Digital Assets Report


Like this article?

Sign up to our free newsletter

Financial Stability Board targets fund finance

Related Topics

Dechert’s Matthew Kerfoot (pictured) comments on FSB’s newly issued Policy Recommendations on the use of leverage by investment funds…

In marked contrast to the emerging US deregulatory climate, the Financial Stability Board (FSB) has issued Policy Recommendations to regulate the use of leverage by investment funds. The FSB classifies fund leverage in two ways: balance sheet and synthetic leverage. Balance sheet leverage refers to traditional cash financings through bank lines of credit, prime brokerage margin finance and similar direct financings.  The FSB defines synthetic leverage as financing obtained through total return swaps and other types of derivatives transactions. 

Fund finance and systemic risk

The FSB is concerned that fund leverage can amplify risks to the global financial system through the impact of such leverage on lenders, investors and asset prices.

First, the FSB states that leverage can increase the risk of a fund encountering financial distress, which can then be transferred to the fund’s balance sheet lenders or derivatives counterparties. 

Second, leveraged funds, which can have more volatile swings in net asset value, can also transfer risk to sponsors and investors. Third, falling asset prices and increased margin calls can result in a repetitive cycle of fire sales of assets.

Regulating investment fund leverage

The FSB believes that perceived risks arising from investment fund leverage warrant a globally coordinated regulatory response.

First, the FSB recommends that the International Organisation of Securities Commissions (IOSCO) develop methods of calculating fund leverage to allow “monitoring” for financial stability purposes across jurisdictions.  The FSB is particularly concerned about consistently measuring leverage across balance sheet fund financings, derivatives and securities financing transactions. 

The FSB would like IOSCO to consider developing more risk-based measures to allow regulators to better understand how funds use leverage. Further, the FSB would like IOSCO to consider how to identify risks from “interconnectedness” between leveraged funds and other parts of the global financial system.

The FSB further recommends that regulators monitor the use of leverage by funds that are not subject to leverage limits or which may pose leverage-related risks to the financial system. The FSB would like regulators to develop systems for aggregating and analysing information across different types of funds subject to different regulatory schemes.

More ominously, the FSB recommends that, on the basis of this newly aggregated information across fund types, regulators should “take action when appropriate.” The FSB does not elaborate further on what action regulators should take or when such action would be appropriate.


Like this article? Sign up to our free newsletter

Most Popular

Further Reading