DERA Economist Discusses Market Fragility Concerns and Evolving Risks

In a recent speech, Scott W. Bauguess, the acting director and acting chief economist of the SEC’s Division of Economic and Risk Analysis, discussed trends in the asset management industry and related financial stability risks.  He urged regulators and market participants to “remain vigilant in assessing these evolving risks and their potential impact.” Bauguess highlighted the following trends as concerning:

• The rapid growth in funds investing in fixed-income securities and other alternative investments presents potential market risk because such investments are less liquid and more susceptible to the risk of fire sales, which on a large scale, can threaten financial stability.
• The prevalence of a “herd mentality” among investors and fund managers, who respond similarly to a market shock, e.g., by hoarding cash, can threaten financial stability. Bauguess noted that a key concern is whether capital from redemptions is invested back into the market or banks. Bauguess also observed fund managers’ tendency to collectively shift toward more liquid assets during times of stress and warned that funds’ common pursuit for increased liquidity could exacerbate downward selling pressure in the market.
• Robo-advisers and rules-based investing executed by fixed algorithms could also unintentionally result in mechanical herding -- the effects of which warrant further monitoring for potential market risks.

Bauguess acknowledged that many of the SEC’s market reforms, including the Liquidity Risk Management Rule, address these market fragility concerns but noted there was a continuing need for regulators and market participants to monitor and more clearly assess and respond to these emerging risks using accurate and reliable data.