November 14, 2013
As a risk professional who has worked in the Asset Management industry for approximately 20 years and been involved in intimaate product development discussions at the highest level with one of the largest asset managers/mutual funds with assets exceeding $3 trillion dollars I would strongly advise the Securities Exchange Commission to seriously consider including Asset Management firms in the category of systemically important.
The Office of Financial Research has accurately described the crux of the issue and risk to financial stability imposed by these firms during tail events in the market.
"The diversity of these activities and the vulnerabilities they may create, either separately or in combination, has attracted attention to the potential implications of these activities for financial stability. Some activities highlighted in this report that could create vulnerabilities—if improperly managed or accompanied by the use of leverage, liquidity transformation, or funding mismatches—include risk-taking in separate accounts and reinvestment of cash collateral from securities lending."
The report goes on to describe the lack of transparency associated with the public disclosure of data in separate accounts at privately owned asset management firms. I would submit that the lack of transparency is a source of risk to financial stability however is also a key lever for the Securities Exchange Commission to use to monitor systemic risks in financial markets.
The concentration of counterparty risks across asset management firms (and large insurance firms) should be a key metric for measuring potential conditions of systemic risks in the market. The widespread use of derivatives especially Credit Default Swaps and the exchange of insurance contracts may tend to create even greater opacity in the markets where counterparties offset these trades with other parties not related to the initial transaction. These contra-party transactions may not be transparent to either counterparty creating a dominoe effect during "tail-events" which may result in calls on collateral or withdrawals of liquidity further accelerating selling.
There is however a ligitmate concern with public disclosure of financial data by asset managers. Many asset managers have not developed the means to aggregate financial data in ways that would provide real time or near real time disclosure of the risk positions and counterparty concentrations that may be required to comply with the reports findings. Asset managers would need time to develop technology to aggregate trade data that would be sufficient to recognize systemic risks resulting from these counterparty activities as well as the means to monitor and react to systemic risks.
As an example, derivative trades require collateral deposits of securities and cash to secure counterparty trades however daily monitoring of collateral is not possible. Additionally, market conditions may result in a scarcity of high quality collateral. Under collateralized derivatives trades may worsen during market contagion creating an accelerant of selling high quality securities.
Gaps in technology may limit a firm's ability to manage liquidity using manual means to monitor collateral on a monthly basis which may not be timely enough to respond to rapid deterioration in market conditions. This is but one example of the need for additional technology solutions to address the underlying infrastructure impacting systemic risk.
Major events "freeze" participants in place because of a lack of technological nimbleness inherent across financial markets to "see" and respond to liquidity risk. The "herding" effect is only a symptom of a much larger systemic risk, the lack of real-time systems, which give firms the ability to monitor liquidity between counterparties and across the enterprise as market conditions change during risk events.
Secondly, asset managers' concern about public disclosure of financial data is a threat to the ability of these firms to manage their funds in ways that do not tip off market participants to fund investment strategies. These concerns can be addressed appropriately and further argues for the movement toward an industry clearinghouse to improve the lack of transparency.
The report does an excellent job of focusing on behavioral issues that may lead to the sources of risk posed by asset managers. "Regulation of asset managers often focuses on limiting conflicts of interest between asset managers and their clients, which can help mitigate these risks. However, such regulation focuses on helping ensure that managers adhere to their clients desired risk-return profiles, but does not always address collective action problems and other broader behavioral issues that can contribute to asset price bubbles or other market cycles."
The report fails in its analysis of disparate or inadequate risk management systems to respond to market contagion. This report inaccurately assumes more advanced risk systems exist than are currently available or that risk professionals have direct lines of sight into these systemic risks. Regulators should better understand the limits of these risk systems and the cultural behavioral risk alluded to which make it challenging for risk professionals to overcome business pressure to "reach for yield" or the "herding" effect brought on by popular investment strategies intended to produce excess yield and increase systemic risk.
In isolation, one firm's systemic risk to financial markets may not be apparent from the perspective of a single firm. The collective behavior of market participants requires a dispassionate observer to monitor the approaching developments of systemic risk. In the heat of battle, once a firm realizes it has exceeded acceptable risk exposures the damage may already be done while counterparties and other market participants simply react in unison to protect themselves from the inevitable fall out.
I agree that the findings in the report provide a framework for developing strong parameters for monitoring asset managers going forward. Further research should be advanced with participation from industry risk professionals who have greater insights into the challenges of managing systemic risks at their firms. One area of weakness in the report is the section on Firms as a Source of Risk. While it is true that failure of any of these large asset managers would have major financial implications the analysis of the likeihood of failure is weakened by the examples. "Heightened redemptions from the funds and accounts managed by the asset management divisions of Bear Stearns, Wachovia, and Lehman occurred in step with other destabilizing events in the market."
With the exception of the failure of one money market fund, shareholders and employees of the largest asset managers paid the price for market contagion as firms shed costs to offset severe drops in revenue.
The argument that "firms are a source of risk" must be supported with data that quantifies the likelihod of default and takes into account how customer accounts are protected through SIPC including the resolution of default in the event of failure. Regulation(s) for resolving asset management failure may be informed by the FDIC thereby providing clear guidance for managing risk and exposures in the event of a future Bear Stearns-like failure or a "Fidelity Investments" event which may be more complicated given the complexity of a privately owned asset management firm.
Lastly, the risk exposure in transmission channels is real and growing. The derivatives market has grown exponentially since the 2008 events and exceeds the GDP of all industrialized and emerging markets. "The connections asset managers have with an array of financial companies, both within a holding company structure and with outside entities, could transmit risks among asset managers, other financial companies, and broader markets."
Transmission risk is both direct and indirect in that asset managers may also act as investment agents for foreign sovereign entities whose national pension funds and foreign debts are interconnected with asset managers globally. These are not new risks but as asset managers expand in search of increasingly large asset pools to manage to achieve higher economies of scale the risk of global contagion will increase. Derivatives enhance the exposure to global contagion, when it occurs, and given the scope and scale of the derivatives market excess leverage facilitated through these channels can become triggers for financial instability. Central bankers have warned about the shadow banking markets which may require limits on global systemic exposure(s) that are racheted or pegged to global GDP.
Thank you for the opportunity to comment on these matters and I wish the Commission luck in their efforts to find ways to manage systemic risks.
Copyrighted material redacted. Author cites:
Darby, Michael R. "Over-The-Counter Derivatives And Systematic Risk To The Global Financial System," Advances in International Banking and Finance, 1997, v3(1), 215-235. Available at http://www.nber.org/papers/w4801.
Goldin, I. and Vogel, T. (2010), Global Governance and Systemic Risk in the 21st Century: Lessons from the Financial Crisis. Global Policy, 1: 4–15. doi: 10.1111/j.1758-5899.2009.00011.x. Available at http://onlinelibrary.wiley.com/doi/10.1111/j.1758-5899.2009.00011.x/abstract.
Dijkman, Miquel. "A Framework for Assessing Systemic Risk," The World Bank, Policy Research Working Paper 5282. Available at http://elibrary.worldbank.org/doi/pdf/10.1596/1813-9450-5282.