The SEC has proposed sweeping changes to liquidity risk management practices used by Mutual Funds and ETFs. Although the SEC began formulating new regulations following the 2009 events, the failure of Third Avenue Management to process shareholder redemptions in one of their mutual funds has added impetus to this plan. As a recap, Third Avenue Focused Credit Fund, in lieu of cash, had taken steps to provide its shareholders with interests in a trust that would be used to liquidate the fund’s assets once it had been closed down. Since that time, the Fund has come to an agreement with the SEC, permitting it to postpone honoring redemption requests until it can liquidate the fund’s assets in orderly fashion.
As such, the SEC remains focused on open-end mutual funds’ abilities to provide investor redemptions in seven (often reduced to fewer in prospectus language) business days. They are therefore proposing new restrictions in the form of updates to:
- Rule 22e(4)
- Rule 22c(1)
- Regulation S-X
- Form N(1a)
- Form N-PORT
- Form N-CEN
These restrictions will apply to all asset classes, and will apply to open-ended ETFs (i.e. not UITs) as well. In very brief terms, the main features, as proposed at the time of this writing, include:
- The Manager must determine the liquidity of their assets based on the number of days required to convert it (in entirety) to cash (inclusive of settlement) and bucket it into 1 of 6 terms;
- The Fund must develop a liquidity and redemption risk plan, incorporating cash flow projections, investment strategy, asset liquidity, borrowings, derivatives usage and other liquidity sources (cash, equivalents, credit lines, other funding sources);
- The Fund may need to conduct risk assessments daily (or even more frequently) and potentially under dual scenarios (standard and stressed);
- The introduction of Swing Pricing (already common in UCITS funds) may be permitted, in which certain activity levels trigger an allocation of costs to subscribers / redeemers;
- The role of the Fund Board is accentuated in that it must periodically review and approve both the plan and the liquidity risk assessments themselves, and the relevant delegations.
The Impact of the Proposed Regulations
The proposed regulations will have a disproportionate impact on certain types of portfolios, notably small cap and offshore (particularly emerging market) funds. Naturally, fixed income funds will be affected much more directly than those holding mostly equities.
Additionally, the mechanics of swing pricing in the U.S. poses various challenges, including the growing belief that the swing mechanism is unworkable under current U.S. market conditions. First, a Swing Threshold would be required to determine if Swing Pricing is in effect. Second, a Swing Factor would be calculated to determine the impact on effective NAV at which a subscription/redemption for that day would be processed. While it is unclear at this time the magnitude of the impact of swing pricing on NAV and performance calculations, critics of the proposal claim that it “distort(s) the comparative performance records of different funds to reward those that apply swing pricing most aggressively” and provides “inadequate safeguards to prevent overly aggressive use of swing pricing to enhance observed fund returns.”
The Liquidity regulations are one (major) piece of a broader “1940 Act Modernization” effort by the SEC, which also includes money markets and derivatives changes. On its face, the liquidity rule expansion has both data and process implications which will be a challenge to meet. Larger firms will likely look upon this as a major fixed cost, which they can bear more readily than their smaller competitors.
Conversely, the rules are not yet finalized and there has been major pushback by the industry. With a Presidential election and new SEC chief on the horizon, the final format and timetables are still far from definite, but nonetheless, we will likely see some changes by the end of 2016.
Although it remains to be seen whether sufficient data exists to accurately assess liquidity to SEC granularity - other outcomes, which can be safely assumed include:
- The data component of this initiative will be prominent, both in breadth and depth
- Boards will have a greater need for information about the results of the new processes
- Portfolio managers’ roles will change materially as their ability to adhere to both benchmark and liquidity mandates will conflict
While the fate of liquidity regulation is still undetermined, the Third Avenue story, and subsequent SEC sweep, illustrate that in difficult markets in particular, it is important to have your position, shareholder, and valuation data well organized, and easily accessible. Furthermore, asset managers should review their risk and compliance controls, procedures, and investment guidelines closely such that their portfolios are well prepared for market shocks. By taking the steps that it has, the Commission has shown that it will be proactive in working to prevent disorderly fund closures and other actions that ultimately harm mutual fund shareholders.