Open-end investment funds a potential vulnerability to assets markets: IMF

Open-end investment funds, which have grown significantly to $41 trn globally in the first quarter of 2022, pose a major potential vulnerability to the asset markets, the IMF said

Open-end investment funds, which have grown significantly to USD 41 trillion globally in the first quarter of 2022, pose a major potential vulnerability to the asset markets, the IMF said on Tuesday and called for greater international regulatory coordination to ensure their effectiveness.

In its latest edition of the global financial stability report, the International Monetary Fund noted that open-end funds play an important role in financial markets, but those that offer daily redemptions while holding illiquid assets can amplify the effects of adverse shocks by raising the likelihood of investor runs and asset fire sales.

This contributes to volatility in asset markets and potentially threatens financial stability, it said.

These concerns are particularly pertinent now as central banks normalise policy amid heightened uncertainty about the outlook. A disorderly tightening of financial conditions could trigger significant redemptions from these funds and contribute to stress in asset markets, the report said.

Given the global operations of funds and their cross-border spillover effects, liquidity management practices should be deployed consistently at the global level to ensure their effectiveness, which calls for greater international regulatory coordination, IMF said in the report.

Released ahead of the annual meeting of the IMF and the World Bank, the report said that policymakers should ensure that adequate liquidity management tools are used by these funds.

A wide range of tools is available to potentially mitigate the vulnerabilities and systemic impact of open-end funds, but effective implementation of these tools is lacking.

Since the global financial crisis, there has been remarkable growth in open-end investment funds. The total value of their net assets has quadrupled since 2008, reaching USD 41 trillion in the first quarter of 2022 and accounting for approximately one-fifth of the assets of the nonbank financial sector, the IMF said.

Fabio Natalucci, Deputy Director of the Monetary and Capital Markets Department; Mahvash S Qureshi, division chief in the IMF's Monetary and Capital Markets Department and Felix Suntheim, a senior financial sector expert in the Global Financial Stability Analysis Division of the IMF's Monetary and Capital Markets Department, wrote a joint blog post over the issue.

Looking beyond the pandemic-induced market turmoil, our analysis shows that the returns of assets held by relatively illiquid funds are generally more volatile than comparable holdings that are less exposed to these fundsespecially in periods of market stress, they said.

The IMF said additional liquidity management tools could include limiting the frequency of redemptions by linking it to the liquidity of funds' portfolios to directly address the underlying vulnerability related to the liquidity mismatch.

Tighter monitoring of funds' liquidity risk management practices by supervisors and regulators should be considered, it recommended.

Given the adverse cross-border spillover effects, recipient economies need to take appropriate policy responses to mitigate potential systemic risks from volatile capital flows sourced from open-end funds," the IMF said.

"These should include continued deepening of domestic markets; the use of macroeconomic, prudential, and capital flow management measures; and foreign exchange intervention in line with the recommendations of the International Monetary Fund's Institutional View, the report said.