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SEC Proposes Rules on Liquidity Risk for Funds

SEC Proposes Rules on Liquidity Risk for Funds

Peter D. Fetzer




I read with interest the SEC rule proposal on liquidity risk management for mutual funds and exchange-traded funds (ETFs).  This was no small task given that the release weighs in at well over 400 pages, and the text, to say the least, is dense.  My first reaction was that if adopted, this rule proposal will require significant changes to fund operations, disclosure and reporting requirements.  My second reaction was to go back through the release to see what nuggets the SEC had provided in terms of direct or indirect guidance to help mutual funds and ETFs manage their liquidity risk today.
 
Others, including the SEC, have already ably summarized the rule proposal.  My aim is not to summarize, but to provide some reaction to the proposal and highlight certain SEC guidance that may require more immediate action on the part of a fund’s board of directors.  While I have attempted to capture the key guidance and statements, more can surely be found in the dense release, and I remain alert to other items that may come to light as I continue to assess the proposal.
 
I believe that the proposal is a welcome step in helping funds understand, assess and address their liquidity risk.  However, the proposal in its current form may have a significant impact on the operational aspects of funds, resulting in an increase in expenses that will be borne by shareholders, and it is not clear that all aspects of the proposal are workable.  For example, the proposal suggests funds may need to engage in daily, perhaps even hourly, assessments of their liquidity risk, taking into account foreseeable shifts in the market and foreseeable redemption patterns.  The problem is that foreseeability is seldom easy, but is far more easily second guessed in hindsight, and funds will be expected to apply this foreseeability standard in times of market distress and volatility, which are times when it is arguable that very little is truly foreseeable.
 
With regard to the potential added burdens on funds, we note, as was noted by the SEC in the rule proposal, that the nature of the portfolio holdings of alternative funds, small cap funds and foreign funds may make them more susceptible to liquidity risk.  So, these type of funds may be disproportionately impacted if the rule proposal is adopted, as they may be required to devote more of their time and resources to bring their operations into compliance with the new rules.
 
The “swing pricing” that the SEC has proposed seems to be a reasonable attempt at passing on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.  However, it also appears that it will result in reporting complexity when it comes to financial reporting, which may deter funds from implementing it.
 
Now to the guidance (direct and indirect) that I noted in the rule proposal.  The following are items that I believe chief compliance officers and boards of directors should consider in addressing risk liquidity risk today:
 

  1. The SEC seems to believe that many funds may have been a bit lax in managing their “liquidity risk.”  Specifically, the SEC stated that “while some funds and their managers have developed comprehensive liquidity risk management programs, others have dedicated significantly fewer resources to managing liquidity risk in a formalized way,” and then later stressed that “a mutual fund must adequately manage the liquidity of its portfolio so that redemption requests can be satisfied in a timely manner.”  In other words, liquidity risk management is not only a regulatory compliance matter, but also a risk management matter, and should be taken seriously.
  2. The SEC views “liquidity risk” as “the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.”  And the SEC states that it believes a fund must also consider “both expected requests to redeem, as well as requests to redeem that may not be expected, but are reasonably foreseeable,” when evaluating its liquidity risk.
  3. The SEC provided guidance on key factors to consider when assessing the “liquidity risk” of a fund.  They are not an exhaustive list of factors, but an illustrative list: “(A) short-term and long-term cash flow projections, taking into account the following considerations: (i) the size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods; (ii) the fund’s redemption policies; (iii) the fund’s shareholder ownership concentration; (iv) the fund’s distribution channels; and (v) the degree of certainty associated with the fund’s short-term and long-term cash flow projections; (B) the fund’s investment strategy and liquidity of portfolio assets; (C) use of borrowings and derivatives for investment purposes; and (D) holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.”
  4. The SEC noted that “as a practical matter, many investors expect to receive redemption proceeds in less than seven days as some mutual funds disclose in their prospectuses that they will generally pay redemption proceeds on a next-business day basis.”  And then the SEC followed this up by noting that it believes a fund may have liability for failure to redeem on a next-business day basis when the prospectus states the fund generally or usually redeems on a next-business day basis.
  5. The SEC provided guidance on key factors to consider when assessing the liquidity of individual portfolio holdings.  They are not an exhaustive list of factors, but an illustrative list:  “(A) the existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants; (B) the frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange); (C) the volatility of trading prices for the asset; (D) the bid-ask spreads for the asset; (E) whether the asset has a relatively standardized and simple structure; (F) for fixed income securities, the maturity and date of issue; (G) restrictions on trading of the asset and limitations on transfer of the asset; (H) the size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and (I) relationship of the asset to another portfolio asset.” With regard to derivative securities the SEC noted that “assets used by a fund to cover derivatives and other transactions would be liquid when considered in isolation,” but that when evaluating the overall liquidity of a fund, the fund would have to consider that such assets “are only available for sale to meet redemptions once the related derivatives position is disposed of or unwound.”  So, a fund should “classify the liquidity of these segregated assets using the liquidity of the derivative instruments they are covering.”
  6. The SEC stated that it believes “that, as part of a fund's management of its liquidity risk, a fund that engages in or reserves the right to engage in in-kind redemptions should adopt and implement written policies and procedures regarding in-kind redemptions.”  It expects that “these policies and procedures would address the process for redeeming in kind, as well as the circumstances under which the fund would consider redeeming in kind.”
  7. The SEC provided guidance on the use of borrowing arrangements and other funding sources as a liquidity risk management tool and the use of exchange-traded fund (ETF) portfolio holdings as a liquidity risk management tool.  While the SEC generally seemed to endorse the thoughtful use of borrowing arrangements as a liquidity risk management tool, the SEC expressed some concerns about the use of ETF portfolio holdings as a liquidity risk management tool.  The SEC noted that while ETFs may be useful in managing purchases and redemptions, “funds should consider the extent to which relying substantially on ETFs to manage liquidity risk is appropriate,” stating, for example, that “an ETF whose underlying securities are relatively less liquid ... may not be able to be counted on as an effective liquidity risk management tool during times of liquidity stress.”

About The Author

Peter Fetzer is a partner and business lawyer with Foley & Lardner LLP. His practice focuses primarily in the areas of securities regulation, mergers and acquisitions, corporate governance and general corporate counseling to mutual funds, exchange traded funds, publicly traded investment advisers and public companies. He can be reached at pfetzer@foley.com.
















































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