US fund managers are fearful and fiercely resisting a Securities and Exchange Commission plan to force them to mark some money market funds to market, a proposal that could affect almost $US1 trillion of their funds under management. It’s a good illustration of the potential unintended consequences that could flow from the tide of post-crisis financial regulation.
Using a floating or market pricing of the underlying investment in the funds that invest in corporate debt and municipal securities rather than the traditional $1 a unit fixed price is rational. It would avoid the problem that was exposed in the aftermath of the Lehman Brothers collapse, where a number of funds 'broke the buck', creating losses for investors too slow to exit.
If introducing such a regulation were to trigger a mass exodus of funds as investors sought more stable assets, like bank deposits, it could introduce an unintended source of instability to the US system.
In a KGB interview last week, Credit Suisse’s chief economist Neal Soss made the point -- in what was probably a reference to the Volker rules on banks taking principal positions -- that the new US regulatory environment could affect the ability of markets to respond flexibly to pressure.
"There always are. I think one of the risks under current circumstances arises from the intersection of tightening (US monetary policy) policy when, if and as it comes and the new regulatory environment that makes it very difficult for the dealer community to have an elastic balance sheet to achieve the risk transfer from people who want to sell securities to other people who are willing to buy them," he said.
"The dealers used to facilitate that by taking the assets into inventory and then searching for a counterparty. That sort of behaviour is much more difficult to achieve now because we have higher capital requirements on the dealers, more stringent liquidity requirements on the dealers and so forth.
"And if there’s a risk to some kind of unstable consequence, I think it probably resides in that intersection. It’s an untested regulatory regime for the beginnings of a tightening cycle," he said.
That answer was in relation to a question about the potential unintended consequences of more than half a decade of extraordinary monetary policies within the major developed economies, which has seen volatility fall to remarkably low levels and reflects minimal (if any) pricing in of risk.
While Soss says the market has priced in perhaps half the risk that US interest rates will start to rise from the middle of next year, he is fairly sanguine about the impact of the probable move towards normalising US rates. He says markets will have up to a year to price in the remainder.
He did, however, also refer to the potential for the flows of capital from developed economies to less developed markets to reverse. These flows have been under-pinned by the negative real official interest rates in the US, Europe and Japan and the search for yield and returns from riskier asset classes that they have promoted.
That’s something that was highlighted by Adrian Blundell-Wignall, the special adviser to the OECD’s secretary-general for financial markets, in a speech in Sydney yesterday.
"There has been a huge super-highway of money flowing into emerging market credit because it has got much higher yield. The question is whether this super-highway is a dual carriageway," he said, according to Fairfax Media.
If investors suddenly decided to exit higher-risk exposures and all tried to get out at the same time (similar to the 'taper tantrum' last year when Ben Bernanke first hinted at the winding down of the Federal Reserve Board’s massive bond and mortgage-buying program) it would create convulsions and seizures in markets and, potentially, another crisis.
The unknowns in markets are whether and how central banks can withdraw the unprecedented stimulus and ultra-cheap liquidity they have been pumping into markets since 2008 without igniting implosions in asset values that have been pumped up by the search for yield.
Blundell-Wignall believes post-crisis monetary policies have created asset bubbles in emerging economies, including China’s, that could end in currency shocks and defaults on debt. One could argue that it isn’t only developing economies that could be affected if US monetary policy causes global ripples. Equity, debt and housing markets in some parts of the developed world, including Australia, might also be impacted.
A fresh bout of turmoil in global markets would interact with (and stress-test) the new financial regulatory architecture of the system. That adds another layer of complexity and uncertainty to how markets for both financial and real assets might function under pressure.
At present markets are sanguine, complacent even, about the levels of risk within the system. It wouldn't take much of an event to change that.