Global regulators are set to sharpen their scrutiny of hedge funds, clearing houses and pension assets this year after a run of crises has shifted watchdogs’ focus towards risks outside the banking system.
The disparate group, loosely defined as “non-bank financial institutions” by regulators, has been thrust into the spotlight after a series of market ructions over the past two years.
“It’s different now,” Andrew Bailey, governor of the Bank of England, told reporters in mid-December as he spoke of the “urgent” need to escalate global policymakers’ long-running studies and recommendations on non-bank financials into swift global action.
The first seeds for regulators’ NBFI awakening were sown in March 2020 when hedge funds were sucked into a dash for cash by Covid-panicked markets. Two years later, the London Metal Exchange had to temporarily close its nickel market because a squeeze threatened its clearing house.
Before 2022 was out, European governments rescued energy companies caught out by soaring energy prices, and the BoE had to intervene to arrest a collapse in UK government bond markets that was triggered by poorly appreciated risks in obscure investment strategies run by pension funds whose operations straddled the UK, Ireland and Luxembourg.
The crises collectively shone a light on the risks that largely migrated, whack-a-mole style, elsewhere in the financial system after watchdogs tightened regulations on banks following Lehman Brothers’ collapse in 2008.
“It’s critical for global regulators to look at, 15 years later or so, is this what we wanted to achieve?” said Ana Arsov, co-head of global banking at Moody’s, echoing Bailey on the need for global co-ordinated action since they both argue that the sector is so international it can only be tamed by worldwide measures.
Regulation of NBFIs, which now account for almost half of global financial assets, is unfamiliar territory for policymakers in more ways than one.
Liquidity has been the biggest stressor in the recent run of upsets, unlike in the 2008 financial crisis where concerns centred on whether institutions, chiefly banks, had strong enough balance sheets to cover all of their liabilities in a market of falling asset prices and rising loan defaults.
The BoE announced last month the world’s first stress tests that will look at the underlying risks in key financial markets where NBFIs are major participants, an exercise that, Arsov said, could be “very helpful”.
The Financial Stability Board, where the world’s biggest central banks, finance ministries and regulators formulate policy, will this year report on how well countries have implemented their 2021 recommendations to improve oversight of money market funds, vehicles that act like bank accounts in the investment industry and are meant to be ultra safe, and will advance policies in other areas.
“Since the dash for cash we’ve been trying to work out what’s happened and then work on addressing the vulnerabilities,” the FSB’s outgoing secretary-general Dietrich Domanski told the Financial Times of the early pandemic era turmoil when companies were forced to call on more than $100bn of credit lines after market financing dried up.
An early area of focus has been money market funds where the FSB has proposed a variety of measures including some that would reduce “cliff effects”, where herd-like selling is triggered once artificial thresholds are crossed, and other proposals that would limit the gap between the maturity of instruments a fund invests in and the liquidity it guarantees its investors.
The second area is open-ended funds, which the FSB sees as an area likely to contribute to the kind of “abrupt spikes in liquidity demand” that trigger bailouts because there is a fundamental mismatch between the instant redemption they promise their clients, and the challenges of selling assets at pace in a falling market.
One proposal to deal with issues around first-mover advantage in a falling market is “swing pricing”, which smooths the price received by all traders within a window. “It has the potential to go quite some way in addressing issues [of price spirals],” Domanski said. “But it is not a magic bullet either.”
The FSB is also trying to better understand things such as hidden leverage in various parts of the NBFI market.
“We need to recognise that this is a very diverse part of the financial system which is in a number of respects different from banks,” Domanski added of NBFIs. “Nobody would seriously claim that you should apply the same set of regulations to open-ended funds and insurers and pension funds, just to name three.”
There are dozens of policy initiatives under way across the world, as regulators try to get to grips with a multitude of potential issues. Global securities regulator Iosco has laid out a range of proposals to improve liquidity in key financial markets, particularly during times of stress.
Scott O’Malia, chief executive of ISDA, said he expected the role of intermediaries like clearing houses to be a “key issue” for 2023. In December, the FSB called for “urgent work” to address contingency plans for the collapse of both clearing houses and insurers.
Meanwhile, in the US, the Securities & Exchange Commission is pursuing the biggest shake-up of equities trading rules in two decades by introducing a range of measures that will primarily lower costs for small investors but will also mitigate against the kind of frenzied trading triggered by 2021’s meme-stock boom.
In Europe, Andrea Filtri, analyst at Mediobanca, said the focus would probably shift from 2022’s work around the structure of Europe’s markets, to looking at liquidity issues “in a challenging rising rate and quantitative tightening environment”.
“There are several dozen markets which could be subject to LDI-style black swan without necessarily having the adequate toolkit for it,” he said, referencing the LDI funds of pension plans that triggered September’s UK gilt market turmoil.
Domanski also said NBFIs were fraught with feedback loops and amplifications, which made solutions harder to find. “Before 2020, talking about silver bullets, some people might have said well the answer is to hold liquidity in government bonds [ . . .] Over the past few years we have seen that under stress.”
“What is needed as a basis for policy action [ . . .] is a clear understanding on how these [NBFI entities interact].”