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Presentation from Deputy Assistant Secretary Patrick Pinschmidt to the Financial Stability Oversight Council on Asset Management.

(Archived Content)

As prepared for delivery
Thank you.
I want to start by describing the Council’s work that has led up to today’s update.  As Secretary Lew noted, the Council has been actively reviewing potential risks to financial stability in asset management for some time, engaging with key stakeholders along the way. 
In May 2014, the Council hosted a public conference on asset management that brought together a diverse group of industry and non-industry participants and helped shape the Council’s initial approach to its work. 
Subsequently, the Council announced its decision to focus on potential risks related to industry-wide products and activities across the asset management sector.  In December of 2014 the Council issued a notice for public comment that asked for input on a broad array of potential areas of risk, as well as existing risk management practices. 
This ongoing engagement with market participants and other stakeholders has contributed greatly to the discussion and follows the Council’s intent to carry out its work in a thoughtful and transparent manner.
Throughout its review and consistent with its mandate, the Council has focused on identifying potential risks to financial stability, rather than investment risk.  As discussed in the Council’s request for public comment, investment risk is a normal and necessary part of market functioning.  The Council’s focus on the asset management industry is directed at assessing whether asset management products or activities could create, amplify, or transmit risk more broadly in the financial system in ways that could affect U.S. financial stability.
The statement the Council is voting on today focuses on five areas: (1) liquidity and redemption; (2) leverage; (3) operational functions; (4) securities lending, and (5) resolvability and transition planning.  Liquidity and redemption risk and leverage were the key areas of focus by the Council, and will thus be the focus of my presentation today.
For each of these five areas, the Council has reviewed potential risks to financial stability and considered the materiality of such risks and potential mitigants, including the extent to which market practices or regulations may address any such risks. 
Throughout this process, the members of the Council have consulted extensively and have drawn on the expertise of their staffs and those of the member agencies.  Additionally, the Council considered many sources of information, including publicly available data, data reported on the SEC’s Form PF, analyses from market participants, academic studies, and, of course, information submitted in response to the Council’s request for public comment. 
Finally, the Council’s review also recognizes that the SEC has issued several proposed rules since May 2015 affecting the asset management industry. 
The Council considered the potential implications of the proposed SEC rulemakings, but today’s update does not evaluate specific provisions of the proposed rules given that any final rules may differ from what has been proposed.  As the SEC rulemaking process progresses, the Council intends to monitor the effects of any regulatory changes and their implications for financial stability.
Now, let me summarize the key findings highlighted in the Council’s statement.
The Council’s review of liquidity and redemption risks focused on pooled investment vehicles. There are two primary features of these investment vehicles—liquidity transformation and first-mover advantage—that  may raise potential financial stability concerns, particularly during times of market stress, and from vehicles holding less-liquid assets.  To help mitigate these financial stability risks, the statement describes six steps that should be considered:
First, robust liquidity risk management practices for mutual funds should mitigate the risks of potential deterioration in the liquidity of fund assets, particularly with regard to preparations for stressed conditions by funds that invest in less-liquid assets. 
Second, clear regulatory guidelines addressing limits on mutual funds’ ability to hold assets with very limited liquidity should be considered.
Third, enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices would also help mitigate financial stability risks.
Fourth, take steps to allow and facilitate mutual funds’ use of tools to allocate redemption costs more directly to investors who redeem shares should help reduce first-mover advantage and mitigate the risk that less-liquid asset classes would be faced with widespread sales under stressed conditions. 
Fifth, consider additional public disclosure and analysis of external sources of financing for mutual funds.
And finally, regulators should consider whether these measures are appropriate for reducing potential liquidity risks in collective investment funds and similar pooled investment vehicles subject to their respective jurisdictions.
The next area the Council focused on was leverage, both in the registered fund as well as the private fund space.  While the statement notes and welcomes the SEC’s recent rulemaking on the use of leverage by registered funds, the primary focus of the update concerns the private fund space.  Industry-wide data on Form PF confirmed that, on average, the use of leverage by private funds is not particularly elevated, but also indicated that the use of leverage appears to be concentrated in larger funds.  However, fully evaluating these issues requires additional analyses, involving more and better data.
To be clear, available measures of leverage are imperfect in this context.  Likewise, the relationship between a hedge fund’s level of leverage and risk, and whether that risk may have financial stability implications, is highly complex.  On a standalone basis, leverage is clearly not an adequate proxy for risk in a particular trade or across a fund. 
For example, a seemingly elevated amount of gross notional leverage for an arbitrage strategy might represent a perfectly acceptable level of risk, particularly in cleared, liquid instruments.  
Distinctions in investment strategies, as well as counterparty exposures, the volatility and liquidity of the assets being levered, the extent to which positions are hedged, and financing terms, all play a critical role in understanding hedge fund risks.  While hedge fund reporting data on Form PF has increased transparency to regulators on the use of leverage, this data does not provide a complete picture of important situational distinctions when looking beyond headline leverage exposures.      
Currently, a host of important factors are difficult to fully evaluate, especially because hedge funds and their counterparties are supervised or regulated by multiple agencies across various jurisdictions. 
This means that no single regulator has a complete window into the risk profile of funds, limiting the Council’s ability to assess potential risks to financial stability from these activities.
Thus, the Council is creating an interagency working group that will share and analyze relevant regulatory information in order to better understand hedge fund activities and further assess whether there are potential risks to financial stability.  The working group will also assess the sufficiency of and use of regulatory data to evaluate the extent and types of leverage employed by hedge funds, and will consider potential enhancements to this data as well as the establishment of standards governing the measurements of leverage.
The working group will seek to provide findings to the Council by the fourth quarter of this year.  If risks to financial stability are identified, the Council will (1) determine what actions can be taken by regulators using existing authorities; (2) assess whether existing regulatory and supervisory tools are sufficient to address such risks, and (3) consider whether additional authorities may be needed for market regulators or other supervisory agencies. 
Now, moving on to the final three areas addressed in the statement: operational risks, securities lending, and resolution and transition planning. 
The Council’s review of operational risks specifically focused on the potential for a disruption or failure of a service provider or the provision of a flawed service resulting in broader transmission of risk.  Here, the Council believes further analysis is appropriate and will seek continued engagement with industry participants and other stakeholders to develop a greater understanding of service providers, their operating infrastructure, and the measures used by asset managers to mitigate these potential risks.
With regard to securities lending, the Council believes that more comprehensive information on securities lending activities across the financial system is necessary to fully assess the materiality of potential risks.  In addition to encouraging a number of important data enhancements already underway, the Council encourages improved and regular data collection and reporting, interagency data sharing, and additional engagement with international counterparts.  As these efforts unfold, the Council will be in a better position to assess potential risks.
Finally, the Council also considered questions around resolvability and transition planning.  The Council identified certain potential risks associated with stress scenarios affecting asset management entities and has noted steps to address such risks in the context of its analysis of liquidity and redemptions and leverage. The Council recognizes that SEC staff is working to develop a proposed rule for SEC consideration to require registered investment advisers to create and maintain transition plans that address, among other items, a major disruption in their business. 
This concludes my summary of the Council’s statement, and I will now turn it back over to Secretary Lew.