On 14th May 2020, the General Board of the European Systemic Risk Board (ESRB) discussed the Market illiquidity and implications for asset managers and insurers due to coronavirus (COVID-19).
ESRB stated that the sharp fall in asset prices observed at the onset of the coronavirus pandemic was accompanied by significant redemptions from some investment funds and deterioration in financial market liquidity. Market conditions have stabilised most recently – to a large extent on the back of decisive actions taken by central banks, supervisory authorities and governments in the EU and globally. However, investment funds and insurers with regard to unit-linked insurance products may see further redemption pressures if the macroeconomic outlook worsens by more than is currently anticipated.
First Segment – Corporate Debt:
This segment comprises investment funds with significant exposures to corporate debt. At the onset of the COVID-19 pandemic, there were significant redemptions from funds investing in corporate debt. Furthermore, investment funds hold a significant proportion of the stock of non-financial corporate bonds outstanding in Europe. Any future redemptions pressures from open-ended funds with short redemption periods could result in fund managers selling less liquid assets quickly, thereby contributing to a deterioration in liquidity conditions in corporate debt markets. This could have adverse spill overs on other financial institutions with exposures to these assets (such as insurance companies, pension funds or banks) or an adverse impact on the cost and availability of market-based financing for non-financial corporations.
Second Segment – Real Estate:
This segment identified by the General Board comprises investment funds with significant exposures to real estate. The necessary public health restrictions required to contain the spread of COVID-19 could result in a reduction in real estate market transactions and an increase in valuation uncertainty. Real estate investment funds are estimated to account for approximately one-third of the EU commercial real estate market. Any potential future redemptions from investment funds that have significant real estate holdings, if associated with real estate asset sales in an environment of low transaction volumes, could contribute to downward real estate valuation pressures. This could have adverse implications for other financial institutions with exposures to real estate (including through the use of real estate as collateral for lending).
The General Board highlighted that liquidity management tools available to fund managers can help to mitigate ‘first-mover advantage’ dynamics and the risk of asset fire sales. Individual fund managers often have a range of tools at their disposal to use in such situations, including swing pricing and redemption gates, although there is significant variation in the availability of those tools both across EU jurisdictions and across market segments (e.g. between investment funds and insurers offering unit-linked products). Some asset managers have already employed these tools in the light of the deterioration in market liquidity and rising redemption requests observed at the onset of the coronavirus shock. In addition to helping to protect investors, the timely use of liquidity management tools (including those that promote an adequate allocation of redemption costs) also reduces the risk of forced sales of less liquid assets in periods of stress, helping to guard against the adverse system-wide effects stemming from fire sale dynamics across the financial system.