Good intentions and misconceptions

Author: | Published: 18 Mar 2015
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Tim Cameron, managing director and head of Sifma’s asset management group discusses how post-recession regulations are impacting the asset management industry, and what asset managers are doing about it

Since the global financial crisis, regulators both in the US and abroad have implemented an unprecedented amount of regulations that are aimed at strengthening the financial system and protecting investors. Asset managers, who are entrusted with managing the savings and retirement money of millions of workers and retirees throughout the US, must now adapt their businesses to comply with these regulations, while still ensuring their clients meet their financial goals. Collectively, members of SIFMA's Asset Management Group manage approximately $30 trillion of assets under management on behalf of investors, and our membership is diverse, ranging from the largest global financial players to independent, smaller firms across the country.

As fiduciaries who are focused on the best interests of their investor clients, asset managers support a regulatory infrastructure that strengthens the resiliency of the financial system. Yet, in practice, many of these well-intentioned regulations seem to actually be creating new risks in the marketplace or, in some cases, simply moving risks from one place to another. In particular, we are concerned some regulation is constricting liquidity in certain fixed income markets, which could hamper the ability of asset managers to help investors accomplish their financial goals.

Regulatory onslaught

There's no question that responsible, balanced regulations are vital to a robust financial system, and that the financial crisis demonstrated the need for an enhanced regulatory framework. However, regulators must be careful not to swing too far in the other direction. It's important that new rules do not constrict the markets' ability to facilitate capital formation and meet the needs of investors. The capital markets are the backbone of the US financial system and a key provider of capital. Indeed, Federal Reserve and European Central Bank (ECB) data show that in the US, non-financial companies rely on the capital markets for 75% of their credit needs, while just 25% comes from banks. Compare that to Europe where we see nearly the reverse, with 80% of credit coming from banks and just 20% coming from fixed income investors.

"Asset managers support a regulatory infrastructure that strengthens the resiliency of the financial system"

In the name of protecting financial markets, regulators have created a mosaic of regulations that touch every corner of the financial services industry, including asset managers and the sell-side banks and broker-dealers. Some regulatory changes, such as the implementation of Form PF (private fund), directly focus on the activities of asset managers. Asset managers are also affected by regulations imposed on banks and broker-dealers, such as the capital rules, which impact market making, thus limiting the amount of capital and liquidity in the marketplace. All of these regulations have the potential to increase investor costs, change markets, and/or decrease investment opportunities.

Beyond these multiple individual regulations, asset managers and their activities have also become a primary focus of the Financial Stability Oversight Council (FSOC) and international regulators are considering if asset managers or various financial products/activities should be designated as systemically important to the financial system. The FSOC, as well as the Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO), are setting the tone from the top: all began by reviewing asset managers for designation as systemically important, and have since indicated a shift to focusing on activities and products, as they work to determine whether to impose prudential-like regulations on asset managers, funds or aspects of the asset management industry – which is something we oppose, as it is not necessary and could lead to serious negative consequences for investors and the broader markets. This process has, in many ways, been concerning. The unique characteristics of asset managers, and the role they perform in the marketplace, does not appear to be fully acknowledged by prudential regulators seeking to impose a whole new set of regulations.

In 2014, Sifma AMG focused in large part on education efforts, and we have also petitioned for a more transparent regulatory process for designating firms as systemically important, to help give asset managers a voice in this debate. It's important to recognise that investment funds and asset managers operate differently than other types of financial entities, and do not create risks that could be considered systemic to the financial markets. Asset managers don't own the investment risks taken by their investor clients and do not back-stop investment losses – risk is borne by the ultimate investor. Investors understand risk is an inherent part of investing; without taking risks, there would be insufficient returns for investors saving for retirement, education and other needs. Risks are broadly distributed in the investment industry and shift in response to investor preferences and exogenous factors that impact all participants. Therefore, designation of a few investment funds or asset managers is not likely to reduce the overall level of risk associated with the activities of funds and other markets participants, since entities that are not designated will continue to engage in the same activities. Instead, designation will simply make it even more difficult and costly for asset managers to operate, and more expensive for investors to participate in financial markets.

Fortunately, FSOC and the FSB/IOSCO have both begun to focus on activities and products after acknowledging that enhanced regulation of asset managers is not warranted. The Securities and Exchange Commission's (SEC) active role in the FSOC's discussions has also been encouraging, as the SEC is the primary regulator of the asset management industry in the US, and has in-depth knowledge and understanding of asset managers. As the SEC chair, Mary Jo White, noted in a December 2014 speech at the New York Times DealBook conference, tackling systemic risk demands a broader programme than one agency can execute. Systemic risks cannot be addressed alone, and the market perspective that the SEC brings is an essential component of FSOC's efforts. We appreciate the FSOC's acknowledgement in the recent Notice Seeking Public Comment on Asset Management Products and Activities that investment risk is a normal part of market functioning. Rather than seeking to eliminate risk, Sifma AMG believes risk should be managed through adequate disclosures, and through appropriate regulation of various activities that take place across the system as a whole, much of which is already well under way.

"Regulations have the potential to increase investor costs, change markets, and/or decrease investment opportunities"

Further, while the SEC's role in the FSOC is both essential and welcomed by asset managers, Sifma AMG has concerns that the FSOC's focus on the asset management industry may pressure the SEC to consider changes in 2015 that fundamentally alter how it regulates asset managers and funds. The mission of the SEC is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. Throughout the many decades that asset managers have been regulated by the SEC, the agency has developed a deep understanding of the asset management business. They recognise that asset managers are evaluated by the performance they generate for investors, and that they are in the business of managing risk and protecting the clients' assets (and their own reputation). Therefore, it is in both the regulator's and the asset manager's best interest to help clients manage risk. Asset managers, through the work they perform on behalf of their clients, are very familiar with a wide spectrum of risks, which are inherent when investing in various asset classes: interest rate risk, sector risk, economic risk, liquidity risk, and operational risk, to name a few. But, asset managers themselves are not inherently risky.

Since the FSOC has shifted its focus to asset managers, chair White has stated publicly that the SEC is considering what additional changes may be necessary to make the asset management industry "safer". As part of this process, many asset managers have received a bevy of data requests, in many cases asking for information that is available under other reporting requirements. Asset managers recognise the SEC's efforts to better understand various activities and products, and believe the SEC should remain the industry's primary regulator, rather than ceding this responsibility to the FSOC. However, the breadth and scope of the data requests are extensive and will require significant resources from asset managers, and it's not always clear what purpose or questions the data is meant to address. Further, the SEC is considering other regulations, such as leverage restrictions, stress testing, and resolution regimes, which seem to mark a shift that, in some instances, appear less appropriate for asset managers and funds.

Broker-dealers and banks also have undergone significant changes to implement the most significant overhaul of the industry since the 1930s, in the name of risk reduction. Regulations mandated by the Dodd-Frank Act and Basel Accords are forcing dealers to focus on activities that require less capital and balance sheet capacity, and/or are considered less risky, and they are decreasing their market-making activities. For example, the Volcker Rule's restrictions have caused bank-affiliated dealers to exit proprietary trading businesses and to calibrate carefully their permitted activity in connection with market-making in some impacted sectors. Internationally, the Net Stable Funding Ratio, the Fundamental Review of the Trading Book, and European Union structural reform measures will all have the impact of reducing liquidity in the marketplace. As many regulations aren't fully or completely implemented, we also do not yet know what the cumulative impact of new prudential regulation will be over the next several years.

Implications for liquidity in the fixed income markets

Few would disagree that today, the financial system as a whole is safer and better capitalised than before the crisis. That said, all market participants must work to ensure the mosaic of new regulations does not harm investors going forward.

Regulations impacting the asset management industry, as well as the financial industry generally, have led to a market with increased liquidity bifurcation. Market-makers are changing their strategies, and liquidity is reducing in the secondary markets for some securities. These trends are placing upward pressure on trading costs, widening bid-ask spreads, and causing activity to concentrate in the most liquid instruments and deteriorate in the less liquid ones.

Essentially, markets have changed and trading activity has shifted, forcing asset managers to adapt their trading strategies to protect against these liquidity challenges. Less liquidity could mean that an asset manager may be unable to divest, or take, a position immediately on behalf of a client. It could also mean that a corporation or other entity may have a more difficult time accessing funding for critical projects that can spur job creation and economic growth.

Further, as regulators continue to implement new regulations, asset managers and other market participants worry that these regulations will cause market liquidity to deteriorate further. For example, while asset managers support efforts to make our markets more transparent, for many illiquid markets, extra transparency may actually have a counter-productive effect on liquidity. In these situations, providing additional information to the market at large could move the market in an adverse direction for investors willing to take on risk at a fair price, by alerting others about trades before they occur.

Ironically, while regulators such as the FSOC continue to focus on entities such as asset managers, and attempt to mitigate risk from the marketplace, this lack of liquidity – created in many ways by over-regulation – may ultimately increase market volatility and create a new normal that asset managers would need to navigate. Liquidity and market-making help the markets work by addressing supply and demand imbalances, by dampening the impact of shocks on market volatility, and by helping investors value their assets. Further, the world is currently awash in central bank liquidity; when central banks begin to withdraw liquidity from the marketplace, the deterioration in liquidity could be compounded.

In their efforts to contain risks, regulators are shifting the orientation of risk from market-makers and intermediaries to investors, for whom the regulations were designed to protect in the first place. Regulators are justified in their quest to protect the system, but they need to do so from a holistic perspective that balances the role played by investors (and, by extension asset managers), and the role various products and activities play in helping investors achieve their goals. Investor participation is essential to a robust financial system that can drive growth and prosperity in the US, so it is imperative that regulations do not discourage or impair an investor's ability to engage in the capital markets.

Asset managers finding solutions

Asset managers are working to adapt to the new regulations and develop solutions to ensure investors have the same easy access to fixed income products moving forward. Sifma AMG is engaging with other market participants to help drive consensus and develop solutions. All recognise that there is not a silver bullet solution. However, thoughtful discussions are yielding many ideas that are worth considering.

"Market-based solutions will likely remain the best possible solutions, as opposed to layering on more regulation"

For example, our members have discussed whether it would be feasible to develop trading venues with alternative structures to the traditional dealer-to-customer or dealer-to-dealer interface. By developing trading venues that encourage multiple parties from the buy- and sell-side to come together and communicate, there is the opportunity to increase market connectivity and thus increase liquidity. Such protocols could take many forms, such as an all-to-all request for quotation (RFQ) system or an open trading system that pools sell-side inventory and matches it with buy-side orders.

Product standardisation is also being explored for the most liquid corporate bonds. Liquidity in the bond market is often constricted because trading activity spans a broad array of distinct securities. For example, a company like Dow Chemical has 318 different Committee on Uniform Securities Identification Procedures (CUSIPS) in the marketplace. Some argue standardisation could improve liquidity by reducing the amount of unique securities, improving the ability to quote and trade the bonds, and that standardisation could also create liquidity by improving transparency, and dampening volatility in the market through more regular and predictable issuances.

Regardless of the specific solution, each has one thing in common: the need for stakeholders to understand how the market has changed, and to recognise that behaviours must change accordingly. For asset managers and investors, this means the possibility of becoming price-makers as well as price-takers. For other market participants, it may mean helping to lead development of alternative trading venues. For regulators, it means considering the potential unintended consequences of current regulations, and promoting market innovation to self-correct for loss of liquidity and other concerns.


Timothy Cameron
Managing director and head

Sifma Asset Management Group
T: 202.962.7447

1101 New York Avenue, NW, 8th Floor
Washington, D.C. 20005

In the year ahead, the asset management industry will more fully evaluate these possible solutions to address the problems that are arising in financial markets as a result of the new regulatory framework. Asset managers are faced with a "double whammy" of rules: regulations impacting banks and broker-dealers are likely to constrict market-making and capital formation, while the new focus of prudential regulators on the business of asset managers could lead to over-regulation that constricts a manager's ability to serve investors. Market-based solutions will likely remain the best possible solutions, as opposed to layering on more regulation. Encouragingly, regulators are interested in hearing from the buy-side regarding these concerns, and we believe this dialogue is essential to ensure there is regulatory support for market solutions. Ultimately we believe, through market innovation, capital markets can continue to fuel the engine of the US economy while providing investors with an attractive option for achieving their financial goals.