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Regulators Should Bolster Lines of Defense For Open-Ended Bond Funds

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EDITOR'S NOTE: During the pandemic, the bond market plunged into crisis. Then, the Fed came along with its bond-buying program to “backstop” the market, according to Yahoo! Finance. Now, a report from the Bank for International Settlement suggests, “Regulators should bolster lines of defense for open-ended bond funds to cut systemic risk in periods of market turmoil.” Economists and authors of the report, Stijn Claessens and Ulf Lewrick wrote that “This episode has sparked a discussion about bond OEFs’ resilience, the comprehensiveness of their liquidity management tools, especially in times of stress, and the tools’ adequacy for financial stability more broadly.” If the bond market doesn’t make changes, the next crisis could be even worse. 

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Regulators should bolster lines of defense for open-ended bond funds to cut systemic risk in periods of market turmoil, according to a report by the Bank for International Settlements.

As the coronavirus roiled markets last year, bond funds dumped assets in droves to keep up with investor redemptions, exacerbating already-poor liquidity and pricing pressure. Conditions were tense until authorities moved to backstop bond markets, raising questions over the efficacy of existing safeguards, said BIS, a Swiss oversight body for the world’s central banks.

“This episode has sparked a discussion about bond OEFs’ resilience, the comprehensiveness of their liquidity management tools, especially in times of stress, and the tools’ adequacy for financial stability more broadly,” economists Stijn Claessens and Ulf Lewrick wrote in the report.

Among the ideas put forward by Claessens and Lewrick are liquidity buffers that can be expanded during times of ample funding and released during periods of stress. More stringent regulation could ensure that liquidity mismatches are adequately managed.

“Regulation that takes a macro-prudential perspective of the sector could support financial stability by ensuring that tools internalize the effect of spillovers arising from bond OEFs’ actions,” the authors wrote.

Big Benefits

In addition, funds could introduce redemption notice periods that better reflect the liquidity profile of the portfolio. They could also make changes to an existing mechanism that enables firms to pass on some of the trading costs to investors who redeem. Along with other current tools, this so-called swing pricing made little difference last March, according to BIS’s analysis.

The authors acknowledge that such changes pose implementation challenges and require cost-benefit considerations. Advocates of the current industry setup point to the swift market recovery and reversal of fund outflows that followed the turmoil of March 2020.

Still, the important role that bond OEFs play in funding the economy suggests that enhancing their resilience “would yield significant macroeconomic benefits,” according to Claessens and Lewrick.

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