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Comment by Joy Dunbar, Editor of Absolute UCITS
Liquidity sloshing around in markets has of course tightened as a result of the credit crunch and the drying up of easy money.
Notwithstanding the repeated doses of quantitative easing (QE) from the Bank of England and the Federal Reserve, and the long-term refinancing operations (LTRO) of the European Central Bank, it is a trend that seems set to continue – as banks are being encouraged by regulators to deleverage their balance sheets and beef up their cash buffers, a long process that could take up to 15 years to complete.
The course of action by the banks has highlighted the divide between countries that saved in the good times (like Germany and China) and those that didn’t – and the structural problems and imbalances it created for governments around the world. But that topic is for another blog.
The concern that deleveraging of banks has created for markets is that borrowers are crying out for loans. But at the same time, banks are unable to lend as much because they need to reduce their loan books in order to boost capital ratios.
One possible solution might be to allow UCITS funds to invest in loans – which is potentially another way to inject liquidity into the markets. Indeed, some banking lawyers and private equity managers have called on European regulators to include loans as an eligible asset for investment within the wrapper, according to a recent article in International Financial Law Review.
Widening eligible assets in UCITS to include loans would potentially improve funding channels for corporations and companies. However, the wrapper by its very nature trades liquid financial instruments – and with loans there is of course a significant built-in liquidity mismatch. Loans take, on average, roughly 40 days to settle while bonds typically settle in the clearing systems a maximum of three days after trading.
According to the IFLR article, regulators could allow for gating restrictions on UCITS funds in order to provide the necessary liquidity. Another way to access loan investments at the moment, which is a costlier option, would be for UCITS funds to incorporate tailored indices and derivatives via total return swaps to create a loan index solution.
The UCITS directive, as it currently stands, means that allowing loans in the wrapper is very difficult or very expensive.
A desire to protect investors may mean that, even if European regulators change the directive to include loans as an eligible asset, they may still be a difficult asset class to invest in. Also, the irony of financial regulation in Europe at the moment means that almost any change that could help the markets is often perceived as suspicious.
Are loans an appropriate asset class for UCITS? The jury is still out. But allowing loans within the UCITS wrapper could help European markets out of a difficult spot. The ultimate question is whether the regulators think it would be good for investors.