February 25, 2024

regulators seek to avoid liquidity hiccups

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Banks are in the business of “maturity transformation” — converting funding from relatively short-term deposits into long-term loans. This works very well as long as depositors do not require all their money back at the same time. Regulators have thus long focused on measures to prevent these bank runs.

New global rules, proposed by the Financial Stability Board and the International Organization of Securities Commissions, aim to do this too for the open-ended fund sector, worth $60tn in 2022 according to the Investment Company Institute.

Some, including mutual funds and property funds, have a potential liquidity mismatch. Clients can ask for their money back daily, selling their shares back to the fund at that day’s calculated net asset value. Yet the fund itself may be invested in either illiquid assets. Cash buffers, designed to absorb typical trading volumes, may anyway prove insufficient in a rush to sell.

Institutions in this position may find it difficult to sell assets, or have to take a big discount to NAV, causing those investors remaining in the fund to suffer losses. Such concerns were heightened by the collapse of the Woodford fund in 2019. More recently property funds such as Blackstone’s have faced excessive redemption requests.

At first glance, the FSB’s approach looks sensible. The idea is to classify funds into buckets, depending on how illiquid their underlying holdings are judged to be.

National legislation will need to define what falls into which category. Broadly speaking, funds that are mostly invested in liquid holdings can carry on as they were. Funds replete with illiquid assets could delay redemptions, or charge additional fees to reflect any extra exit costs.

None of this is foolproof. All assets can become illiquid given sufficient market ructions. Yet some are clearly riskier than others. Meanwhile, herd behaviour is damaging to financial markets. Moves that minimise the incentive to stampede should be welcomed.

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