that IOSCO should develop consistent metrics for quantifying leverage (both on balance sheet, and synthetic leverage through derivatives) and that national authorities should monitor leverage that may pose systemic risks and take action as appropriate. Most of the FSB recommendations were operationalised by a 2018 set of IOSCO recommendations and good practices on liquidity management.
The part played by MMFs in the “dash for cash” renewed regulatory attention on this particular type of fund. In October 2021 the FSB published a new set of policy proposals for MMFs. This was discussed in a previous blog post Regulating shadow banking: New International standards for money market funds. Interestingly, these proposals were presented as a series of policy options for regulators – a toolbox from which they could select tools appropriate to their specific situations. These tools were concerned with imposing on redeeming fund investors the cost of their redemptions, enabling funds to absorb credit losses, addressing regulatory thresholds that may give rise to cliff edge effects, and reducing liquidity transformation.
Current developments
Work is still continuing at an international level on both the MMF and the general investment fund work streams.
As regards MMFs, the FSB is due to complete a stocktake by the end of the year of the measures taken by member jurisdictions to address MMF resilience and the reasons given for the policy choices made. This is to be followed up by 2026 with an assessment of their effectiveness in addressing financial stability risks. IOSCO is also reviewing its 2012 recommendations in the light of the FSB’s 2021 proposals.
As regards other types of open-ended fund, earlier this month the FSB consulted on revisions to some aspects of its 2017 recommendations and IOSCO consulted on guidance regarding some elements of its 2018 recommendations. IOSCO is looking to finalise its guidance by the end of the year and is also expected to review other elements of its 2018 recommendations. In broad terms, the FSB and IOSCO intend to be more specific about measures to limit first mover advantage for redeeming investors and ensure that the liquidity available to them is calibrated to take into account the liquidity of the fund’s assets.
The UK provides an interesting example of further developments at national level, in view of the recent UK LDI crisis. As regards UK regulation, the Bank has had to work with the fact that it does not directly regulate the main participants in LDI. Accordingly, it recommended in March that TPR act as soon as possible to specify minimum levels of resilience for the LDI funds in which pension scheme trustees may invest. Since then, both the FCA and TPR have published detailed guidance on LDI resilience. The Bank also launched, in June, its first ever system-wide exploratory exercise, to improve understanding of the behaviours of funds and other market participants in stressed market conditions, and how they might interact to amplify shocks to UK markets that are core to UK financial stability. (Earlier this year, the FCA authorised the first open-ended long-term asset fund, specifically designed for investment in long-term, less liquid assets. Requirements aimed at controlling the liquidity risk are a particular feature of the FCA’s rules for funds of this kind.)
The future
If the history of banking regulation is a guide, the macroprudential regulation of funds is likely to be an iterative process, with standards and requirements becoming more prescriptive and granular over time, each successive step prompted by a crisis which the previous regime had failed to prevent. Several factors are likely to make progress difficult, including a funds sector which is very diverse even at national level, national regulatory landscapes which are often complex and fragmented, and a wider environment in which political emphasis on national competitiveness may combine with fading memories of the GFC to constrain the energy directed at international coordination efforts. Besides which, regulation of funds with a view to protecting against systemic risk is a relatively new science, certainly compared to the banking sector regulation - central banks and prudential regulators have not traditionally been very involved with investment funds. But, to return to the warning referred to at the beginning of this post, the Bank of England clearly believes that, whatever the difficulties may be, it is important that standard-setters, regulators and supervisors should move quickly.
