United States: Possible Worlds Versus Probable Worlds − The Metaphysics Of Systemic Risk: FSOC Revisits Asset Managers

On April 18, 2016, the Financial Stability Oversight Council (FSOC) again warned that asset managers present systemic risk to financial stability in five key areas:

  • liquidity and redemptions;
  • leverage;
  • operational functions;
  • securities lending; and
  • resolvability and transition planning.

In a 27-page statement, FSOC detailed its concerns and how regulators should respond to those risks.

In response, SEC Chair Mary Jo White, who also serves as a member of FSOC, said she supported FSOC's efforts, which she characterized as "complementary" to the SEC's current regulatory initiatives. She noted that the SEC evaluates systemic risks in reliance on its own studies by its Division of Economic and Risk Analysis (DERA) and has responded with its own rule proposals independent of FSOC's analysis. "Today's FSOC update thus should not be read as an indication of the direction that the SEC's final asset management rules may take," she said in a public statement.

FSOC's paper updates its review of potential risks to financial stability "from certain asset management products and services," including hedge funds, registered investment companies, collective investment funds and commodity pools. It follows a controversial Office of Financial Research (OFR) study on "Asset Management and Financial Stability," published in September 2013, and FSOC's Notice Seeking Comment on Asset Management Products and Activities, published on Dec. 24, 2014.

FSOC maintains that its review, consistent with its Dodd-Frank mandate, focuses on "identifying potential risks to financial stability, rather than investment risk." The review, it says, seeks to assess whether asset management products or activities "could create, amplify or transmit risk more broadly in the financial system in ways that could affect U.S. financial stability."

We summarize FSOC's five areas of focus here, primarily as they affect private funds and registered investment companies.


Mutual funds. FSOC notes that mutual funds, in particular, create "liquidity transformation" because they offer daily liquidity while investing in less-liquid assets. During a "stress event," illiquid assets held by mutual funds may fall rapidly when shareholders redeem large amounts of their holdings. This daily liquidity thus creates "first-mover advantage" when remaining shareholders bear the bulk of the risks because funds sell more liquid assets to pay off early redeemers.

This risk is particularly acute for mutual fund investors, FSOC says, because transaction costs associated with meeting redemptions generally are passed on to remaining investors. While mutual funds may not invest more than 15 percent of their assets in illiquid securities, this limit "does not take into account the size of a fund's position or potentially lengthy settlement times, which could delay a fund's ability to convert securities into cash," and may also invest in less-liquid securities that are not subject to this limit. FSOC is also focusing on whether fund borrowings through lines of credit or inter-fund lending could transmit liquidity stress to other entities or markets during times of market stress.

ETFs. Exchange-traded funds (ETFs) are not subject to the same types of liquidity risks, FSOC said, because generally they redeem in kind. But, FSOC cautioned, ETF arbitrage mechanisms may "break down in times of severe market stress," in which case bid-ask spreads may widen, creating a divergence between ETF share prices and net asset values.

Hedge funds. FSOC noted that hedge funds restrict investors' ability to redeem and thus are not subject to the same kinds of liquidity risks that mutual funds experience. But, during times of stress, hedge funds may experience liquidity issues when they are forced to sell illiquid assets.

FSOC's views. Among other things, FSOC believes that mutual funds should adopt "robust liquidity risk management practices" and guidelines for limiting investment in illiquid securities, coupled with enhanced reporting and steps to remove "first-mover advantages."


Hedge funds. FSOC helpfully notes that leverage involves risk because it can magnify potential direct or indirect losses. These risks "may have implications for U.S. financial stability." The relationship between a hedge fund's level of leverage, and the potential financial stability implications "is highly complex." While FSOC has found available data contained in Form PF are helpful, it believes that available information is not adequate to fully asses these risks and potential mitigants.

Mutual funds and ETFs. FSOC notes that some "alternative strategy funds," particularly highly leveraged funds do not represent a large part of total assets under management but have experienced significant growth and have received "a disproportionate share of industry net inflows."

FSOC's views. Citing "a need for further analysis," FSOC is creating an interagency working group to analyze and better understand whether hedge funds pose potential risks to financial stability. FSOC "welcomes the SEC's efforts to limit the amount of leverage that registered investment companies" can use through derivatives and will monitor the effects of the SEC's regulatory changes.


FSOC is concerned that a disruption or failure of a large service provider could transmit risk to the broader financial system. Reliance on technology by the asset management industry "calls for greater understanding of potential risks."


FSOC believes that reinvestment of cash collateral by securities lenders (generally excluding mutual funds) creates a potential risk to financial stability. FSOC "encourages enhanced and regular data collection and reporting" in this area.


FSOC believes that "the rapid failure or closure of a large, global asset manager," particularly during times of market stress, could create potential challenges and risks to financial stability. FSOC welcomes the SEC's efforts to propose a rule to address transition planning.


The Dodd-Frank Act created FSOC to identify and control systemic risks to the U.S. financial system. But the Dodd-Frank Act does not clearly define systemic risk, and FSOC has not addressed this uncertainty.

While an ongoing analysis of systemic risks is important to the stability of the U.S. financial system, FSOC should distinguish between analysis and recommendations for action. That is, it is not useful to discuss the possibilities of what could happen without discussing the probability that those events may occur.

Thus, FSOC should determine the likelihood that a destabilizing event will occur before it recommends actions to correct those events. Without this determination, FSOC will require the financial system to undertake changes that could be costly and which could even increase, rather than decrease, the likelihood of destabilization.

Nowhere is this dilemma more evident that in the area of asset management. It should come as no surprise that the SEC's recent regulatory initiatives address FSOC's enumerated concerns about potential risks to financial stability. The SEC's proposed rules and statements concerning liquidity risk management, limits on investment company use of derivatives, enhanced reporting by private fund advisers, and transition planning appear designed to head off potential regulation from empowered bank regulators who are not as well positioned as the SEC to regulate those risks.

The SEC appears to be gradually shifting toward prudential regulation in response to pressure from FSOC.

On a positive note, the FSOC paper did not suggest that it should move toward regulating funds or asset managers as "systemically important financial institutions," or SIFIs. Perhaps this omission suggests that FSOC is moderating its approach and applying a kinder, gentler approach in the road to promoting financial stability, rather than wielding a club and insisting that everyone should be regulated as a bank. Or, more likely, it is simply reacting to the United States District Court's decision to overturn FSOC's decision to designate MetLife as a SIFI.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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.

In association with
Related Video
Up-coming Events Search
Font Size:
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
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
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.


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.


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.


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.


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.


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.


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.