After pandemic’s liquidity storm, possible fund reform

With Covid-19-related stress in financial markets subsiding, regulators are turning their minds to possible reforms.

Recently, banking regulators in both Canada and the U.S. announced the withdrawal of emergency measures that were introduced in response to financial market disruption last spring.

Further, policymakers are contemplating whether lessons learned in the midst of that market stress should be met with rule changes.

On March 26, the European Securities and Markets Authority (ESMA) launched a consultation on potential reforms to money market fund regulation in the European Union (EU).

The ESMA said that it will review the stress experienced by money market funds during the onset of the Covid-19 crisis in March 2020, and consider whether the episode warrants regulatory changes.

Among other things, the consultation will consider possible reforms to liquidity buffers, valuation rules, and whether fund managers should be required to use certain liquidity management tools.

The ESMA also said that it will gather feedback on other potential changes linked to credit ratings, disclosure and stress testing.

“The Covid-19 crisis has been challenging for money market funds,” said Steven Maijoor, chair of the ESMA, in a release.

Maijoor noted that a number of funds “faced significant liquidity issues” last March amid large redemption demands, and there was also a “severe deterioration in the liquidity of money market instruments.”

At the same time, the Bank of England and the U.K.’s Financial Conduct Authority (FCA) published the results of a joint survey of open-ended investment funds, which examined their response to the financial market stress in March 2020.

That survey found that fund managers took divergent approaches to using the liquidity management tools at their disposal to deal with the market stress.

For example, “There were significant differences in how similar funds facing similar flows applied swing pricing.”

It also reported that most corporate bond fund managers “appeared to overestimate the liquidity of their holdings, and for some funds were particularly overoptimistic. Some categorized most of their holdings as liquid under almost all market conditions, which did not appear realistic on the basis of their exposure to less liquid assets.”

Additionally, the report said that funds that were predominantly held by institutional investors suffered “much larger” outflows during the market stress than funds that were largely retail.

“This provides an initial indication that professional investors may react more quickly in stress,” it said.

While the U.K. report documented the experience of funds during the crisis, it doesn’t make any reform recommendations based on those findings.

The ESMA’s consultation will run until June 30. It expects to publish the results of its review in the second half of 2021.