Will regulators take aim next at fund managers and liquidity management?

One of the talking points by the Fed and others on market illiquidity has been on how mutual funds, especially opened ended ones, and ETFs create issues when investors sell en masse. Funds that offer short term liquidity to shareholders but may have assets that take time to sell (without a fire sale), end up with a gap that is dealt with by disposing of their most liquid (and often highest quality) assets first. This leaves the rest of the fund investors holding a potentially inferior set of investments.

Regulators have suggested that fund managers report each asset by their liquidity and use swing pricing. Swing pricing is the practice of (when markets are stressed) passing on costs associated with liquidation (that would otherwise end up with the remaining shareholders) to all the shareholders. From a SEC white paper “Liquidity and Flows of U.S. Mutual Funds”:

“…Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.  It is designed to protect existing shareholders from dilution associated with shareholder purchases and redemptions and would be another tool to help funds manage liquidity risks…”

In a recent IMF paper Global Financial Stability Report (GFSR): Vulnerabilities, Legacies, and Policy Challenges, Risks Rotating to Emerging Markets (October 2015) which addresses open-ended bond mutual funds, they said:

“…Another key development has been the rise of larger but more homogeneous buy-side institutions, particularly more important for financial intermediation while becoming more sensitive to redemption pressures, more prone to herd behavior (as documented in the April 2015 GFSR), and less likely to absorb order flow imbalances or to make markets…”

We have written about this in our Sept 29th post “The FSB takes on fund leverage and liquidity”, “The SEC wants to make sure mutual funds and ETFs are liquid for investors. This isn’t going to be as simple as it sounds.” on Sept 24th and yesterday in “More on market liquidity: is there another side to the Fed’s argument?”.

But there is another aspect to this issue. It was brought up by the authors of “Who is afraid of BlackRock?”, Massimo Massa, David Schumacher and Yan Wang. They noted that when BlackRock and BGI merged, the stocks owned by the combined firms underperformed. They write:

“…We find that other institutional investors re-balance away from stocks that experience a large increase in ownership concentration due to the pre-merger portfolio overlap between BlackRock and BGI. Over the same period, institutional ownership migrates towards comparable stocks not held by BGI funds prior to the merger. The re-allocation of institutional ownership has price impact. Stocks that experience large increases in ownership concentration due to the merger experience negative returns that do not fully revert. These stocks also become permanently less liquid and less volatile…”

This is not a TBTF argument or even really about shadow banking. They are saying that concentrated ownership results in illiquidity. In an interview on CNBC, Massa suggested that big funds like BlackRock ought not to offer next day liquidity.

The paper consider two scenarios: Are other investors afraid prospectively of a large withdrawal from BlackRock leading to a future fire sale? Those investors will shy away from owning those investments for fear of getting sucked in should some sort of idiosyncratic event occur, a classic externality. They call this the “fire sale risk hypothesis”. Alternatively, will investors do the opposite and copy what BlackRock is buying. This could, as the authors put it, “lead[s] to more market depth, higher liquidity and a positive price impact due to the increased buying pressure triggered by the motive to re-balance.” This is referred to as the “information hypothesis”.

The research led them to conclude the former (“fire sale risk hypothesis”) is true. Liquidity deteriorated as well. From the paper:

“…Stock liquidity deteriorates during the merger process, primarily once BlackRock enters the merger process. None of the measures detect any evidence of reversals in stock liquidity after the merger completes. The liquidity effects we estimate are not only statistically significant but also economically meaningful…”


“…For stocks not held by BlackRock funds prior to the merger, we find no effect on stock liquidity…”

The authors say, in their conclusion:

“…Our results have important implications because they clarify the impact of concentrated ownership on stock markets and because they suggest that large asset managers may have systemic risk implications. Our results suggest that the presence of large asset managers can reduce stock volatility at the expense of lowering liquidity…”

Massa, in the CNBC interview, suggested that big funds like BlackRock ought not to offer next day liquidity during times of stress.

Needless to say, BlackRock disputes the research and conclusions. Their objections were outlined in the CNBC video.

Regulators tried to designate BlackRock a SIFI, but were rebuffed. Could open-ended funds find themselves subject to LCR-type constraints or will it be limited to the liquidity markers and possibly swing pricing that the SEC is suggesting? We suspect that the regulators are just getting started with examining the fund investment industry and the bigger the target is, the more attention they will get.



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