Early this year, the Financial Stability Board (FSB)1 and the International Organization of Securities Commissions (IOSCO)2 issued a Consultative Document regarding Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions (the "Consultation"). The Consultation would include asset managers and investment funds among the potential global systemically important financial institutions (generally referred to as "G-SIFIs," with G-SIFIs that are not banks, insurance companies or subsidiaries of banks or insurance companies referred to as "NBNI G-SIFIs"). We found the Consultation’s discussion of the possible global systemic risks posed by asset management firms confusing, but think this is an improvement over last year’s report by the Office of Financial Research on Asset Management and Financial Stability (the "OFR Report"), which engaged in purely speculative assessments that ignored fundamental characteristics of the asset management business.
Confused thinking may eventually lead to sound conclusions if we can identify the sources of confusion. This Client Alert discusses some aspects of the Consultation that we found most confusing with respect to the proposed assessment of asset managers and investment funds. It is not exhaustive, but may aid clients interested in commenting on the Consultation (comments are due by April 7, 2014) in formulating and organizing their thoughts.
This Alert does not provide a complete summary of the Consultation, as much of it does not relate to asset managers or investment funds. A brief discussion of the Consultation is necessary, however, before proceeding to our analysis. Clients are encouraged to review the Consultation in its entirety before reading this Alert.
The Consultation is a step in the FSB’s continuing process to identify "institutions whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the wider financial system and economic activity."3 FSB proposed a general framework for reducing the systemic risk of G-SIFIs in 2010, and in July 2013 adopted methodologies for banks and insurance companies.4 The Consultation proposes specific assessment methodologies for three types of NBNI G-SIFIs: finance companies, market intermediaries and investment funds. The Consultation also includes a cursory "back-stop" methodology for any NBNI G-SIFIs that might not fall under these three categories.
The Consultation supposes:
There are three channels whereby financial distress of an NBNI financial entity is most likely to be transmitted to other financial firms and markets, and thereby pose a threat to global financial stability. These three channels are: (i) the exposures of creditors, counterparties, investors, and other market participants to the NBNI financial entity (exposures/counterparty channel); (ii) the liquidation of assets by the NBNI financial entity, which could trigger a decrease in asset prices and thereby could significantly disrupt trading or funding in key financial markets or cause significant losses or funding problems for other firms with similar holdings (asset liquidation/market channel); and (iii) the inability or unwillingness of the NBNI financial entity to provide a critical function or service relied upon by market participants or clients (e.g. borrowers) and for which there are no ready substitutes (critical function or service/substitutability).5
The first two of these channels correspond to the "transmission channels" for financial distress identified in the OFR Report.6
Should Asset Managers Be Treated as Market Intermediaries or Investment Funds?
A superficial look at the Consultation might suggest that the proposed assessment methodologies would not apply to asset managers. Asset managers clearly are not finance companies. Asset managers are not typically referred to as market intermediaries, and the Consultation’s consistent insertion of "(securities broker-dealers)" after the term "market intermediaries" creates an impression that the assessment methodologies are limited to broker-dealers. The discussion of investment funds also acknowledges various considerations that "distinguish the risk profile of a fund from that of a fund manager."7
Such a superficial reading is clearly incorrect. First, the Consultation explicitly requests comments on whether FSB/IOSCO should broaden the scope of the investment funds methodology to include, in the alternative:
i. Families of funds, defined as funds with similar investment strategies managed by the same asset manager;
ii. Asset managers on a stand-alone basis; or
iii. Asset managers and their funds collectively.
The Consultation also suggests defining families of funds based on common investment strategies rather than sharing a common asset manager, or assessing unspecified "asset management-related activities" rather than entities.
Second, and less obviously, the list of activities in which market intermediaries may engage includes: "Providing advice regarding the value of securities or the advisability of investing in, purchasing or selling securities."8 This essentially is the definition of an investment adviser in the U.S.9 In other words, the Consultation proposes to treat asset managers as market intermediaries unless the FSB adopts an alternative approach that would assess asset managers in conjunction with investment funds. To further confuse matters, after claiming that "‘Market intermediaries’ generally include NBNI financial entities that are in the business of managing individual portfolios," the Consultation notes that "entities that some jurisdictions consider as ‘portfolio managers’ might more appropriately be assessed for systemic risk purposes under the methodology for asset management entities."10 This suggests that assessment of whether assets managers should be considered NBNI G-SIFIs might vary by jurisdiction, which seems contrary to the notion of a "global" SIFI.
We would suggest that the FSB’s confusion over whether to assess asset managers as market intermediaries, in combination with their investment funds or on a stand-alone basis reflects a failure carefully to reflect on the relationship between asset managers and the supposed transmission channels of financial distress. The Consultation shares this lapse with the OFR Report. For example, why would the exposure of "creditors, counterparties, investors, and other market participants to" an asset manager create a greater systemic threat to the global financial system than, say, exposure to an automobile manufacturer? Unlike a bank, insurance company or hedge fund, leverage incurred by an asset manager might be used to fund its operations, not the investment portfolio that it manages. Moreover, if "the assets of a fund are separated and distinct from those of the asset manager," as the Consultation acknowledges,11 why would the liquidation of the asset manager’s proprietary assets pose a greater systemic risk than any other type of investor? If the potential systemic risk would stem from the, typically, much larger amount of assets under management, what would be gained by lumping the asset manager’s proprietary assets together with the assets held by the investment funds it manages? The Consultation does not grapple with these questions.
Should Open-End, Closed-End and Hedge Funds Be Lumped Together Under One Assessment Methodology?
The proposed method of assessing investment funds:
is designed to cover "collective investment schemes (CIS)", including authorised/registered open-end schemes that redeem their units or shares (whether on a continuous or periodic basis), as well as closed-end ones.… [T]he methodology would therefore cover disparate fund categories, from common mutual funds (including sub-categories thereof such as money market funds (MMFs) and exchange-traded funds (ETFs)) to private funds (including hedge funds, private equity funds and venture capital).12
The Consultation recognizes one essential characteristic of these funds: that their shareholders are not "exposed" in the same sense as creditors and counterparties.
[F]rom a purely systemic perspective, funds contain a specific "shock absorber" feature that differentiates them from banks. In particular, fund investors absorb the negative effects that might be caused by the distress or even the default of a fund, thereby mitigating the eventual contagion effects in the broader financial system.13
Apart from a general definition of a "hedge fund,"14 however, the Consultation does not discuss the structural differences of various types of investment funds and, thus, does not consider the relationship between their structure and the "channels" by which financial distress might be transmitted to the financial markets.
An unleveraged closed-end fund, for example, has no "exposures" that might be affected by the fund’s financial distress and could not be forced by shareholder redemptions to liquidate assets. Indeed, it would be hard to imagine how such an investment fund could ever be in financial distress. The same could be said of an ETF that only redeemed its creation units in-kind. Thus, the presence or absence of a right to cash redemptions might be an important factor in assessing the systemic risks of investment funds overlooked by the Consultation.
Even a right to cash redemptions does not necessarily give rise to a risk of asset liquidation. The Consultation acknowledges "asset managers may temporarily implement specific liquidity management tools such as swing pricing, anti-dilution levies, redemption gates, side-pockets, redemptions in kind or temporary suspensions."15 For example, many investment funds organized under the EU UCITS Directive have the right to limit redemptions on any day to ten percent of the total shares in issue. None of the proposed assessment methodologies refers to these "tools." Perhaps they should be considered in determining the ratio of portfolio liquidity to investor liquidity proposed as Indicator 4-4.
Having acknowledged, "the very different nature of funds’ risk profiles when compared with those of other financial entities,"16 we find it puzzling that the proposed assessment methodologies would ignore differences in the nature of various investment funds. Were their natures properly taken in to account, we doubt that most investment funds would be considered G-SIFIs, regardless of their size or activities.
Can Investment Funds Provide a Critical Function or Service?
Like the OFR Report, the Consultation initially identifies exposure and asset liquidation as the only transmission channels applicable to investment funds. The Consultation goes so far as to note:
funds close (and are launched) on a regular basis with negligible or no market impact. In other words, the investment fund industry is highly competitive with numerous substitutes existing for most investment fund strategies (funds are highly substitutable).17
The Consultation nevertheless proposes three Indicators under the heading "Substitutability." The Consultation explains, "some funds are highly specialised and invest in thinly traded markets. In order to assess the substitutability of these funds, the following indicators are proposed that focus on the fund’s (i) trading turnover related to a specific asset and (ii) its trading activity relative to its peers."18
We find by this rationale confusing in at least two ways. First, is making an investment "a critical function or service," which is the core of the Consultation’s definition of substitutability? Secondary market trading in an asset does not provide a service to the issuer the asset. Nor do we typically think of one party to a secondary market trade providing a service to the other party, except where a party is acting as an intermediary for the trade, which should be covered in the assessment methodologies for market intermediaries. We do not find it intuitive to treat an investment fund as a service provider (other than to its shareholders) simply because it trades in a thinly traded market.
Second, how could trading a specific asset result in systemic financial risk unless the asset is systemically important itself? The fact that few market participants trade a low volume of a specific asset would seem to belie any systemic significance. The proposed Indicators do not require, however, any assessment of the systemic importance of the specific asset under consideration.
The Financial Times has reported, "BlackRock, Fidelity, PIMCO, and Vanguard were summoned to meet global regulators in London … to discuss whether large asset managers should be considered as [G-SIFIs]."19 We hope that these discussions addressed some of the confusing issues identified in this Client Alert. It would be helpful for FSB and IOSCO to supplement their analysis of the assessment methodologies to discuss in greater depth the relationship between the "transmission channels" of financial distress and the operation of asset managers and their funds. Certainly, any further research by OFR or other systemic-risk oversight organizations should focus on this relationship and seriously consider the possibility that many investment funds and their managers cannot pose any systemic risk to the global financial system, regardless of their size.
1. The G20 established the FSB "to coordinate at the international level the work of national financial authorities and international standard setting bodies and to develop and promote the implementation of effective regulatory, supervisory and other financial sector policies." http://www.financialstabilityboard.org/about/overview.htm.
2. As its name implies, IOSCO is an international organization composed of securities regulators. http://www.iosco.org/about.
3. Consultation at 1.
4. Consultation at note 3.
5. Consultation at 3.
6. "Asset managers could transmit risks across the financial system through two primary channels: (1) Exposure of creditors, counterparties, investors, or other market participants to an asset manager or asset management activity, and (2) disruptions to financial markets caused by fire sales." OFR Report at 21.
7. Consultation at 30.
8. Consultation at 21.
9. "‘Investment adviser’ means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities …." 15 U.S.C. § 80b-2(a)(11).
10. Consultation at 21 and n. 24.
11. Consultation at 30.
12. Consultation at 28.
13. Consultation at 29.
14. "The following are the characteristics that in combination may indicate the presence of a hedge fund: (a) use of leverage; (b) performance fees based on unrealised gains; (c) complex strategies, which may include use of derivatives, short selling, high frequency trading and/or the search for absolute returns; and (d) tendency to invest in financial rather than physical assets." Consultation at 28, n. 35.
15. Consultation at 30.
16. Consultation at 29.
17. Consultation at 30.
18. Consultation at 34.
19. Chris Flood, Big Four Fund Groups Summoned to Talks over Size, Financial Times (Feb. 16, 2014).