Financial watchdog calls for stricter rules in bond and DeFi markets

The Bank for International Settlements has called for tougher rules to stop bond funds from amplifying risks to financial market stability and has thrown its weight behind calls for tighter supervision of blockchain-based decentralised finance.

The umbrella body for central banks around the world said in its latest quarterly review that action was needed after bond funds had been forced to sell assets “on an elevated scale” in March 2020. An abrupt and widespread rush to the exits from these funds added to coronavirus-induced volatility across fixed income markets that was relieved only by massive interventions by central banks, the BIS said.

The institution’s position adds to earlier proposals for new safeguards by the IMF, Financial Stability Board and the International Organization of Securities Commissions.

“The turmoil raised questions about whether bond funds’ own lines of defence can prevent the potential amplification of risks during periods of stress,” said the BIS. A destabilising “fire sale” of financial assets could have arisen if central banks had not stepped in with a wide range of emergency measures, including huge new asset purchases schemes, many of which are still in place.

Fixed income funds own 18 per cent of outstanding US corporate bonds and 17 per cent of outstanding eurozone corporate bonds, giving these vehicles a critically important influence in determining prices.

Most bond funds allow end investors to take their money out with just a single day of warning, but the BIS said longer notice periods for withdrawals could be introduced to remove the problem of trying to sell illiquid assets in a falling market.

Its analysis indicates that managers of bond funds overestimated how much of their portfolio they would be able to sell in a single day to raise cash, particularly in volatile market conditions.

The BIS also suggested that, in some circumstances, actively managed fixed income funds could transfer bonds instead of cash to clients who wanted to make withdrawals. This arrangement, known as an “in-kind redemption”, already exists for index-tracking exchange traded funds. It effectively transfers more pricing risk from a portfolio manager to an end investor.

Fixed income managers could also make more use of “swing pricing” by imposing bigger reductions in the value of withdrawals by investors who want to redeem immediately from a fund in a period of market stress. Swing pricing can reduce the first-mover advantage that an investor gains if they sell out before others in a way that can drag prices down.

The BIS also expressed concerns about the rapid and unsupervised growth of decentralised finance. The authors of the paper said these new markets can become a threat to financial stability if they seep into mainstream activities, partly because DeFi lacks shock absorbers such as banks. DeFi rests on the idea that preprogrammed algorithms handle transactions without human intervention and without a central authority.

“If DeFi were to become widespread, its vulnerabilities might undermine financial stability,” the report stated.

This is the first time the BIS has sounded a note of caution about DeFi markets, although it has previously highlighted risks around stablecoins, which underpin decentralised transactions.

“There is a ‘decentralisation illusion’ in DeFi since the need for governance makes some level of centralisation inevitable and structural aspects of the system lead to a concentration of power,” the authors of the report said.

The BIS said that policymakers should focus on targeting managers, owners of platforms and codes where transactions take place, noting that they are “the natural entry points for policymakers”.

DeFi markets have grown exponentially in the past 18 months, with the total amount of funds locked in DeFi services surging 1,700 per cent over the past year to hit $247bn, according to data specialist Elliptic.