On August 26, 2019, the Committee submitted a comment letter to the International Organization of Securities Commissions (“IOSCO”) and to the Financial Stability Board (“FSB”) responding to IOSCO’s report on leverage (“IOSCO Leverage Report”), which sets forth “a proposed framework to help measure leverage used by investment funds that in some circumstances could pose financial stability risks” and the FSB’s report, Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (“FSB Asset Management Report”).
The IOSCO Leverage Report is intended to develop a proposed framework to “help measure leverage used by investment funds which in some cases could pose financial stability risk.” The IOSCO Leverage Report was issued in response to Recommendation 10 in the FSB Asset Management Report, which asks IOSCO to:
“identify and or develop consistent measures of leverage in funds to facilitate more meaningful monitoring of leverage for financial stability purposes and help enable direct comparisons across funds and at a global level. IOSCO should also consider identifying and/or developing more risk-based measure(s) to complement the initial measures with a view to enhance authorities’ understanding and monitoring of risks that leverage in funds may create. In both cases, IOSCO should consider appropriate netting and hedging assumptions and where relevant build on existing measures.”
The Committee recommended that the FSB and IOSCO remain focused on an activities-based approach to identifying any potential systemic risk posed by investment funds and not seek to identify individual investment funds that could pose a financial stability risk. The Committee appreciates efforts by the FSB and IOSCO to develop a proposed framework to measure the use of leverage by investment funds to determine whether it constitutes a systemically risky activity. We have long supported an activities-based approach to addressing any potential systemic risk posed by investment funds and/or the asset management industry, and do not believe that the failure of any individual investment fund or asset manager would pose systemic risk. Nonetheless, it is plausible that the excessive use of leverage across the investment fund industry, coupled with inadequate risk-management practices, could be a systemically risky activity that could lead to steeper asset price falls than would otherwise be the case in a market downturn, and that such steeper asset price declines could contribute to a contagious run on the financial system. Therefore, establishing a standardized global measurement of leverage may be a worthwhile policy goal in determining whether the use of leverage across the investment fund industry is a systemically risky activity.
The Committee believes it is critical to apply any such leverage measures solely on an asset class-by-asset class basis and not on an aggregated basis across asset classes held by an investment fund, as there are vast differences in the relative riskiness of underlying asset types that would make a single aggregated measurement of an investment fund’s leverage meaningless and misleading. The Committee further believes any leverage measures used by regulators should net short and long positions within the same asset class in order to accurately measure risk. Additionally, regarding interest rate swaps, the Committee supports making adjustments to account for duration. Finally, the Committee has reviewed the leverage measures being considered by IOSCO and among them, finds that Net Notional Exposure, which would account for netting and hedging arrangements, to be the most appropriate measure of risk.
The Committee’s letter can be found here.