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Liquidity Risk Management Is Central to Open-Ended Funds

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Liquidity Risk Management Is Central to Open-Ended Funds Lessons from COVID-19: Liquidity Risk Management is Central to Open-Ended Funds Barbara Novick Joanna Cound Donald Edgar Martin Parkes Vice Chairman Head of EMEA Risk and Global Public Policy Public Policy Quantitative Group Analysis Group Stefano Pasquali Geoff Radcliffe Samantha DeZur Adam Jackson Head of Liquidity Global Accounting Global Public Global Public Policy Research, BlackRock and Product Policy Group Group Solutions Services Additional contributors: Souheir Asba; Sam Brindley; Svetlana Butvina; Helen Davies; Kate Fulton; Michael Huang; Roberto Langstroth; Kenny Maung; Georgie Merson; Emma Munro; Janet Oram; Kacie Overlander; John Perlowski; Winnie Pun; Kashif Riaz; Carly Wilson Introduction volatility and liquidity deteriorated significantly, including in The Global Financial Crisis in 2008 (“GFC”) began in the markets traditionally seen as very liquid and low risk. While financial sector and propagated out to the real economy. the GFC is often referred to as a ‘credit crisis’, the COVID A combination of poor underwriting standards, excessive Crisis is increasingly recognized as a ‘liquidity crisis’. leverage throughout the financial system, gaps in supervision, and – in some cases – fraud resulted in an This environment provided an extreme test of mutual funds’ historic global recession. Following the GFC, policy makers resiliency. The vast majority of mutual funds demonstrated implemented reforms to strengthen the resilience of the their resilience, meeting redemption requests despite financial sector, including reforms that reshaped the challenging market conditions, with only a small fraction of regulatory environment across a wide range of asset funds needing to use extraordinary risk management tools. management products and activities. These reforms Some policy makers and academics have commented on included new rules for money market funds, registration the outflows from open-ended mutual funds (“OEFs”) and reporting requirements for private and alternative during the COVID-19 crisis, suggesting a mismatch funds, enhanced mutual fund and investment adviser between the liquidity of the underlying assets and the daily reporting, expansion of liquidity risk tools, and detailed redemption feature of many OEFs. Some of these concerns liquidity risk management and stress testing programs for are misplaced and overlook how liquidity risk management mutual funds. Our ViewPoint “The Decade of Financial tools are applied in managing mutual funds; however, some Regulatory Reform: 2009 to 2019” details the rules that concerns are valid, and warrant a closer look to identify were introduced specific to the asset management sector. potential solutions. The COVID-19 Crisis in 2020 began as a health crisis and We have written a series of ViewPoints addressing Lessons became an economic crisis. Countries around the world from COVID-19 covering short-term markets, including took measures to contain the pandemic, which included money market funds, as well as thought pieces on ETFs and 1 locking down significant portions of their economies. In on the US municipal bond market. This ViewPoint focuses response, financial markets experienced sharply increased on other OEFs, primarily bond funds, but also The opinions expressed are as of November 2020 and may change as subsequent conditions vary. blackrock.com/publicpolicy November 2020 | Public Policy | ViewPoint income-generating funds such as bank loan funds and real angels,” ticked up sharply reflecting the changed estate funds. We examine the effect of stressed markets on economic outlook due to COVID-19 and the sudden open-ended funds in Part I, addressing market conditions decrease in demand for oil. Most mutual funds, however, and fund flows in both the US and Europe.2 Part II reviews are allowed to hold ‘fallen angels’ and many investors are the liquidity risk management (“LRM”) tools available to motivated to stay invested in them at least on a short managers and their use during March 2020. Part III term basis, as downgrades of higher quality names often summarizes the lessons learned from the COVID-19 crisis represent an investment opportunity before the bonds and makes recommendations to increase the effectiveness establish a new equilibrium. Furthermore, opportunistic of LRM tools, thereby enhancing the resilience of mutual investors and long-term strategic high yield investors funds. viewed wider spreads as an attractive entry point. • The heterogeneity of bond funds was reflected in fund Key observations and flows. Bond funds include a range of investment styles recommendations and underlying asset classes. While during March average weekly outflows from high yield corporate bond Observations funds ranged from 1.8% to 3.8% globally, higher quality • The outbreak of the COVID-19 pandemic resulted in a funds saw relatively small outflows and, in some cases, liquidity crisis in March 2020 that contrasted sharply attracted inflows. with the credit crisis experienced during the GFC. The economic and financial implications of lockdown • Liquidity risk management is tailored to the type of measures around the world were reflected in broad risk- fund. Liquidity risk management is central to managing off sentiment and a flight to cash and quality, impacting OEFs. Fund managers consider both the underlying a wide range of asset classes. In addition, the sudden asset class and the fund investors in designing a drop in equity prices drove portfolio rebalancings from liquidity risk management program for a specific fund. fixed income into equities.3 For example, a multi-sector investment grade bond fund will have a different composition than a high yield only • The cost of accessing liquidity for fixed income fund. Likewise, a fund held in defined contribution plans securities rose sharply. While trading volumes in fixed is likely to have different redemption patterns than a income markets generally held up through March and fund distributed on a wealth management platform. April, price uncertainty and transaction costs increased significantly. Central bank interventions were targeted to • Liquidity risk management tools include both ex-ante addressing these market conditions via outright and ex-post measures. The increased focus on liquidity purchases plus a series of primary and secondary market risk management, more rigorous liquidity stress testing, programs. 4 and expanded disclosure and reporting since the GFC provided a solid foundation for most funds to meet the • Sales of corporate bonds reflected portfolio scale of flows in March 2020. Fund managers actively rebalancings as well as de-risking by multiple market manage liquidity risk ex-ante through suitable product participants. Bond funds represent only one type of structuring, layering liquidity, modelling redemption holder of fixed income securities. In the US, for example, behaviour, and, in some jurisdictions, employing swing mutual funds account for less than 20% of the pricing. In extreme situations, some funds can use ex- ownership of any given fixed income sector. In order to post tools such as suspending redemptions or in-kind understand the market dynamics, we need better data on redemptions. the remainder.5 The SEC observed in their recent report on the US Credit Markets: • While a few European funds suspended dealing, this was due to material valuation uncertainty rather than “‘Commission staff estimate that bond mutual funds outflows, and did not result in any contagion across experienced $255 billion of net outflows during asset managers, asset classes or jurisdictions. Robert March 2020, with another $21 billion in outflows Ophèle, AMF Chairman, noted in a recent speech that: from bond ETFs. However, the overall trading volume “Open-ended investment funds sometimes faced in the corporate bond market dwarfs these values large redemption requests, but suspensions were during the same period and, therefore, it is rare and did not trigger any systemic spillovers. reasonable to conclude that bond fund redemptions Furthermore, funds considered vulnerable in the did not materially disrupt this market or materially stress simulations by the European Securities & add to stresses experienced by the market.’ 6 Markets Authority (ESMA) and the European • Concerns about funds ‘forced selling upon credit Systemic Risk Board (ESRB) did not face any of the downgrade’ proved to be misplaced. Bonds problems feared.” 7 downgraded from IG to HY, commonly called “fallen 2 • Securities regulators had extensive data on funds and granular data on fund end-investor types and flows would supplemented this with outreach to market improve redemption modelling in liquidity stress tests. participants. The GFC reforms included detailed Ensure fund managers are operationally prepared regulatory reporting, providing markets regulators with 3 fund liquidity surveys, fund liquidity characteristics, and for stress events. large redemptions flows by fund. 8 Once the market We recommend that policy makers require managers to experienced stress, markets regulators reached out to have contingency plans in place. As part of their business participants for real-time color on various sectors and continuity planning, managers should test the underlying products. In addition to closely monitoring the situation, procedures on how to use the full range of available markets regulators swiftly provided targeted relief.9 liquidity management tools in a crisis situation. Recommendations 4 Mandate shorter bank loan settlement periods. Greater adoption
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