[Federal Register Volume 79, Number 247 (Wednesday, December 24, 2014)]
[Notices]
[Pages 77488-77495]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2014-30255]


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FINANCIAL STABILITY OVERSIGHT COUNCIL

[Docket No. FSOC-2014-0001]


Notice Seeking Comment on Asset Management Products and 
Activities

AGENCY: Financial Stability Oversight Council.

ACTION: Notice.

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SUMMARY: Consistent with its responsibility to identify risks to the 
financial stability of the United States, the Financial Stability 
Oversight Council (Council) is issuing this notice seeking public 
comment on aspects of the asset management industry (Notice), in 
particular whether asset management products and activities may pose 
potential risks to the U.S. financial system in the areas of liquidity 
and redemptions, leverage, operational functions, and resolution, or in 
other areas. The Council is inviting public comment as part of its 
ongoing evaluation of industry-wide products and activities associated 
with the asset management industry.

DATES: Comments must be received no later than February 23, 2015.

ADDRESSES: Interested persons are invited to submit comments on all 
aspects of this Notice. All submissions must refer to docket number 
FSOC-2014-0001.
    Electronic Submission of Comments: Interested persons may submit 
comments electronically through the Federal eRulemaking Portal at 
http://

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www.regulations.gov. Electronic submission of comments allows the 
commenter maximum time to prepare and submit a comment, provides for 
timely receipt, and enables the Council to make the comments available 
to the public. Comments submitted electronically through http://www.regulations.gov can be viewed by other commenters and interested 
members of the public. Commenters should follow the instructions 
provided on that site to submit comments electronically.
    Mail: Comments may be mailed to Financial Stability Oversight 
Council, Attn. Patrick Pinschmidt, Deputy Assistant Secretary for the 
Financial Stability Oversight Council, 1500 Pennsylvania Ave. NW., 
Washington, DC 20220.
    Public Inspection of Comments: Properly submitted comments will be 
available for inspection and downloading at http://www.regulations.gov.
    Additional Instructions: In general, comments received, including 
attachments and other supporting materials, are part of the public 
record and are available to the public. Do not include any information 
in your comment or supporting materials that you consider confidential 
or inappropriate for public disclosure.

FOR FURTHER INFORMATION CONTACT: Patrick Pinschmidt, Deputy Assistant 
Secretary for the Financial Stability Oversight Council, Department of 
the Treasury, at (202) 622-2495; Lyndsay Huot, Senior Policy Advisor, 
Office of the Financial Stability Oversight Council, Department of the 
Treasury, at (202) 622-5874; or Eric Froman, Office of the General 
Counsel, Department of the Treasury, at (202) 622-1942.

SUPPLEMENTARY INFORMATION: The Dodd-Frank Wall Street Reform and 
Consumer Protection Act (Dodd-Frank Act) established the Council to 
identify risks to the financial stability of the United States, promote 
market discipline, and respond to emerging threats to the stability of 
the U.S. financial system. Consistent with those purposes, the Council 
continually monitors the financial marketplace to identify potential 
risks to U.S. financial stability.
    The Council has been engaged in work over the past year to analyze 
risks associated with the asset management industry and whether any 
such risks could affect U.S. financial stability. The Council 
recognizes that asset management is an important component of the 
financial services industry and that there are meaningful differences 
within the asset management industry, with diverse investment 
strategies, corporate structures, regulatory regimes, and customers. To 
further the Council's work, in May 2014, the Deputies Committee of the 
Council hosted a public conference on the asset management industry and 
its activities, at which practitioners--including CEOs, treasurers, and 
risk officers--as well as academics and other stakeholders discussed a 
variety of topics related to the industry. The Council subsequently 
directed staff to undertake a more focused analysis of industry-wide 
products and activities to assess potential risks associated with the 
asset management industry. Based on that and other work, certain areas 
of interest have been highlighted by the Council as warranting further 
review and analysis.
    The Council is now seeking public comment in order to understand 
whether and how certain asset management products and activities could 
pose potential risks to U.S. financial stability. Specifically, this 
Notice requests information about whether risks associated with 
liquidity and redemptions, leverage, operational functions, and 
resolution in the asset management industry could affect U.S. financial 
stability.\1\ The Council also welcomes input on other areas associated 
with asset management products and activities that could affect U.S. 
financial stability.
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    \1\ In this regard, the Council is acting consistent with the 
purposes described in section 112(a)(1) of the Dodd-Frank Act, see, 
e.g., 12 U.S.C. 5322(a)(1)(A) (``identify risks to the financial 
stability of the United States that could arise from the . . . 
ongoing activities, of . . . nonbank financial companies''), as well 
as pursuant to specific duties of the Council. See, e.g., 12 U.S.C. 
5322(a)(2)(C) (requiring the Council to ``monitor the financial 
services marketplace in order to identify potential threats to the 
financial stability of the United States'').
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    The Council recognizes that investment risk is inherent in capital 
markets, representing a normal part of market functioning. The 
Council's focus on the asset management industry is directed at 
assessing whether asset management products or activities could create, 
amplify, or transmit risk more broadly in the financial system in ways 
that could affect U.S. financial stability. Financial stability risks 
may arise even where existing measures protect individual market 
participants (including particular asset managers, investment vehicles, 
and investors) because these measures may not fully take into account 
the effects of possible stress on other market participants, markets 
themselves, or the broader economy. Similarly, risks to financial 
stability might not flow from the actions of any one entity, but could 
arise collectively across market participants. Further, the Council 
notes that certain activities that do not pose risks to financial 
stability during normal times may do so during periods of financial 
market stress or stress at a particular firm.
    A number of different types of entities subject to varying 
regulatory frameworks engage in asset management activities, including 
but not limited to registered investment advisers, banks and thrifts, 
insurance companies, commodity trading advisors, and commodity pool 
operators.\2\ These entities provide a variety of asset management 
products, herein referred to as ``investment vehicles,'' such as 
separately-managed accounts (SMAs) and ``pooled investment vehicles.'' 
\3\ Pooled investment vehicles include investment companies registered 
under the Investment Company Act of 1940 (Investment Company Act) 
(registered funds), private funds (including hedge funds), bank 
collective investment trusts, and commodity pools. The Council is 
interested in obtaining information on potential risks to the U.S. 
financial system that may arise from the asset management activities of 
any entities or investment vehicles.
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    \2\ Many of these entities provide a range of financial 
services. For the purposes of this Notice, the Council is interested 
in the asset management activities of these entities and any risks 
that they could present to the broader financial markets. As 
discussed in Sections III and IV, the Council is also exploring the 
existence of potential risks that could arise from interconnections 
with affiliated companies.
    \3\ SMAs are accounts managed by a registered investment 
adviser, in which the client, which could be a pension fund, 
sovereign wealth fund, or other entity or individual, retains direct 
and sole ownership of the assets under management and which are 
typically held at an independent custodian on behalf of the client. 
For purposes of this Notice, SMAs are included in the term 
``investment vehicles.''
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    The Council recognizes that the Securities and Exchange Commission 
(SEC) is undertaking several initiatives that would apply to investment 
companies and investment advisers regulated by the SEC and may address 
some of the risks described in this Notice.\4\ While the SEC's 
initiatives are not specifically focused on financial stability, the 
Council intends to consider the impact these initiatives may have in 
reducing any risks to U.S. financial stability associated with the 
asset management industry.
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    \4\ See Unified Agenda of Regulatory and Deregulatory Actions 
(Fall 2014) (initiatives relating to derivatives use by investment 
companies, fund liquidity management programs, transition plans for 
investment advisers, stress testing for large asset managers and 
large investment companies, and information reporting by SEC-
regulated entities).
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    The Council's analytical process will depend importantly on the 
existence

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and availability of high-quality data and information, which are 
essential to the ability of the Council to carry out its statutory 
purposes. The Council notes that information is available in varying 
degrees about different asset management products and activities. A 
core component of the Council's review is an evaluation of the extent 
to which sufficient data are available to monitor and assess potential 
risks in the asset management industry and whether there are areas 
where additional data and information would be helpful to the Council, 
as well as to market participants.
    The Council has not made any determination regarding the existence 
or nature of any potential risks to U.S. financial stability discussed 
in this Notice. Throughout this Notice, the Council asks questions 
regarding areas of potential risk in the asset management industry and 
will consider the input received in each case in evaluating whether any 
of these areas might present potential risks to U.S. financial 
stability. In the event the Council's analysis identifies risks to U.S. 
financial stability, the Council will consider potential responses.

I. Liquidity and Redemptions

    Liquidity risk generally refers to the risk that an investor will 
not be able to buy or sell an asset in a timely manner without 
significantly affecting the asset's price.\5\ Most financial assets 
expose investors to some degree of liquidity risk, whether they invest 
directly in the assets or indirectly through a pooled investment 
vehicle. While the Council welcomes broader input on liquidity risks 
that may be associated with investment vehicles generally, the Council 
is focused on exploring whether investments through pooled investment 
vehicles that provide redemption rights, as well as their management of 
liquidity risks and redemptions, could potentially influence investor 
behavior in a way that could affect U.S. financial stability 
differently than direct investment.
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    \5\ The term ``liquidity risk'' is used herein to describe 
market liquidity risk, as opposed to funding liquidity risk. Funding 
liquidity risk, which involves the risk that an entity is unable to 
meet its cash or other obligations in a timely manner, is a means 
through which leverage may contribute to financial market stress, a 
subject discussed in Section II.
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    In particular, the Council is interested in exploring the ways in 
which investors in some pooled investment vehicles could have greater 
incentives to redeem than if they were to sell a direct investment in 
the financial assets comprising the vehicle's portfolio. Investors in 
pooled investment vehicles that offer near-term access to redemptions 
could face increased redemption incentives, especially during periods 
of financial market stress, because the costs associated with 
redemptions are shared and, as a result, partially borne by remaining 
shareholders.\6\ As a result, investors could have an incentive to 
redeem before other investors to avoid sharing the costs associated 
with other investors' redemptions. This incentive to redeem from pooled 
investment vehicles may be magnified for vehicles invested in less-
liquid asset classes. Managers of such vehicles might need to sell 
assets at a discount to meet redemptions, particularly during times of 
stress, and the cost would have to be borne by remaining investors in 
the vehicle. If a manager of such a vehicle were to sell more-liquid 
portfolio assets in order to minimize the price impact of early 
redemptions, liquidity risk could be concentrated on investors 
redeeming later. As a result, investor perceptions of how liquidity and 
redemption risk are managed in pooled investment vehicles could 
potentially heighten redemption incentives and increase the likelihood 
of asset sales.
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    \6\ In contrast, because SMAs impose the full cost of asset 
sales on the redeeming investor, SMAs are unlikely to create the 
same incentives for the investor to redeem.
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    The Council seeks input on whether these issues affect redemption 
behavior from pooled investment vehicles in a way that could ultimately 
affect financial stability. Specifically, the Council is interested in 
whether such redemption incentives could make fire sales more likely in 
the asset markets in which the pooled investment vehicles invest, as 
well as in correlated or broader asset markets.
    The Council also is interested in redemption incentives associated 
with pooled investment vehicles in which lenders reinvest cash 
collateral received to secure a loan of securities.\7\ Such a pooled 
investment vehicle may experience redemptions triggered by terminations 
of securities loans, and the related requirement to repay cash 
collateral. The Council seeks input on whether such redemptions might 
increase during times of financial stress and whether this may result 
in the potential broader market impacts discussed above.
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    \7\ Securities lending is a transaction involving the temporary 
transfer of a security by one party (the lender) to another (the 
borrower) in exchange for cash or non-cash collateral. Securities 
loans generally are collateralized by an amount exceeding the value 
of the securities loaned, and the required collateral amount is 
marked-to-market daily. Most securities lending in the United States 
is secured by cash collateral, and lenders generally reinvest cash 
collateral to earn additional income.
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    The Council understands that pooled investment vehicles may employ 
a variety of techniques to manage liquidity risks.\8\ For example, some 
investment vehicles maintain a portion of assets in cash or highly-
liquid assets to meet redemption requests and may modify their 
portfolio composition based on market conditions to manage redemption 
requests.\9\ Many exchange-traded funds (ETFs) redeem in kind as a 
matter of course, and those that allow authorized participants (APs) to 
redeem in cash frequently impose transaction or liquidity fees that 
force the AP to bear the liquidity-related costs of its own 
redemption.\10\ Hedge fund investors often are subject to an initial 
``lock up'' period and thereafter may only redeem their interests on a 
periodic basis. Insurance separate accounts may serve as funding 
vehicles for life insurance policies or annuity contracts that provide 
deferred benefit payments and redemption disincentives (such as early-
surrender charges and loss of economic and tax benefits).\11\ Some 
private funds may have additional redemption restrictions that may be 
imposed during times of stress, such as size limits on redemptions 
(partial ``gates'') or temporary suspension of redemptions. The Council 
is interested in the effectiveness of these measures during

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periods of overall market stress, as well as the potential impact on 
broader financial markets from the exercise of such measures.
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    \8\ Regulatory requirements regarding liquidity in pooled 
investment vehicles and redemption practices are also critical to 
understanding risks and risk management. The Council is aware of 
existing regulations in this area and, while the discussion notes 
some relevant regulatory constraints, this Notice is not intended to 
provide a comprehensive discussion of regulatory requirements.
    \9\ In addition, SEC guidance provides that mutual funds and 
exchange-traded funds (ETFs) generally may not invest more than 15 
percent of their net assets in ``illiquid securities.'' Illiquid 
securities are defined as securities that cannot be sold or disposed 
of in the ordinary course of business within seven days at 
approximately the price at which the fund has valued the investment. 
Revisions of Guidelines to Form N-1A, Investment Company Act Release 
No. 18612 (Mar. 12, 1992) 57 FR 9,828 (Mar. 20, 1992).
    \10\ ETF shares are traded on an exchange. Investors (other than 
APs as discussed below) do not transact in shares directly with the 
ETF, but instead buy and sell shares in the secondary market (and do 
not have a right of redemption). ETF shares may only be redeemed by 
(or issued to) certain broker-dealers or other institutions that 
have contractual arrangements to act as APs for the ETF. ETF shares 
are issued and redeemed in block-size aggregations (e.g., 50,000 
shares) referred to as creation units, typically in an in-kind 
transaction in which an AP delivers or receives a specified 
portfolio of securities, other assets, and cash. Whereas mutual 
funds typically redeem their shares in cash but reserve the right to 
redeem in kind, ETFs typically redeem in kind but reserve the right 
to redeem in cash.
    \11\ Insurance separate accounts often are registered under the 
Investment Company Act as unit investment trusts.
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    The Council is also interested in the extent to which asset 
managers may not always manage investment vehicles in a way that 
prevents or fully mitigates the risks to the investment vehicle and to 
the broader financial system. For example, investor preferences 
regarding an investment vehicle's investment strategy and portfolio 
allocation may generally encourage the vehicle to remain fully, or 
almost fully, invested in particular asset classes and limit the 
vehicle's holdings of cash or highly-liquid assets. Similarly, 
competitive pressures to increase returns and outperform benchmarks may 
provide disincentives to holding cash or highly-liquid assets. The 
Council also seeks input on the degree to which the risk management 
practices of asset managers sufficiently account for the possibility of 
simultaneous asset sales by multiple investors or the likelihood of 
significantly larger price effects in times of stress.

Questions for Public Comment

    The Council requests comment on the questions below. The Council 
also welcomes input on other areas relating to liquidity and redemption 
risks in the asset management industry that could potentially present 
financial stability concerns.\12\
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    \12\ There may also be interconnections between liquidity and 
leverage risks, or between liquidity risk and activities such as 
securities lending. For example, leveraged investment vehicles whose 
posted collateral assets decline in value may need to sell other 
assets to obtain the liquidity required to meet margin calls. With 
respect to securities lending, if cash collateral is invested in 
assets with longer maturities than the loan terms, lenders could 
face liquidity risks that result in lender losses. See Section II 
for a discussion of risks associated with leverage.
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    1. How does the structure of a pooled investment vehicle, including 
the nature of the redemption rights provided by the vehicle and the 
ways that such vehicles manage liquidity risk, affect investors' 
incentives to redeem? Do particular types of pooled investment 
vehicles, based on their structure or the nature of their redemption 
management practices, raise distinct liquidity and redemption concerns 
(e.g., registered funds, private funds, or ETFs)?
    2. To what extent do pooled investment vehicles holding particular 
asset classes pose greater liquidity and redemption risks than others, 
particularly during periods of market stress? To what extent does the 
growth in recent years in assets in pooled investment vehicles 
dedicated to less liquid asset classes (such as high-yield bonds or 
leveraged loans) affect any such risks?
    3. To what extent might incentives to redeem shares in a pooled 
investment vehicle or other features of pooled investment vehicles make 
fire sales of the portfolio assets, or of correlated assets, more 
likely than if the portfolio assets were held directly by investors?
    4. To what extent does the potential for terminations of securities 
loans that would trigger redemptions from cash collateral reinvestment 
vehicles or other asset sales pose any distinct financial stability 
concerns? To what extent do investment vehicles reinvest cash 
collateral in assets with longer maturities relative to the lender's 
obligation to repay the collateral, which may increase liquidity risk? 
How much discretion do lending agents have with respect to cash 
collateral reinvestment? To what extent do lending agents reinvest cash 
collateral in vehicles managed by the same firm that manages the 
investment vehicle lending the securities?
    5. How do asset managers determine whether the assets of a pooled 
investment vehicle are sufficiently liquid to meet redemptions? What 
liquidity and redemption risk management practices do different types 
of pooled investment vehicles employ both in normal and stressed 
markets, and what factors or metrics do asset managers consider (e.g., 
the possibility that multiple vehicles may face significant redemptions 
at the same time, availability of back-up lines of credit) in managing 
liquidity risk?
    6. To what extent could any redemption or liquidity risk management 
practices (e.g., discretionary redemption gates in private funds) used 
in isolation or combination amplify risks?
    7. To what extent can competitive pressures create incentives to 
alter portfolio allocation in ways that may be inconsistent with best 
risk management practices or do not take into account risks to the 
investment vehicle or the broader financial markets?
    8. To the extent that liquidity and redemption practices in pooled 
investment vehicles managed by asset managers present any risks to U.S. 
financial stability (e.g., increased risks of fire sales or other 
spillovers), how could the risks to financial stability be mitigated?
    9. What additional information would help regulators or market 
participants better assess liquidity and redemption risks associated 
with various investment vehicles, including information regarding the 
liquidity profile of an asset class or of a particular type of 
investment vehicle?

II. Leverage

    Leverage is created when an investor (e.g., investment vehicle) 
enters into transactions resulting in investment exposures that exceed 
equity capital. Leverage can be financial (i.e., borrowings reflected 
on the balance sheet), or synthetic (i.e., exposures embedded in the 
structure of financial instruments such as derivatives). While the use 
of leverage with appropriate controls and risk management can be a 
useful component of an investment strategy, high degrees of leverage 
can present risks to investment vehicles by magnifying the impact of 
asset price or rate movements.
    In this Notice, the Council is interested in exploring ways in 
which the use of leverage by investment vehicles could increase the 
potential for forced asset sales, or expose lenders or other 
counterparties to losses or unanticipated market risks, and the extent 
to which these risks may have implications for U.S. financial 
stability. For example, during periods of financial market stress, 
declines in asset prices could lead to collateral or margin calls, 
requiring leveraged investors to meet those demands through asset sales 
that could in turn result in further declines in asset prices. 
Additionally, the exposures created by leverage establish 
interconnections between borrowers and lenders--and possible further 
interconnections between lenders and other market participants--through 
which financial stress could be transmitted to the broader financial 
system.
    The Council understands that the use of leverage by investment 
vehicles can vary significantly depending on the type of investment 
vehicle and type of investment strategy. In particular, the Council is 
interested in the extent and full variety of ways that private funds 
and SMAs obtain leverage.\13\ While the Council recognizes that 
registered funds are generally limited in their use of leverage, it is 
nonetheless also interested in the nature and extent of leverage 
obtained by registered funds, including through the use of derivatives.
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    \13\ While an SMA represents a direct investment by a client and 
investment management agreements may specify limitations relating to 
leverage, the Council is interested in whether, and how, the use of 
leverage by investors is affected when the investors' assets are 
managed through SMAs.
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    Leverage can be obtained by investment vehicles through a variety 
of secured financings, including margin credit, repurchase agreements 
(repos), prime brokerage financing

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arrangements, securities lending transactions, or bank loans. 
Investment vehicles may also obtain leverage through derivative 
transactions. Entering into numerous derivative contracts or having 
large directional exposures through derivatives may significantly 
increase the complexity of risk management and the associated level of 
risk within the investment vehicle. Some private fund strategies rely 
extensively on the use of derivatives to obtain leverage. Registered 
funds may also use derivatives, subject to certain limitations.\14\
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    \14\ A number of regulations apply to derivatives transactions. 
For example, exchange-traded and centrally-cleared derivatives are 
subject to specific margin rules and clearinghouse protocols to 
support payment of potential counterparty obligations. For certain 
swap and security-based swap transactions, rules (or proposed rules 
will) require mandatory clearing and execution on trading platforms, 
collection of margin, and data reporting and recordkeeping. Over-
the-counter derivatives that are not centrally cleared may be more 
difficult to value, transfer, or liquidate, potentially exposing 
contracting parties to greater counterparty credit risk.
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    The Council recognizes that derivatives are also used by investment 
vehicles for purposes other than obtaining leverage, such as 
establishing hedges against market risks. The Council is interested in 
better understanding whether and how derivatives are used by various 
types of investment vehicles to obtain leveraged market exposures, as 
opposed to hedging risks relating to other investment positions.
    U.S. regulations restrict leverage for certain types of investment 
vehicles. For example, the Investment Company Act constrains the amount 
of leverage that may be employed by mutual funds and other registered 
funds. Mutual funds may only incur indebtedness through bank borrowings 
with 300 percent asset coverage.\15\ Registered funds may engage in 
repos, but must segregate liquid assets equal to the repurchase price 
of the securities. Registered funds may also use derivatives, for 
hedging purposes or to enhance returns, subject generally to a 
requirement to segregate liquid assets for their derivatives 
transactions.\16\
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    \15\ Closed-end registered funds are also subject to the 300 
percent asset coverage requirement on their indebtedness. Closed-end 
funds may borrow both from banks and nonbank lenders, and closed-end 
funds are permitted to issue preferred stock subject to a 200 
percent asset coverage requirement.
    \16\ The amount of liquid assets to be segregated varies 
depending on the transaction and would generally either be the full 
obligation due at the end of the contract or, with respect to 
certain cash-settled derivatives, the daily mark-to-market 
liability, if any, of the fund under the derivative. In certain 
cases, registered funds may cover their derivatives transactions by 
holding a fully offsetting position. The SEC issued a concept 
release on the use of derivatives by registered funds in August 
2011. See Use of Derivatives by Registered Investment Companies 
Under the Investment Company Act of 1940, Investment Company Act 
Release No. 29776 (Aug. 31, 2011). Among other things, the concept 
release requested comment on the benefits and shortcomings of the 
asset segregation approach and potential alternatives.
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    By contrast, private funds, including hedge funds and other 
unregistered funds, are not subject to the leverage restrictions 
imposed on funds registered under the Investment Company Act. In 
addition, certain publicly offered products other than registered 
funds, such as exchange-traded commodity pools, may provide investors 
with more highly leveraged investment exposures than would be available 
through registered funds. SMAs may also employ leverage.\17\ Because 
regulators currently do not collect data on SMA portfolio positions on 
a systematic, industry-wide basis, information regarding the types of 
assets held in these accounts, their counterparty and other exposures, 
and amounts of leverage are not routinely available to regulators for 
assessment and monitoring purposes.
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    \17\ Because SMAs are not collective investment vehicles, they 
are not subject to restrictions on leverage under the Investment 
Company Act. The investment management agreement between the client 
and asset manager, however, may specify limitations relating to the 
use of leverage.
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Questions for Public Comment

    The Council requests comment on the questions below. The Council 
also welcomes input on other areas relating to the risks of leverage in 
the asset management industry that could potentially present financial 
stability concerns.
    1. How do different types of investment vehicles obtain and use 
leverage? What types of investment strategies and clients employ the 
greatest amount of leverage?
    2. To what extent and under what circumstances could the use of 
leverage by investment vehicles, including margin credit, repos, other 
secured financings, and derivatives transactions, increase the 
likelihood of forced selling in stressed markets? To what extent could 
these risks be increased if an investment vehicle also offers near-term 
access to redemptions?
    3. How do asset managers evaluate the amount of leverage that would 
be appropriate for an investment strategy, particularly in stressed 
market conditions? To what extent do asset managers evaluate the 
potential interconnectedness of counterparties? How do lenders or 
counterparties manage their exposures to investment vehicles?
    4. What risk management practices, including, for example, widely-
used tools and models or hedging strategies, are used to monitor and 
manage leverage risks of different types of investment vehicles? How do 
risk management practices in investment vehicles differ based on the 
form of leverage employed or type of investment vehicle? How do asset 
managers evaluate the risk of potential margin calls or similar 
contingent exposures when calculating or managing leverage levels? How 
are leverage risks managed within SMAs, and to what extent are such 
risks managed differently than for pooled investment vehicles?
    5. Could any risk management practices concerning the use of 
leverage by investment vehicles, including hedging strategies, amplify 
risks?
    6. To what extent could the termination of securities borrowing 
transactions in stressed market conditions force securities lenders to 
unwind cash collateral reinvestment positions? To what extent are 
securities lenders exposed to significant risk of loss?
    7. To the extent that any risks associated with leverage in 
investment vehicles present risks to U.S. financial stability, how 
could the risks to financial stability be mitigated?
    8. What are the best metrics for assessing the degree and risks of 
leverage in investment vehicles? What additional data or information 
would be useful to help regulators and market participants better 
monitor risks arising from the use of leverage by investment vehicles?

III. Operational Risk

    Operational risk refers to the risk arising from inadequate or 
failed processes or systems, human errors or misconduct, or adverse 
external events. Examples include business disruptions or failures in 
systems and processes, either within a firm or at external service 
providers relied upon by a firm. Like other financial services firms, 
asset management firms rely significantly on both affiliated and 
unaffiliated providers of technology, data, and other operational 
services, and they are exposed to operational risk in many different 
forms. While the Council is interested in any areas of operational risk 
within the asset management industry that could present risks to U.S. 
financial stability, the Council is particularly interested in two 
areas: (1) Risks that may be associated with the transfer of 
significant levels of client accounts or assets from one asset manager 
to another; and (2) risks that may arise when multiple asset managers

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rely on one or a limited number of third parties to provide important 
services, including, for example, asset pricing and valuation or 
portfolio risk management.\18\
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    \18\ While Section IV focuses on the financial implications of 
the failure or closure of an entity in the asset management 
industry, the Council is also interested in any unique operational 
risks that may arise if an asset manager, its affiliates, or 
investment vehicles were to fail or be liquidated.
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    The Council is interested in exploring any potential risks 
associated with the transfer of a significant level of client accounts 
or assets from an asset manager and whether there could be obstacles to 
this process, particularly during a period of financial market stress, 
that could pose risks to U.S. financial stability.\19\ Such transfers 
could occur on a large scale for various reasons, including damage to a 
manager's reputation that leads clients to select other managers or a 
manager's voluntary or involuntary exit from the business. Although 
clients have routinely replaced asset managers without significant 
impact in non-stressed situations, there could be delays or other 
obstacles associated with transferring client accounts to other 
managers or transitioning client assets to another custodian, 
particularly in a stressed scenario.
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    \19\ The transfer of client accounts or assets refers to the 
transfer of SMAs. Outflows of assets from a manager in the form of 
redemptions from pooled investment vehicles are discussed in Section 
I.
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    The Council seeks information on market practices, processes, and 
systems employed by asset managers and other market participants (e.g., 
custodians and transfer agents); these entities' operational 
capabilities to transition client accounts and assets between managers; 
and the effectiveness of such market practices, processes, and systems 
in times of idiosyncratic or market stress.
    The Council is also interested in exploring risks associated with 
reliance on service providers--either affiliated entities or 
independent third-party providers--for important components of the 
asset management business. Asset managers may use service providers for 
key functions or may be providers of such services to other asset 
managers or financial institutions. For example, asset managers often 
use affiliated entities or third parties to provide custody, brokerage, 
asset pricing and valuation, portfolio risk management, and 
administrative services (e.g., recordkeeping, accounting, and transfer 
agency services).
    The Council seeks to understand the potential risk across the asset 
management industry if multiple asset managers rely exclusively on one 
or a small number of providers for certain services and the resulting 
risk if one of these providers either ceases operations or renders the 
services in a flawed manner (e.g., providing asset pricing and 
valuation or portfolio risk models that contain errors in methodology). 
Careful consideration of how asset managers use service providers, 
particularly the degree of reliance by multiple asset managers on a 
concentrated number of service providers, is important in understanding 
whether there may be risks to certain markets or asset classes if asset 
managers were to suffer a disruption in service.
    More generally, strong operational controls and risk management are 
important within the asset management industry in areas such as 
accounting and recordkeeping, trading operations (including algorithmic 
trading), data security, custody, and pricing and valuation. Asset 
management firms, like other financial services firms, rely 
significantly on technological systems, including processing, 
recordkeeping, and communications systems, which are vulnerable to a 
number of operational risks ranging from normal system disruptions to 
targeted cyber-attacks. Asset managers that operate globally may be 
confronted with additional operational risks. The Council is interested 
in understanding whether any operational risks to asset managers could 
have broader implications for U.S. financial stability.

Questions for Public Comment

    The Council requests comment on the questions below. The Council 
also welcomes input on other areas relating to operational risks in the 
asset management industry that could potentially present financial 
stability concerns.
    1. What are the most significant operational risks associated with 
the asset management industry and how might they pose risks to U.S. 
financial stability? What practices do asset managers employ to manage 
operational risks (e.g., due diligence, contingency planning)?
    2. What are the risks associated with transferring client accounts 
or assets from one manager to another and how do these risks vary 
depending on the nature of the client, the asset types owned by the 
client (e.g., derivatives), or how the asset type is traded or cleared? 
For certain asset classes or strategies, are the number of asset 
managers offering a comparable strategy so concentrated that finding a 
substitute would present challenges? How rapidly could investment 
management accounts be transferred, including during a time of 
financial market stress?
    3. What market practices, processes, and systems need to be in 
place to smoothly effect transfers of client accounts or assets by 
asset managers and/or custodians? What differences exist in information 
technology systems, processes, or data formats that could pose 
operational risk, particularly when markets are stressed? Are there 
specific risks related to foreign clients, foreign custodians, foreign 
assets, or the use of offshore back-office operations?
    4. While asset liquidation is not required for, and is not 
typically associated with, the transfer of client accounts, are there 
any significant risks of asset liquidations in the event of a large-
scale transfer of accounts or assets from an asset manager?
    5. To what extent do asset managers rely on affiliated or 
unaffiliated service providers in a concentrated or exclusive manner 
for any key functions (e.g., asset pricing and valuation, portfolio 
risk modeling platforms, order management and trade processing, 
trading, securities lending agent services, and custodial services)? 
What would be the impact if one or more service providers ceased 
provision of the service, whether due to financial or operational 
reasons, or provide the service in a seriously flawed manner? To what 
extent do potential risks depend upon the type of service provided, 
whether the provider is affiliated with the asset manager, or whether 
the service provider is non-U.S. based? What due diligence do firms 
perform on systems used for asset pricing and valuation and portfolio 
risk management?
    6. What operational interconnections exist between the asset 
manager and the investment vehicles it manages, among investment 
vehicles managed by the same asset manager or affiliated managers, or 
between the asset manager and its affiliates? For example, to what 
extent do asset management firms rely on shared personnel, technology, 
or services among affiliates? Could any of those interconnections 
result in operational risk transmission among affiliated investment 
vehicles or asset managers in the event of a failure and resolution of 
an affiliate? Do market practices ensure that operational 
interconnections are sufficiently documented to allow for an orderly 
continuation of an investment vehicle's operations if the asset manager 
or affiliated or independent third-party service providers were to 
declare bankruptcy?
    7. What are best practices employed by asset managers to assess and 
mitigate

[[Page 77494]]

the operational risks associated with asset management activities 
performed by service providers, whether affiliated with the asset 
manager or not, and how common are these practices across the industry? 
What agreements or other legal assurances are in place to ensure the 
continued provision of services? What are asset managers' contingency 
plans to deal with potential failures of service providers, and how 
might these plans be impacted by market stress?
    8. To the extent that any operational risks in the asset management 
industry present risks to U.S. financial stability, how could these 
risks to financial stability be mitigated?

IV. Resolution

    The Council is interested in the extent to which the failure or 
closure of an entity could have an adverse impact on financial markets 
or the economy.\20\ While previous sections of this Notice explore 
aspects of potential risk that could be associated with material stress 
at an asset manager or investment vehicle, this section explores 
whether there are specific financial interconnections that could 
present risks if an asset manager, investment vehicle, or affiliate 
were to become insolvent, declare bankruptcy, or announce an intent to 
close and liquidate.\21\ The Council seeks information on whether there 
are any financial interconnections, such as transactions, investments, 
or loans across affiliated investment vehicles, between investment 
vehicles and an asset manager, or with third parties, that could 
complicate resolution in the asset management industry, particularly 
during a period of financial market stress. The Council also is 
interested in understanding the potential implications of the failure 
or liquidation of a private fund for financial stability.\22\ The 
Council also seeks information on whether there are any actions that 
market participants or counterparties to contracts could take that 
would adversely affect a resolution or give rise to liquidity concerns. 
The Council would like to explore whether there are issues that could 
make the resolution or liquidation of an asset manager or an investment 
vehicle with international operations more complex. For example, the 
Council seeks input on the extent to which access to assets in foreign 
jurisdictions or shared services located abroad may be impaired, or 
proceedings may be subject to multiple jurisdictions with potentially 
conflicting resolution regimes. In addition, the Council seeks 
information on practices or planning undertaken by asset managers to 
help mitigate the potential for disruption to clients or markets more 
generally in the event of a failure of a firm or liquidation of an 
investment vehicle.
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    \20\ For the purposes of this Notice, resolution refers to the 
commencement of proceedings in bankruptcy or, if bankruptcy is not 
appropriate, other proceedings or processes for the resolution, 
reorganization or liquidation of a legal entity.
    \21\ A pooled investment vehicle is owned by its investors, who 
are entitled to distribution of the vehicle's net assets if the 
vehicle were to be closed and liquidated.
    \22\ As discussed in Section II, leverage can present risks to 
investment vehicles, and the use of leverage by some private funds 
has raised concerns in the past. For example, margin calls and 
liquidity constraints were a prominent reason for the near-failure 
of Long-Term Capital Portfolio LP and the other funds managed by 
Long-Term Capital Management in 1998, which led a consortium of 
commercial financial institutions to recapitalize these funds to 
avoid potential financial instability. See ``Hedge Funds, Leverage, 
and the Lessons of Long-Term Capital Management,'' Report of the 
President's Working Group on Financial Markets (April 1999).
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    The Council recognizes that asset management firms and investment 
vehicles have closed without presenting a threat to financial 
stability. The Council notes that an investment vehicle has a separate 
legal structure from the asset manager, any parent company, or any 
affiliated investment vehicles under the same manager. In addition, the 
assets of the investment vehicle are not legally available to the asset 
manager, its parent company, or affiliates for the purpose of 
satisfying their financial obligations or those of affiliated 
investment vehicles. Nonetheless, the Council would like to explore any 
potential issues that may arise in a resolution or liquidation of an 
entity in the asset management industry, particularly in circumstances 
of financial market stress, and if an entity were to have a high degree 
of complexity and multi-jurisdictional operations.

Questions for Public Comment

    The Council requests comment on the questions below. The Council 
also welcomes input on other areas relating to resolution and 
liquidation in the asset management industry that could potentially 
present financial stability concerns.
    1. What financial interconnections exist between an asset manager 
and the investment vehicles it manages, between an asset manager and 
its affiliates, or among investment vehicles managed by the same or 
affiliated asset managers that could pose obstacles to an orderly 
resolution? To what extent could such interconnections result in the 
transmission of risk among asset managers and affiliated investment 
vehicles? Do market practices ensure that any financial 
interconnections are sufficiently documented to allow for an orderly 
continuation of operations if an asset manager, investment vehicle 
(e.g., private fund), or affiliate were to become insolvent, declare 
bankruptcy, or announce an intent to close?
    2. Could the failure of an asset manager or an affiliate provide 
counterparties with the option to accelerate, terminate, or net 
derivative or other types of contracts of affiliates or investment 
vehicles that have not entered insolvency?
    3. In what ways, if any, could the potential risks associated with 
liquidity and redemption or leverage discussed in Sections I and II, 
respectively, impact the resolution of an asset manager or investment 
vehicle in times of financial stress?
    4. Are there interconnections that exist between asset managers and 
other financial market participants that in times of financial stress 
could transmit risks? For example, are there risks that securities 
lenders indemnified against borrower default by an asset manager 
lending agent may terminate their loans if the asset manager were to 
fail? \23\ If so, could those terminations have disruptive consequences 
if counterparties face an unexpected requirement to return borrowed 
securities upon early loan terminations?
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    \23\ Securities lending agents often indemnify lenders against 
borrower default, and under indemnification agreements must cover 
the shortfall between the value of the securities on loan and the 
value of the collateral pledged by the borrower (but typically not 
losses resulting from cash collateral reinvestment).
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    5. For asset managers, investment vehicles, or affiliates that 
operate internationally, in what ways could cross-border resolution 
complicate an orderly insolvency or resolution in one or more 
jurisdictions? Do contracts with service providers, such as custodians 
or prime brokers, allow for assets to be custodied, or subcustodied, at 
offshore entities, and what are the implications for resolution?
    6. What contingency planning do asset managers undertake to help 
mitigate risks to clients associated with firm-specific or market-wide 
stress?
    7. To the extent that resolution and liquidation in the asset 
management industry present risks to U.S. financial stability, how 
could the risks to financial stability be mitigated?
    8. What data currently are available or should be collected to 
monitor activities that may affect a resolution?

V. Conclusion

    The Council invites comment on all of the questions set forth in 
this Notice and welcomes input on other issues that

[[Page 77495]]

commenters believe are relevant to the Council's understanding of risks 
to U.S. financial stability, if any, posed by asset management products 
and activities. The Council recognizes the areas of risk highlighted in 
this Notice may be interrelated and welcomes views on whether the 
interrelation of any of the risks described above or any other risks 
might present financial stability concerns. The Council will consider 
all comments as part of its evaluation of potential risks to U.S. 
financial stability.

    Dated: December 18, 2014.
David G. Clunie,
Executive Secretary, Department of the Treasury.
[FR Doc. 2014-30255 Filed 12-23-14; 8:45 am]
BILLING CODE P