A report by the U.S. Treasury's Office of Financial Research on asset managers and systemic risk is inaccurate and should not be relied on for policy decisions or regulatory action of any kind, says the Investment Company Institute's General Counsel Karrie McMillan and Chief Economist Brian Reid. In a Q& A with Money Management Executive, they discuss why the U.S. Treasury Office's assessment of asset managers fails to present a balanced view, their message to regulators on Volcker Rule implementation and enforcement, and the SEC's expected new money market fund rules.

Q: How do you view the regulatory landscape and how will current regulation most impact money managers (mutual fund/ETF providers)?

(McMillan) The current regulatory landscape in the U.S. and globally continues to be in flux, as it has been since the 2008 financial crisis. The Dodd-Frank financial reform law is still being implemented and regulators could designate additional systemically important financial institutions. Market structure issues and cross-border swaps issues are also on the table. All of these could affect money managers. In addition, the SEC has a new chair and two new commissioners and is considering a proposal to change money market fund regulation in 2014. That final rule could require money market fund providers and their investors to make significant adjustments in their operations and investing.

Q: Late last year the U.S. Treasury Department's Office of Financial Research (OFR) issued a report claiming that asset management firms and the activities in which they engage can introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability. How does this report impact registered funds?

(McMillan/Reid) One of the biggest challenges in the coming year is FSOC's continued work on analyzing the asset management industry for firms that could be deemed "systemically important."The recent report on the asset management industry requested by FSOC and conducted by the OFR, titled "Asset Management and Financial Stability," falls far short of providing an accurate and balanced view and should not be relied upon for policy decisions or regulatory action of any kind.

One of the most fundamental flaws of the study is that it too often analyzes asset managers as if they were banks. The report acknowledges that asset management is an agency business-that is, that such firms manage, but do not own, the assets that they invest on behalf of their clients. As a result, asset managers don't bear the risks of losses in those assets on their own balance sheets. Yet that crucial fact gets lost as the report proceeds. Many of the purported risks that the OFR report describes are those faced only by entities that take on balance-sheet risk. The report also fails to mention the risk-limiting regulations that have governed registered investment companies successfully for more than 70 years and fails to take into account readily available data. For example, the authors raise concerns about investors "herding" into hot asset classes and then causing "fire sales" when they rush to redeem en masse. Yet the record of market breaks-which ICI has examined as far back as 1945-demonstrates that fund investors have not redeemed in droves during market downturns, whether driven by terrorist events, the 2001 dot-com bubble burst, or even by the 2008 financial crisis, the worst downturn since the Great Depression.

ICI will continue to engage with the FSOC agencies about RICs and their existing risk-limiting regulations and their role in the markets. And we will continue to advocate for bringing additional, much-needed transparency and accountability to the FSOC process.

Q: Can you name regulatory developments that are having a positive impact on mutual funds or ETFs?

(McMillan) The Volcker Rule was not aimed at registered investment companies and at more than 900 pages, it will take some time to understand its full scope and impact.

Among our many concerns before the rule was finalized, the most important was the need for regulators to make clear that it does not affect the organization or activities of U.S.-registered funds and regulated non-U.S. retail funds because of the negative impact that could have on their investors. Our initial review of the final rule indicates that regulators appear to have heard our concerns. While we continue to examine the details, we appreciate the effort the agencies have made to tailor the Volcker Rule's definition of covered funds to exclude both registered U.S. funds and regulated non-U.S. retail funds. We believe this reflects congressional intent.

We are urging regulators to continue to work together in the implementation and enforcement phases, as they did in the development stage.

Q: The U.S. has the world's largest ETF market, which remains the primary growth driver for the global industry. Do you expect this will continue?

(McMillan/Reid) While we cannot predict the future, the growth of ETFs has been strong for the past decade, as investors-both institutional and retail-increasingly invest in ETFs. With the increase in demand, sponsors have offered more ETFs with a greater variety of investment objectives. We expect that the strong retail and institutional investor demand for ETFs will continue.

Q: What flow trends are you seeing in money market mutual funds? Why is that the case?

(Reid) Most striking is that despite offering near-zero yields for five years, money market fund assets totaled $2.7 trillion as of December 23, 2013-the same asset level as before the financial crisis. That tells us that money market funds offer a unique and necessary cash management service that is highly valued by institutional and individual investors.

Q: What's your future outlook for money market mutual funds, if you can say so in light of impending changes to their regulation by the SEC?

(McMillan) As the expert regulator for mutual funds, we think it is appropriate that money fund regulation decisions occur at the SEC. The SEC has put forth a money market fund proposal and is considering public comments. ICI has urged the agency to exempt tax-exempt funds from structural changes to preserve their important benefits to the economy. We cautioned the SEC against imposing both alternatives in its rule proposal on money market funds, because doing so would drive investors into products that are less regulated and potentially riskier. We expect a final rule in mid-2014 and look forward to seeing it.

Q: Within the next 5 years, what do you think will be the biggest drivers of growth in the mutual fund/ETF industry?

(Reid) The most significant driver of growth in the next five years will be the rapid expansion of an investing class globally, particularly in emerging market countries. Furthermore, as more markets open around the world to foreign investors, opportunities will increase for both investment companies and their shareholders. But there will be strong growth in demand for mutual funds and ETFs even in the U.S. during the next five years, as well. The continuing improvement in the U.S. economy will increase savings and investment among U.S. households, and the number of Americans in their peak savings and investing years (between ages 45 and 64) will continue to grow. Demand for mutual funds and ETFs will also grow among retirees because Baby Boomers will rely much more heavily on mutual funds and ETFs to manage their retirement assets than did earlier generations.

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