Systemic Risk: A regulatory priority

Evolving Asset Management Regulation 2022

Liquidity management in open-ended funds (OEFs) remains high on the regulatory agenda. Analysis of the repercussions of the March 2020 "dash for cash" for OEFs in general, and for money market funds (MMFs) in particular, is concluding at international level, but national regulators continue to consider their response. Russia's invasion of Ukraine has introduced new challenges in capital markets, which has caused regulators to adjust their priorities.

Policymakers are concerned more broadly about stability and transparency in the capital markets, fair treatment of investors and market conduct. Asset managers will be impacted by reforms to trading and clearing arrangements. They will need to ensure appropriate dealing arrangements are in place for their clients.

Key questions for firms

Have we critically analyzed our experience during the 2020 market stress and reassessed our liquidity risk management framework for each fund?
Do our policies, controls, governance arrangements and documentation regarding fund liquidity management need to be augmented to ensure they continue to meet regulatory expectations?
Have we thoroughly analyzed and considered all the factors arising from the war in Ukraine in the context of our portfolio holdings and application of liquidity management tools?
Are we tracking regulatory developments regarding trading, settlement and clearing, and implementing changes as needed?

In the detail

The Financial Stability Board (FSB) has prioritized potential financial stability issues arising from the war in Ukraine. ESMA's¹ June 2022 report on trends, risks and vulnerabilities noted significant asset repricing, sharp jumps in commodity prices, and increased inflationary pressures. ESMA had already warned about liquidity concerns for alternative investment funds (AIFs).

While MMF reform has progressed quickly, OEFs more broadly have been subject to a longer debate — reviews by the FSB and IOSCO² are due to conclude this year, but outcomes are uncertain. Central banks and securities regulators will need to reach agreement on the nature and scale of vulnerabilities arising from liquidity mismatch to reach a policy conclusion. New analyses and commentary continue to emerge. The regulation of exchange-traded funds (ETFs) has also been revisited by IOSCO, but no fundamental changes have been proposed. Existing recommendations have been complimented with proposed good practices.

Reforming Money Market Funds

In October 2021, the FSB set out a policy framework to enhance MMF resilience, calling on regulators to assess and address vulnerabilities in their jurisdictions. The IMF³ set out its own policy considerations a month earlier, including better aligning investors' incentives, strengthening MMF risk management and addressing "market frictions" in short-term funding markets.

Various jurisdictions have begun to consult on proposed reforms, including in the US, the EU and the UK. Reform options are largely aligned across jurisdictions and with the FSB's proposals. The potential changes would seek to reduce so-called "threshold effects" resulting from MMFs breaching liquidity limits (and therefore implementing liquidity fees, gates or suspensions), and to require or facilitate the use of liquidity management tools (LMTs), including "swing pricing". The reforms also seek to amend MMF reporting requirements and stress testing frameworks. In the meantime, authorities continue to adjust existing approaches. For example, ESMA revised its guidelines regarding stress test scenarios for EU MMFs.

A wider focus on open-ended funds

The analysis of the March 2020 events on OEFs more generally, and the corresponding policy response, is expected to conclude shortly.

In November 2021, the FSB's Non-Bank Financial Intermediation (NBFI) progress report found that vulnerabilities can arise from liquidity mismatch in OEFs, that LMTs were used inconsistently, and that OEFs' asset sales contributed to stress in underlying markets. In parallel, the IMF proposed expanding the availability of LMTs and noted the benefits of swing pricing. It also suggested that a conclusive move away from daily liquidity for funds investing in illiquid assets would be beneficial, and that enhanced reporting and disclosure on OEF liquidity is "vital".

More recently, in April 2022, a joint FSB/IMF report on US dollar funding and emerging market economy vulnerabilities found that during the "dash for cash", some fixed income emerging market funds invested in less-liquid assets experienced large outflows, and that the behavior of fund managers may have added to selling pressures. It also found that emerging market funds made extensive use of swing pricing.

The remainder of 2022 will be critical in deciding the policy direction. IOSCO and the FSB are reviewing the implementation and effectiveness of their earlier recommendations. In the meantime, central banks and securities regulators have reiterated their expectations, conducted their own analyzes and set out their own proposals:

The French regulator has proposed measures to promote a wider adoption of liquidity management tools.
As part of the EU AIFMD⁴ review, the European Commission proposed harmonizing the availability of LMTs for UCITS⁵ and AIFs.
The Maltese regulator found that liquidity risk in the retail investment fund industry remains contained, with most funds capable of withstanding extreme redemption requests.
From January 2022, the Japanese regulator introduced new liquidity criteria for the classification of assets and new requirements for stress testing.
The Spanish regulator published a technical guide for fund managers, covering policies and procedures, fund design and pre-investment analysis, liquidity analysis and control, and LMTs.
New Swiss requirements entered into force from January 2022. Fund managers are now required to review liquidity risks and other material risks at regular intervals under various scenarios and document the results. Dedicated liquidity thresholds need to be defined for each fund.
The UK regulators proposed a framework to enhance swing pricing and to improve asset-side liquidity classification.
The CBI consulted (PDF 801 KB) on macroprudential measures for Irish property funds. The proposals would introduce leverage limits and additional guidance to align funds' redemption terms more closely with the liquidity of their assets.

Importantly, regulators' ongoing focus is not limited to the policy space. ESMA's supervisory engagement found "room for improvement" and the need for continued monitoring on liquidity stress testing and the valuation of less liquid assets. In Sweden, the regulator has analyzed the need for additional LMTs and plans to test how well prepared the fund sector is for a future crisis. The Maltese regulator also plans to incorporate liquidity risk management into its supervisory engagements. And in the Netherlands, fund liquidity management has been identified as an important area of supervisory focus in the regulator's latest forward-looking agenda.

Regulators are also reviewing how asset managers value the assets held by their funds. IOSCO plans to conduct exploratory work on fund valuations in 2022, looking at situations where fund managers fair value securities if reliable market practices are not available. ESMA launched a "common supervisory action" in January 2022 to examine EU fund managers' approach to valuing less liquid assets.

Impact of the war in Ukraine

As well as the terrible humanitarian impact of Russia's invasion of Ukraine, the war has had consequences for financial markets and the real economy. In the fund management space, in addition to navigating increased volatility in the capital markets, there are challenges for funds with exposures in the region that have become illiquid, hard to value or subject to sanctions.

Various regulators have set out their expectations and potential new rules. For example:

The UK regulator issued new rules allowing the use of side pockets under limited, emergency measures.
The Luxembourg regulator provided clarification regarding temporary and structural measures available to fund managers, including the use of LMTs.
The French regulator reminded asset managers of their obligations regarding risk management, and that they have LMTs to protect clients' interests, as well as to ensure financial stability and guarantee market integrity.
ESMA promoted convergence in the way that EU fund managers and regulators respond to the crisis, to provide clarity and to remind fund managers of their obligations. ESMA concluded that AIF managers can consider using side pockets where it is in the best interest of investors, and that side pockets in UCITS "could be permissible".
The CBI emphasized that the liquidity position of Irish funds must be reviewed on an ongoing basis and be aligned with the fund's redemption policy, and an appropriate suite of LMTs should be deployed. It permits the creation of side pockets in UCITS under certain circumstances and established a streamlined authorization and approval process.
In the US, certain funds with high concentration of exposures to Russia have been provided regulatory relief to suspend redemptions in order for such funds to accomplish an orderly wind down.

Some regulators are also looking to strengthen ties in the light of recent events. For example, in June 2022, the Spanish and Ukrainian regulators signed a memorandum of understanding on mutual assistance and co-operation.

Reporting to regulators increases

Regulators continue to consider whether they have the appropriate data to supervise funds and their managers. In November 2021, the FSB noted the lack of sufficient data to analyze the impact of liquidity mismatch on redemptions. Subsequently, in June 2022, the FSB and IMF announced they had completed the second phase of a G20 initiative to close data gaps identified in the global financial crisis. They noted that challenges remain for some countries regarding non-bank cross-border exposures. Meanwhile, IOSCO has expanded its regular hedge fund survey publication to include other open-ended and closed-ended funds, capturing an estimated 67 percent of the global investment fund universe.

The SEC⁶ has identified US private funds as being a 2022 examination priority. Having identified "significant information gaps", it consulted on enhancements to reporting by private funds. The proposals would require hedge fund and private equity fund managers to notify the SEC of relevant reporting events within one business day, would decrease the reporting threshold for large private equity advisers from USD 2 billion to USD 1.5 billion funds under management (FUM), and would require more information from larger funds regarding their strategy, use of leverage and other matters. The SEC's intention is to improve its ability to assess systemic risk and its oversight of private fund advisers, given recent growth in the industry.

The Monetary Authority of Singapore (MAS) set out its reporting requirements in cases of significant redemptions, gating or suspension of funds. Fund managers now need to notify the MAS if aggregate net redemptions exceed 10 percent of a fund's FUM in a calendar week or exceed five percent of FUM in any given dealing day. The MAS also plans to introduce a standardized fund gating and suspension report to ensure consistency of reporting.

The Luxembourg regulator (CSSF)⁷ requested fund managers notify it of significant developments and issues in the context of the Ukraine crisis. Notifications are required if a fund's net redemptions exceed five percent of a fund's net asset value (NAV) on any day, 15 percent of NAV over a calendar week, or if gates or deferred redemptions are applied. The CBI updated its reporting requirements for Irish MMFs and clarified aspects of its new "Fund Profile V2 return" and reporting requirements for authorized funds. It has also called for regulatory reporting of market risks under AIFMD to be reviewed.

Demands for transparency

In April 2022, IOSCO published (PDF 301 KB) a report on equity market data and noted three considerations for regulators: the importance of considering pre- and post-trade in promoting transparency; the need to ensure fair access to market data; and that consolidating data has the potential to reduce costs and help identify liquidity and compare execution quality.

In Europe, both the EU and the UK have been reviewing their rules under the Markets in Financial Instruments Directive and Regulation (MiFID II and MiFIR). Overall, the proposed changes attempt to improve the existing requirements rather than significant change. There is some consistency between the EU and the UK approaches, for example:

Asset managers are now allowed to pay for research on certain small and medium-sized companies using their clients' money (the regulators having previously "unbundled" commissions and prohibited such practices).
The EU is moving to a full ban on payment for order flow to improve best execution.
Both are seeking to improve conditions to establish a "consolidated tape" with securities price and volume data to increase price transparency and competition between trading venues.
Both are aligning the derivatives trading obligation with the clearing obligation, so that derivatives that must be traded on exchange must also be centrally cleared.

But there is also divergence in some areas. For example, the EU is changing the "double volume cap" (a limit on the level of "dark trading" to a certain proportion of total trading in an equity) to a single volume cap, which would further limit dark trading, and amending best execution reporting. On the other hand, the UK will completely revoke the double volume cap, best execution reporting and the requirement for equities to be traded on a restricted list of venues.

In the meantime, EU national regulators' expectations have continued to evolve. For example, the Belgian regulator will no longer separately request aggregated transaction data and will instead rely on MiFIR transaction reporting.

The US SEC has proposed increasing the availability of information regarding securities lending transactions to improve access to fair, accurate and timely information. Securities lenders would be required to provide details of transactions to a registered national securities association, which would then make the terms available to the public.

The EU Short Selling Regulation was originally introduced to increase transparency of short positions and reduce settlement risk. In 2022, ESMA analyzed short selling bans adopted during the pandemic and proposed amendments to the operation of emergency measures (for example, long and short-term selling bans), enhanced record keeping requirements, and a new centralized system for the publication and disclosure to the public of net short positions. Separately, ESMA proposed a three-year postponement of the mandatory "buy-in" regime under the Central Securities Depositories Regulation, which would come into play where a transaction fails to settle and would give buyers more flexibility and rights to compensation payments.

The French AMF⁸ completed a series of thematic inspections regarding best execution. It requested that asset managers review policies and procedures governing best execution, improve their monitoring of execution quality and strengthen internal control systems. Best execution is also a regulatory theme in Singapore, where the MAS's new requirements became effective in March 2022. The new rules require asset managers to have policies and procedures in place to ensure best execution, and enhanced existing business conduct requirements relating to handling customers' orders.

Derivatives and clearing

IOSCO and banking authorities continue to roll out margin requirements for non-centrally cleared derivatives. From September 2022, funds that have an aggregate average notional amount of non-centrally cleared derivatives greater than EUR 8 billion came under the rules for the first time. They now need to exchange initial margin on uncleared OTC⁹ derivatives contracts.

As part of a program to increase the scope of regulation and to promote investor protection, the Chinese authorities introduced various changes that impact the structure of derivatives markets and market participants. New requirements relate to investor suitability, risk disclosure, controls and transaction reporting. The revised approach will centralize supervision of China's national futures market and allow for cross-border futures trading for the first time. The requirements relating to total return swap transactions have also been updated and broadened.

In February 2022, the European Commission extended EU temporary equivalence for UK central counterparties (CCPs) until June 2025, providing certainty to market participants. At the same time, the Commission consulted on ways to expand central clearing activities in the EU and improve the attractiveness of EU CCPs, to reduce over-reliance on systemic third-country CCPs. In April 2022, the Commission recognized certain US exchanges supervised by the SEC as equivalent to EU regulated markets (allowing derivatives traded on these exchanges to be treated as exchange-traded under EU law) and amended its previous equivalence decision for US CCPs to cover certain additional products.

The Canadian regulators proposed amendments to streamline and harmonize OTC derivatives data reporting standards. The amendments could reduce complexity and costs while improving the consistency and quality of data available to regulators.

Regulating crypto markets

Policymakers across the world are introducing enhanced regulatory frameworks for the classification, issuance, trading and custody of crypto-assets, including the development of crypto securities registers. Central banks are considering the prospect of central bank digital currencies (CBDCs).

For the first time, IOSCO has published a roadmap (PDF 269 KB) to prioritize work on crypto-assets to address potential investor protection, market integrity and financial stability issues, with findings expected in Q4 2023. The first workstream will assess emerging risks around crypto-assets and the different legal and regulatory considerations in each jurisdiction. The second will focus on decentralized finance. It will develop a shared understanding among IOSCO members of emerging risks and trends and how to manage them, produce potential guidance for members, and consider how existing IOSCO principles and standards could be applied.

The FSB also published a statement emphasizing that crypto-assets must be subject to effective regulation, service providers need to comply with their legal obligations, and ongoing international work must be progressed. The FSB considers that "stablecoins" (asset-backed crypto-assets) should be captured by robust regulations and supervision if they are to be widely adopted as a means of payment.

Meanwhile, national regulators have expanded, or are proposing to expand, their regulatory perimeter and oversight. For example:

Australia has consulted on new requirements regarding the classification of crypto-assets, and licensing and custody requirements. In addition, the regulators released guidance for product issuers and market operators regarding exchange traded-products, an information sheet to help firms understand their obligations under existing requirements (clarifying that firms need to hold an authorization in relation to crypto-assets), and set out expectations regarding risk management and a policy roadmap.
Crypto service providers are now subject to enhanced regulation in Cyprus. They are required to register with the regulator and comply with capital and governance requirements.
Amendments to Swiss laws on crypto and distributed leger technology (DLT) require the regulation of custody/storage of crypto-assets and trading facilities. This offers opportunities for financial intermediaries, which can provide these services without the need for a separate license. Other impacts on regulation enter into force gradually throughout 2022.
A new German law introduced the management of cryptocurrency securities registers as a new financial service, which requires a license from the regulator.
Guernsey approved a new law on lending, credit and finance that covers virtual asset service providers, which comes into force by end-2022. Firms will have to be licensed by the regulator.
The UK intends to bring activities that issue or facilitate the use of stablecoins used as a means of payment into the UK regulatory perimeter.

Provisional agreement has been reached on the EU's proposals to regulate crypto-asset markets and the issuers of stablecoins. The proposed regulation — known as MiCA — aims to clarify the application of existing EU rules to crypto-assets and introduce a new, harmonized legal framework for crypto-assets covered by existing rules. The EU has also finalized a pilot regime that sets out conditions to operate a DLT-based market infrastructure, defines which financial instruments can be traded within the pilot and details the cooperation between DLT market infrastructure operators, regulators and ESMA.

The US regulators continue to scrutinize the practices of investment advisers and commodity pool operators in relation to crypto-assets, and are actively engaged in enforcement where they believe such activities are inconsistent with the law or regulations.

Supervising market conduct

Supervisors continue to focus on improving market conduct. In July 2021, the Central Bank of Ireland published a review of market abuse risks, setting out findings and expectations. The review identified some good practices but also areas that should be significantly improved. These included trade surveillance and suspicious transaction reporting frameworks, timely public disclosure of inside information, the quality of insider lists, and staff awareness and training. In the Netherlands, the regulator has identified the prevention of market abuse as a priority in its 2022 agenda and plans to focus on improving the quality of suspicious transaction and order reports.