United States: US Financial Stability Oversight Council Focuses On Asset Management Products And Activities

US Financial Stability Oversight Council Focuses on Asset Management Products and Activities

On April 18, 2016, the US Financial Stability Oversight Council issued an update on its multi-year review of potential financial stability risks in the asset management industry. This note highlights takeaways from that report, summarizes its key sections and predicts next steps.

Here are the highlights:

  • FSOC believes alleged liquidity mismatches (particularly for mutual funds), high leverage (particularly for hedge funds) and other industry practices present potential risks to financial stability.
  • FSOC believes regulators do not collect sufficient data to understand the scope or nature of these risks.
  • FSOC is creating an interagency working group to assess potential risks associated with leveraged hedge funds. The working group must report its findings to FSOC by the fourth quarter of 20161

Brief Background

The creation of the Financial Stability Oversight Council (typically abbreviated to FSOC) was a centerpiece of US regulatory reform legislation that followed the 2008-2009 financial crisis. FSOC coordinates financial stability initiatives across otherwise separate financial regulators and is chaired by the Secretary of the Treasury.

FSOC voting membership, in addition to the Treasury Secretary, includes the heads of the Federal Reserve, Office of the Comptroller of the Currency, Bureau of Consumer Financial Protection, Securities and Exchange Commission, Federal Deposit Insurance Company, Commodity Futures Trading Commission, Federal Housing Finance Agency and National Credit Union Administration, plus an independent member with insurance expertise appointed by the President and confirmed by the Senate2.

Related International Focus

  • The issues raised by FSOC have been vexing policy makers and regulators since the financial crisis. The UK's Turner Review,3 published in 2009, focused on activities carried out by hedge funds and similar entities. It called for regulators to be given powers to collect extensive data on hedge fund activities and other forms of investment intermediation so as to consider their macro-economic risks. In addition, the review considered that regulators should have powers to apply prudential regulation to hedge fund activities that were bank-like in nature or of systemic importance.
  • Issues identified in the Turner Review also have been considered at the international level by the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system. FSB has announced its intention to consult in mid-2016 on the risks posed by funds' liquidity mismatch, leverage within funds, operational risk, challenges in transferring investment mandates in a stressed situation and securities lending activities of asset managers and funds—in other words, most of the same themes addressed in FSOC's report. FSB recommendations are expected by the end of the year.4
  • In Europe, the European Commission's Capital Markets Union is based, in part, on expanding market-based intermediation to fuel EU economic growth. This objective is tempered through regulation to increase transparency, such as the Securities Financing Transaction Regulation (SFTR) which requires firms to reportsecurities financing transactions, and regulatory monitoring for concentration risks, cross border exposures and regulatory arbitrage. Other initiatives aim to revive the securitization market—by providing preferential regulatory capital treatment for investors, in particular bank and investment firm investors, in simple, transparent and standardized securitizations—as well as develop a harmonized approach to the regulation of new innovations such as crowdfunding platforms. Regulation of non-bank credit intermediation remains under consideration.

What Does This Mean?

  • Regulatory focus on asset management "activities" rather than individual firms. Asset managers appear to have fended off so-called "systemically significant" designations for individual firms (at least by US regulators). The industry did so in part by urging regulators to focus on inspecting "activities" rather than firms. This report can be understood, at least in part, as a response from FSOC to that industry position.
  • Regulatory focus on the largest hedge funds. Regulators are likely to focus on the largest hedge funds and have already developed screens to identify these funds with data from SEC Form PF. This is implicitly phrased in the report as its most urgent area of inquiry and also is the aspect that has generated the most press coverage.
  • Intensified data collection. Regulators have two ways to address the information gaps that concern FSOC. One approach is to do more with existing data; for example, identifying which regulators have access to which kinds of data and doing more to synthesize and harmonize their different pools of data. The other approach is to simply request new data from regulated asset managers, their lenders, brokers, counterparties, etc.
    • Until new reporting rules are implemented (and presumably those are coming), any additional information presumably will have to be sought through some combination of mandatory, voluntary or semi-voluntary requests by regulators—who might act singly (e.g., the SEC only) or in groups (e.g., the SEC and Federal Reserve contact a firm together). That in turn suggests targeted information sweeps of large hedge funds or other asset managers and/or the banks and broker-dealers that act as lending, derivatives or trading counterparties.
    • Potentially, these sweeps could expand to derivatives clearinghouses and execution facilities.
    • One also should not assume that rulemaking or other activity in this area will be confined to one side of the industry (e.g., that regulators will be satisfied with hedge fund leverage data developed only from banks or only from funds). A multi-pronged effort that comes at the relevant information from different directions seems likely.
  • Application of bank regulatory themes to funds. A subtext to the report is a generalized concern that longstanding bank roles such as the provision of liquidity to markets and extensions of credit have "migrated" to less regulated funds. Liquidity, leverage, outsourcing and resolvability, themes in the report, are areas of keen interest to bank regulators post-financial crisis, so it is no surprise that they should be extended to funds here.
  • Political dynamics remain uncertain. FSOC speaks for a broad group of regulators with varying agendas, interests and roles as relate to the asset management industry.
    • As an illustration of potentially differing views, the SEC press release accompanying the FSOC report reads as guarded. Chair White pointedly recites the agency's mantra that the SEC is the "primary regulator" in this sphere and goes on to say that: "Today's FSOC update should not be read as an indication of the direction that the SEC's final asset management rules may take."
    • Congress, under Republican leadership, generally has been skeptical of FSOC's asset management initiatives.

Summary of the Report

FSOC's report on the asset management industry builds on a related 2014 roundtable and request for comment and is FSOC's most comprehensive statement in this area to date. Key sections from the report, which address perceived risks associated with (1) liquidity and redemption; (2) leverage; (3) operational considerations; (4) securities lending; and (5) winding down and liquidation, are summarized below.

  1. Liquidity and Redemption Risk

In its discussion of liquidity and redemption risk, FSOC points to pooled investment vehicles and the risk of so- called "liquidity mismatch," focusing in particular on mutual funds, which usually allow investors to redeem daily while holding (and thus potentially needing to sell to satisfy a redemption) somewhat longer-term assets. For these funds, FSOC is especially concerned that large redemptions may occur during a stress event, with the fund and its non-redeeming investors potentially bearing significant costs in selling assets.

As an example of liquidity mismatch, FSOC points to the closure of high-yield bond fund Third Avenue Focused Credit Fund, which was unable to meet redemptions in December 2015 and ultimately closed. The report suggests the fund's portfolio was somewhat anomalous (less liquid and more heavily invested in distressed assets than competitors). FSOC also acknowledges that other high-yield bond mutual funds met redemption requests despite widespread redemption and selling pressures. FSOC nonetheless suggests that had the distress spread and led to other fund closures, it could have driven broader market instability.

Given its concerns, FSOC proposes the following steps:5

  • Adopt liquidity risk management practices. Mutual funds, especially those in less-liquid assets, should adopt risk management practices to reduce the risk of not being able to meet redemptions during stress events;
  • Establish regulatory guidelines on liquidity. FSOC suggests the establishment of regulatory guidelines addressing limits on mutual funds' ability to hold assets with very limited liquidity;
  • Enhance reporting and disclosures on liquidity. FSOC proposes enhanced reporting and disclosures by mutual funds of their liquidity profiles and risk management practices;
  • Allocate redemption costs to redeeming investors. Regulators should assess how mutual funds could allocate redemption costs to investors who redeem shares. FSOC believes allocating redemption costs in this way could reduce redemptions and the potential for widespread sales of less-liquid assets during stress events;
  • Disclose external sources of financing to the public. FSOC supports public disclosure and analysis of external sources of financing (e.g., lines of credit and interfund lending), including events that trigger use of external financing. FSOC is concerned that draws on financing could create liquidity stress for broader markets; and
  • Consider other pooled investment vehicles. Regulators should consider whether the above suggestions or other measures should be implemented for similar vehicles with daily redemptions (e.g., bank collective funds).

Footnotes

1 The full FSOC report is available at https://www.treasury.gov/initiatives/fsoc/news/Documents/ FSOC%20Update%20on%20Review%20of%20Asset%20Management%20Products%20and%20Activities.pdf

2 The regulators are listed as they appear in Treasury's FSOC FAQ, which is available at https://www.treasury.gov/initiatives/fsoc/about/Pages/default.aspx. In addition to the Council's ten voting members, there are five non-voting members who serve in an advisory capacity.

3 The Turner Review was a report produced by the Financial Services Authority in 2009 under the leadership of Lord Turner who chaired the FSA at the time. The FSA has since been split into the Financial Conduct Authority and the Prudential Regulation Authority. 4 The FSB announcement, made in March 2016, is available here.

5 These proposals will be familiar to the mutual fund industry as they track pending SEC liquidity rules for mutual funds. Shearman & Sterling's summary of those proposals is available at http://www.shearman.com/en/newsinsights/publications/2015/10/liquidity-of-mutual-fund-portfolios.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Barnabas W.B. Reynolds
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.