Chief executive of the Financial Conduct Authority (FCA) Andrew Bailey has listed a number of factors that could jeopardise market stability, including the role of open-ended investment funds, following the volatility experienced in early February.
The Chicago Board Options Exchange's Volatility Index (VIX) experienced its largest ever one-day move on 5 February, reaching its highest level since 2015 amid a steep decline in equity markets.
Reflecting on the volatility, Bailey asked: "Are there features of the structure of the system today, such as the larger number of open-ended investment funds, which mean that there are risks to stability which need to be tackled?"
He highlighted the FCA is currently looking at the risks associated with open-ended funds, as part of a reaction to the closures and suspensions seen in UK property funds in the fallout from the 2016 Brexit vote.
According to Bailey, the suspensions were "a major event at the time, which can look a bit less major with the benefit of time and perspective… but, we didn't know this at the time".
"What I think is important here is that investor expectations and understanding matches well the form and structure of the investment vehicles they use," he reiterated.
Bailey also said the FCA cannot "ignore" the market risks posed by short volatility strategies, following the market turmoil of early February.
He explained the "lack of inherent market volatility has led to the growth of strategies targeting volatility by investors, thus increasing risk-taking when volatility falls and cutting exposure when it rises".
He said: "It is not clear yet to what extent such strategies may have contributed to amplifying recent market moves.
"But there is clearly scope here for pro-cyclical behaviour, and that brings its own risks.
"It would, of course, be easy to say that such strategies are an inevitable feature of a search for returns in a world of very low, real interest rates, though this should not be overdone as an argument since volatility will be traded irrespective of the level of rates.
"But we should not ignore the risks to the financial system that can accompany these strategies. Far from it, we should be vigilant and inquisitive."
Bailey further cautioned there is "broader evidence that investors are accepting lower compensation for risk".
"These are all signals that we need to be on high alert, but in doing so recognise the resilience that has been built into the system post-crisis," he said.
Bank balance sheets
However, the FCA boss said there are concerns this resilience is "concentrated in the banking system and not in the world of market-based finance".
Bailey said the global financial crisis had driven a "shift" in the form of financial intermediation from bank balance sheets to market-based activity by investors "typically through investment management vehicles".
Bailey added: "There is a logic to this shift, evidence for which can be seen in the rapid, too rapid, growth of bank balance sheets before the onset of the crisis a decade ago. This was particularly pronounced in the trading books of banks.
"Today, the picture is very different."
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