What did Covid-19's financial markets upheaval tell us about regulating investment funds?

Keynote address by Greg Medcraft

Investment Company Institute Seminar, 25 May 2021

Ladies and gentlemen, it’s a pleasure to open today’s discussion, not least because, as a former investment banker, securities regulator and now international financial policy advisor at the OECD, it’s a world I’ve spent a lot of time in.

First and foremost I’d like to thank Eric Pan and the Investment Company Institute for convening us all and for extending an invitation to the OECD.

I’d like to frame today’s discussions with a few observations on:

1. The policy context around Non-Bank Financial Intermediation coming into the Covid-19 crisis;
2. Some of the major concerns as the pandemic began to weigh on financial markets last March; and
3. Where policy might be headed going forward.

I. The policy context coming into Covid-19

The Covid-19 pandemic struck at the tail end of a post-crisis period that saw considerable changes to the financial system. From a regulatory standpoint, the global financial crisis of 2008 was something of a reckoning for policymakers in terms of the scale and types of financial intermediation in their economies.

Non-bank financial intermediation was of particular concern, as shadow banking contributed to both the root causes of the crisis, the transmission of financial contagion, and the amplification of shocks – but really it was the exposure of banks to these risks and amplifications that policymakers were most focused on.

Post crisis reforms reflected this, centring around the Basel III regulatory framework which essentially sought to ensure bank capital and liquidity were closely monitored to help ensure banks remain solvent and funded even under severe stress – and the experience of the past 15 months have shown these to be largely successful.

We did of course see tighter rules around market-based finance, including investment funds, that mandate liquidity buffers and other practices to reduce the risks around asset and liability mismatch – but these were far less stringent than banking reforms.

From a structural standpoint, market-based finance has waxed while bank-based financing has waned – though banks obviously retain their central role in financing the economy.

As highlight in the OECD’s 2020 report Structural developments in global financial intermediation: The rise of debt and non-bank credit intermediation, the share of total assets in investments funds specifically has grown from 33 percent in 2008 to 40 per cent in 2018 – so it’s fair to say they play a more important structural role in financial markets than they did during the GFC.

II. Concerns coming into the pandemic

The first session today will cover the specific market dynamics during March, so I won’t go into technical details at this stage. Suffice to say that we know that demand for redemptions surged, and that this had an immediate impact on credit conditions to the real economy as borrowing costs spiked, particularly for short-term credit.

We also know that many of the backstops built into investment funds were triggered, but that policymakers were also sufficiently concerned to launch considerable interventions, for example through the Federal Reserve’s Money Market Mutual Fund Liquidity Facility, to calm markets.

This was a necessary move and part of a policy package that almost certainly averted a full-blown financial crisis. But the use of public institutions’ balance sheets to backstop private markets is guaranteed to prompt reflection on whether the current rules in place provide for sufficient resilience in times of stress to prevent moral hazard – and that’s where we’re at today.

III. Where is policy headed?

As many of you know, national and international regulators, from the FSB to the SEC and ESMA, are currently looking into whether the rules and practices in place today are sufficient to avert crisis and financial contagion in the future.

In answering this question, it’s useful to recognise from a starting point that market-based finance is very good at price discovery and so reacts more quickly to negative news. A big question is whether this is efficiency or vulnerability.

This will be an ongoing debate, and exchanges such is this one organised by ICI today will be important as the discourse develops – and I’m pleased to see members of the OECD’s financial markets and capital markets policy communities here today.

In the meantime I want to offer a four observations.

First, that sufficient liquidity buffers in investment funds and other collective investment vehicles are already and will continue to be very useful precautionary measures, particularly where funds are investing in less liquid markets – and that there is scope to reiterate this and strengthen guidance domestically and internationally with respect to liquidity risk practices of regulated funds.

Second, that the FSB/IOSCO Principles of Liquidity Risk Management for Collective Investment Schemes, which were launched in 2018 as a final piece of the post-GFC crisis response, may not have been fully operationalised across jurisdictions.

This is an important tool to ensure that open-ended funds have sufficient liquidity available to meet the kinds of unexpected redemptions we saw in the early days of the pandemic, and we need to make sure it is being fully leveraged.

To this end, IOSCO launched a thematic review in March this year to assess implementation of the recommendation in both regulatory frameworks and in the actual practices of responsible entities.

I should say also that there is still room for market regulators to clarify the appropriate use of gates and suspensions of fund redemptions, so as to reduce the potential for runs – and we should also reflect on whether these important safeguards are set up in a way that ensures they have the intended effects.

Third, that there are elements outside of investment fund governance to consider as well, for example giving greater scrutiny to high-frequency and algorithmic trading, with greater attention to the review of algorithm strategies that are more likely to malfunction during periods of acute market stress and amplify some of the issues we’re looking at today.

Fourth and finally, we need to be conscious of any gap between how these funds operate versus how they are perceived to operate. The investor base is wide, ranging from large institutions to households, with varying levels of sophistication – which means potential for mismatch between how investors view these products in terms of both risk and fund structure.

Ladies and gentlemen, money market funds and open ended funds experienced a real life stress test over the course of 2020. It is only natural that we analyse the results and respond as appropriate.