Funds Industry Engagement Event: COVID-19 Impact on the Funds Industry

When 25 September 2020 2:30 PM
Where Webex

Summary

The Central Bank of Ireland hosted a virtual Funds Industry Engagement Event entitled “COVID-19 Impact on the Funds Industry” on Friday 25 September.

The event was attended by the Central Bank’s Director General of Financial Conduct, Derville Rowland, as well as the Directors of Financial Stability, Economics and Statistics, Securities and Markets, and Financial Regulation / Policy and Risk / Asset Management Supervision. Industry participants included senior representatives from industry associations, management companies, fund service providers, and investment firms.

The purpose of the event was to gain insights from key firms and representative bodies on their experiences, lessons learned, and vulnerabilities identified from the COVID-19 crisis. The event also served as an opportunity for the Central Bank to provide views on the crisis and set out our key supervisory and policy priorities for the funds sector.

Opening Remarks

Derville Rowland, Director General, Financial Conduct opened the event. The full opening remarks are available on the Central Bank’s website.  The key messages included: 

• The funds sector broadly demonstrated sufficient operational resilience throughout the Covid-19 pandemic. However, the episode highlighted certain vulnerabilities and it is recognised that market instability reduced only after substantial non-standard monetary policy support from European Central Bank and other global central banking authorities.
• It is apparent to regulatory authorities that these vulnerabilities need to be looked at. Therefore, further work is required to demonstrate that the funds sector is effectively managing the risks to which it is exposed, particularly in relation to leverage, liquidity and valuation uncertainty and ultimately that the sector is not amplifying risks to the wider financial system.

Session 1: Macrofinancial perspective on Covid-19 and the funds sector

Vasileios Madouros, Director of Financial Stability led a session on the macrofinancial perspective on Covid-19 and the funds sector. The key messages from the Central Bank’s presentation included:

• The market-based finance sector has grown rapidly in recent years and in Ireland, the sector is dominated by investment funds. Funds provide a valuable alternative to bank financing, both globally and domestically. However, like all forms of financial intermediation, market-based finance can contribute to a build-up of financial vulnerabilities.
• Potential structural vulnerabilities that can contribute to amplification of shocks in times of stress. In particular, liquidity mismatches and leverage can result in fire sales.
• At the onset of the Covid-19 shock, many funds experienced a sharp increase in redemptions and challenges in liquidity management. At an individual level, the vast majority of funds managed to meet investor redemption requests, with limited use of tools such as suspensions and gating observed. However, this needs to be seen in the context of unprecedented central bank interventions that played a key role in restoring market functioning. And some of the sector-wide dynamics that have previously been flagged as concerns by financial stability authorities were also evident during the period of stress.
• Some money market funds (MMFs) were particularly vulnerable during the initial ‘dash for cash’ and flight to safety and there was a risk of spill over of liquidity stresses to other parts of the financial system if some MMFs were unable to meet redemptions. Central bank policy measures were key in restoring short-term money market functioning.
• Funds with short redemption periods and investments in less liquid assets saw particular liquidity management challenges (e.g. corporate and EME debt) and responded to elevated redemption pressures by selling less liquid assets, which may have contributed to market pressures. Central bank interventions led to significant improvements in market functioning in corporate debt markets.
• Relative to the UK fund sector, liquidity mismatches in Irish-resident funds that invest in commercial real estate (CRE) are more limited, given their dealing frequency / notice periods. However, some Irish-resident real estate funds have higher levels of leverage, making them more vulnerable to potential falls in CRE prices. The COVID-19 shock has already led to some adjustment in CRE valuations (and an increase in valuation uncertainty).

Points raised by attendees during this session included:

• The support received from central banks was crucial.However, it took some time to work through the system.In particular, US Federal support for money market funds did not filter through to Irish money market funds in the way that direct support would have.
• The need to differentiate fund liquidity and market liquidity.
• While it is clear that certain sub-sectors of the funds industry require changes, industry representatives stated that any regulatory response should ensure that changes do not hamper the overall resilience / response of the financial system which generally worked well.
• MMFs experienced significant pressure because banks were unwilling to contribute to secondary market liquidity for the assets held by money market funds. Noted that banks were less willing to intermediate on money markets during stressed periods, and the impact of post-2008 reforms was mentioned here.
• Also in relation to MMFs, one attendee stressed the need to mindful of the low interest rate environment. Noted the potential for increased costs to run these products if regulatory reform is not appropriately calibrated.Stressed that there was a demand for these products from investors (including financial and non-financial corporates).
• In relation to property funds, one attendee noted that the investors of these funds tend to be institutional with insurers being the largest holders. Noted that levels of leverage in these funds may appear higher due to other factors.

Session 2: Reflections from our supervisory engagements during Covid market events

Colm Kincaid, Director of Securities and Markets led this session. The key messages from the Central Bank’s presentation included: 

• The period of market volatility highlighted the need for adequate resources and expertise within the Irish regulated entity to oversee its operations:
  • Business continuity plans worked well, but were fragile in the face of harsher COVID impact overseas. Capacity to replace reliance on outsourcees was patchy.
  • In some cases, there was a reliance on group policies / processes, and not always clear how those policies / processes took sufficient account of the circumstances specific to the Irish entity.
  • Irish regulated entities must ensure that they have sufficient experienced resources in place to adequately oversee all of their activities, including during time of crisis.
• The need to pay closer attention to managing liquidity risks:
  • With the exception of a small number of funds, the management of redemption requests over this period was addressed. However, this has to be considered against the backdrop of the extraordinary support provided by governments and central banks to the markets in which these funds invest.
  • There was a lack of preparedness by some firms for the possibility of a liquidity event such as an absence of thresholds for escalation or defined escalation lines up to the Irish fund management company (FMC).
  • FMCs must have planned for worst case scenarios and be prepared for future shocks, with trigger alerts in place and defined escalation paths to the Irish FMC.
  • Operational playbooks also need to be in place and ready to be executed in worst-case scenarios.
• The importance of high quality information for boards, investors and regulators:
  • There was positive and timely engagement regarding the implementation of additional daily MMF reporting at the height of the crisis.
  • However, the Central Bank did encounter some delays and pushback from entities based on non-availability of resources or data.
  • FMCs did not always factor in timelines for investor notification and Central Bank approval of potential changes to funds and their supporting documentation.
  • Firms need to be able to access key information as and when it comes to be needed.
  • Firms need to factor in Central Bank approval and Investor Notification Timelines.

Points raised by attendees during this session included:

• The need to be mindful of the benefits of the delegation model. The Central Bank noted that it is not a matter of local versus international structure and acknowledged that an international structure can provide economies of scale and expertise. However, whilst firms may delegate a task, they cannot delegate responsibility as authorisation is granted to the Irish entity.
• There was good senior engagement from the Central Bank at the peak points of the crisis.However, industry had to deal with the suddenness and large volume of data requests. A suggestion would be to put data dashboards / requests in place which could be put on standby. The Central Bank acknowledged the need to improve data collection exercises generally and confirmed that this is also a live topic of discussion at a European level.

Session 3: Potential future policy developments

Gerry Cross, Director of Financial Regulation / Policy and Risk / Asset Management Supervision led this session.  The key messages from the Central Bank’s presentation included:

• The challenges MMFs encountered in March arose due to the unanticipated shock to the global economy and the associated stress in money markets. However, we must also consider what effect market structure and the current regulatory framework had during this period of market stress.
• IOSCO’s Financial Stability Engagement Group (FSEG), working with the Financial Stability Board (FSB), has launched a group looking at MMF resilience and the Central Bank is a member of this group. The themes are investor behaviour, liquidity management, market structure concerns, and regulatory structure concerns and the preliminary phase of this work is due to conclude shortly.
• Liquidity management has been an area of focus since 2010 and is a particularly important component of managing property and corporate bond funds during periods of stress.
• In May, the ESRB issued a recommendation to ESMA on liquidity risks in investment funds. NCAs are now reviewing information in relation to property and corporate bond funds to assess their preparedness in case of a new liquidity stress episode.
• The use of liquidity management tools (LMTs) throughout the Covid-19 market turbulence period has been a particular area of focus for regulatory authorities. Data collection exercises on the use of LMTs during the crisis have further highlighted the need for a harmonised LMT framework. In August, ESMA issued a recommendation to the European Commission highlighting areas to consider during the forthcoming AIFMD review, including the need for a harmonised legal framework for LMTs.
• Leverage also remains an area of focus for regulatory authorities. ESMA recently concluded a consultation for draft guidance to address leverage risks in the AIF sector.
• IOSCO and the FSB have signalled the potential need to develop a macro-prudential framework for the non-bank sector to mitigate the need in future for central banks to intervene in a crisis. In Europe, the ESRB has been, and is expected to continue to be, focused on investment funds from a macro-prudential perspective. The Central Bank is committed to contribute to international and European discussions in this regard.

Points raised by attendees during this session included:

• The need to adopt a data driven approach when analysing Covid-19 related issues, particularly in relation to MMFs. Noted that the affected instruments are held not only by funds thus an all-encompassing debate is needed.
• The 30% MMF liquidity buffer was more of a cliff edge rather than a buffer as when MMFs got anywhere close to this investors started to redeem.
• Speeches from some NCAs seem to suggest that funds are still viewed by some regulatory authorities as being similar to banks (when referring to issues such as liquidity and cash buffers etc.). The Central Bank noted that there has been significant engagement on this between IOSCO and the FSB and there is now an increased awareness of the differences between banks and funds.
• One attendee queried the Central Bank’s view on sustainable finance. The Central Bank confirmed that sustainable finance is now a priority at both European and international fora.

Event Presentation

Attendance at this event was by invitation only.