The Next Market Crash Looms Large in Fund Reform

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A slew of investment mishaps has reinforced how seemingly easy-to-trade securities can become petrified assets in a heartbeat. Nervous about the next market rout, regulators are wrestling with how to protect investors from getting trapped in frozen investment funds without throttling the market. They need to get a wiggle on.

The problem is easy to identify, and incredibly hard to solve: How to impose sufficiently stringent liquidity rules on the various flavors of funds without crimping their ability to deliver returns.

In theory, funds cover the gamut of liquidity, from money-market funds promising instant conversion into cash when needed to real estate assets filled with property that’s difficult to value and hard to offload swiftly. In between are credit funds, which buy corporate bonds of varying creditworthiness, and equity products, with stakes in both publicly traded stocks and private companies.

During times of market stress, though, every one of those asset classes has gotten into difficulties.

Most recently investors panicked in March 2020 as the coronavirus spread and governments locked down their economies. In the U.K., investors withdrew a staggering 10% of the cash held in sterling money-market funds in just eight days in what the Bank of England dubbed a “dash for cash.” In the U.S., institutional investors took 30% out of prime money-market funds in a fortnight.

Such funds seek to outperform cash by buying short-dated commercial paper and certificates of deposit which, in normal times, are among the easiest securities to buy and sell. But as investors sought to withdraw 25 billion pounds ($35 billion) in a bit more than a week in the U.K., they found that the market for those assets “was closed,” as Bank of England Governor Andrew Bailey put it.

It was a frightening moment. Amid the risk of a run on funds, government bond trading was disrupted and market interest rates were pushed higher at the most inconvenient time. Rather than absorbing shocks, the system played a role “in transmitting and amplifying the stress,” Derville Rowland, the Irish central bank director general for financial conduct, said last month.

Unfortunately, attempts to solve the problem risk scaring off fund providers and investors alike. Bailey last month said potential remedies include limiting money-market funds to holding only government securities, restricting the percentage of non-government assets they can hold or requiring investors to give notice before they can get their money back. He acknowledged, though, that such reforms would change the nature and return profiles of funds that are meant to act as cash equivalents.

Efforts to make property funds less susceptible to halting redemptions, as happened in the U.K. after both the Brexit vote and the pandemic’s onset, are also proving tricky. The Financial Conduct Authority recently delayed a decision on proposed changes to its regulations, including a shift to notice periods rather than daily redemptions.

The problem for asset managers is that boosting the money set aside to cover potential withdrawals erodes the scope for returns, while scrapping daily redemptions is likely to deter retail buyers. So next month, Aviva Plc plans to shutter real estate funds it had frozen early in the pandemic. The London-based insurer said it couldn’t meet its investment objectives at the same time as ensuring sufficient liquidity to cope with likely redemption requests.

In Sweden, asset managers are also concerned about restrictions on how frequently funds get repaid will backfire, prompting investors to ask for their money back and driving up borrowing costs for companies. The onset of the pandemic effectively halted trading in the Nordic country’s corporate bond market, prompting more than 30 credit funds to freeze withdrawals. The central bank has proposed ending daily dealing for the products. This week, the Swedish market regulator suggested mutual funds should only be redeemable twice a month.

It’s been two years since then Bank of England Governor Mark Carney warned that investment products containing illiquid assets and promising daily withdrawals were “built on a lie.” The likely solution will involve a smorgasbord of fund classifications with liquidity becoming a key differentiating characteristic, making it imperative fund managers are crystal clear with buyers about how quickly the underlying assets can be liquidated during times of stress.

As knotty as the problem is, overseers need to come up with ways to avoid investors seeing their funds trapped behind gates when the next market crash hits.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mark Gilbert is a Bloomberg Opinion columnist covering asset management. He previously was the London bureau chief for Bloomberg News. He is also the author of "Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable."

©2021 Bloomberg L.P.

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