Regulators are worried about 'complete market dysfunction'

Out of orderFlickr/Shawn Allen/licensed under Creative Commons Attribution 2.0Regulators are worried the markets will become dysfunctional.

The UK’s top official in charge of financial stability has given a clear description of the biggest risks to the system out there at the moment.

It’s to do with liquidity — a word which relates to both the ability to buy and sell assets freely on a functioning market, and also get your money back from an investment fund.

Speaking at the Financial Times’ Regulation in Asset Management conference on Tuesday, Alex Brazier, executive director for financial stability at the Bank of England, described the doom-laden relationship between the two.

If a sell-off in the bond markets leads to investors pulling their money from loss-making funds investing in bonds, the sell-off will intensify further and the panic among investors will worsen too.

“At worst this results in complete market dysfunction,” said Brazier. “It could happen because of a number of feedback loops in the system. Investors are behaving in increasingly pro-cyclical ways. You’ve got this relationship between prices and redemptions. Funds need to have a sense of the systemic rather than a sense of their own funds.”

A systemic collapse of liquidity has been among the biggest fears of regulators for a few years, and came to the fore since high-yield bond fund Third Avenue shut its doors in December.

Brazier saw that investors reacted badly to Third Avenue gating funds — placing restrictions on them pulling their money out — as the high-yield bond market plummeted.

“If fund A suddenly gates [stops investors pulling money], what happens to fund B? Third Avenue closing was a signal there can be contagion effects. What can make sense for an individual fund, might increase risks to the system.”

Barclays put out a research paper last week that said that since 2008, hedge funds have been shortening the amount of time it takes for their investors to redeem their money.

But, as BI’s Matt Turner noted, hedge funds are increasingly in a position where they can’t sell assets quickly to get that money to return to their investors.

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