SEC Sees Broad Industry Engagement on Liquidity Rules

They haven’t received quite the same number of comments as the DOL’s pending fiduciary regulations, but proposed liquidity rules from the SEC have clearly grabbed the investment and advisory industry’s attention. 

One need only briefly review the Securities and Exchange Commission’s (SEC) comments page on recently proposed liquidity rules to see that a wide variety of investment service providers are thinking deeply about how the rulemaking could impact business practices and client service.

Looking specifically at the employer-sponsored retirement planning arena, experts actually project the new liquidity rules won’t have a huge direct impact as currently proposed, due in part to the stringent liquidity rules already applied to mutual funds sold to qualified retirement plans under the Employee Retirement Income Security Act (ERISA). Still, there could be some disruptive impacts, experts have warned, especially if the rules should change the way fund managers structure, trade in, report on and ultimately sell investment products.

Specifically, the SEC is looking to create a new rule 22e–4 under the Investment Company Act, which would require mutual funds to establish substantial liquidity risk management programs. Under the proposed rule, the principal components of a liquidity risk management program would include analysis of a fund’s style classification and monitoring of each portfolio asset’s level of liquidity—as well as designation of a minimum amount of portfolio liquidity, which funds would tailor to their particular circumstances after consideration of a set of market-related factors established by the SEC.

Under the proposed rulemaking language, “liquidity” is not defined strictly in terms of cash, but also in terms of “securities that can easily be converted to cash,” such as commercial paper or government bonds. Under the SEC’s proposed rule, funds will have to describe what securities will make up the fund’s liquidity and how much of each security the fund will hold at a minimum.

NEXT: Industry worries already voiced 

Comments on the SEC’s new liquidity requirements came in quickly from service providers all across the spectrum. In general, commentators agreed in principle with the SEC’s goals of increased transparency and liquidity in investment products—especially those packaged for retail investors and novice retirement plan participants—but many disagreed with the regulator’s proposed approach. Quite a few argue the potential drags on long-term performance associated with increased liquidity are more damaging than any real or perceived lack of liquidity in today’s markets.  

John Hollyer, global head of Vanguard’s Investment Risk Management Group, for example, argues that mutual funds have a very strong track record of managing risk and liquidity. While he agrees that, depending on the final form of the new regulation, retirement plan sponsors could benefit from knowing firms have higher standards for risk management, if mutual funds grow less fully invested in the market because of new liquidity requirements, that could be a real detriment to performance, particularly for long-term investors. Hollyer notes, however, that Vanguard supports the SEC’s stated goal to have funds “establish a top-down board-approved liquidity management program.”

Another commentator was LPL Financial, which provides a variety of services to retirement plan advisers and their plan sponsor clients. In the firm’s formal comment letter, General Counsel David P. Bergers takes a fairly warm tone towards the SEC’s proposal, but with some reservations.

“As an initial matter, LPL wishes to express its support for the SEC's efforts to improve liquidity risk management at mutual funds,” Bergers writes. “We also support increased liquidity disclosure and recommend that the SEC take steps to maximize the uniformity and comparability of liquidity determinations.” LPL further “agrees with the goals of minimizing the risks that (1) investors will not be able to redeem their investments in mutual funds; and (2) remaining shareholders in mutual funds will have their interests in those mutual funds diluted when other shareholders redeem their interests in the mutual funds.”

Still, LPL warns of “certain operational challenges related to the proposed swing pricing that may affect services such as same-day exchanges and dividend reinvestment.” Digging into the point, Bergers says LPL understands that the swing pricing portion of the proposed rule is intended to address an important issue, i.e., the potential for mutual fund redemptions under certain circumstances to impose undue costs on shareholders that remain in the fund.

“The operational requirements that might be necessary to implement swing pricing, however, may be inconsistent with the way mutual fund orders currently are handled throughout the industry,” Bergers suggests. “The proposed rule appears to require a mutual fund that adopts swing pricing to establish a specific time by which it would have to estimate its total net redemptions for the day, before it sets its Net Asset Value (NAV) for the day. The estimated total net redemptions would determine whether the mutual fund had triggered a swing pricing adjustment to its NAV.”

However, LPL suggests many broker/dealers, investment advisers, and retirement plans (collectively referred to as “intermediaries”) process their mutual fund transactions on behalf of customers on an omnibus basis, and the mutual funds receive the orders after they establish their NAV for the day.

The orders that an intermediary sends after the mutual fund establishes its NAV include some important order types, such as same-day exchanges and dividend reinvestments (to assure that those dividends are reinvested the same day they are paid). The effect, Bergers says, is that “receiving some orders post-NAV will make it more difficult for mutual funds to estimate whether they are likely to hit the net redemption targets that would trigger a swing pricing adjustment.”

“If the Commission discourages mutual funds from accepting post-NAV orders to protect the integrity of the swing pricing process, intermediaries that use omnibus processing and their clients would be significantly affected,” Berger concludes.

NEXT: More issues with swing pricing proposal 

In another comment letter, consulting firm Ernst & Young highlights a few other potential issues with the proposed swing price mechanism requirements. According to the firm, if implemented, swing pricing policies and procedures would “directly affect funds’ financial statements and disclosures.”

“Consequently, funds’ auditors would be expected to design and perform procedures to address the risk of misstatement related to swing pricing,” Ernst & Young suggests. “We are concerned that users of a fund’s financial statements may inappropriately believe that the auditor would also be responsible for assessing the reasonableness of the fund’s swing threshold and the swing factor. We don’t believe auditors would have this responsibility because a fund’s swing threshold and swing factor would be regulatory measures not contemplated within the framework of US GAAP.”

The explanation continues: “To determine a fund’s swing threshold and swing factor, a fund’s board of directors and those responsible for administering the fund’s swing policies and procedures would have to exercise significant judgment, and U.S. GAAP does not provide objective criteria that would enable auditors to assess the reasonableness of such judgments. As a result, we believe that the extent of procedures performed by auditors should be limited to gaining an understanding of a fund’s swing pricing policies and procedures and verifying that these policies and procedures have been approved by the fund’s board and have been consistently applied by the fund throughout the year.”

Like LPL, Ernst & Young sees other potential flaws in this process: If swing pricing adjustments are made by a fund on the balance sheet date, “users of the financial statements may find adjusted NAV meaningful, as shareholders would have transacted at the adjusted NAV. However, we believe that the fund’s book value NAV (U.S. GAAP NAV), which is the fund’s NAV calculated after recording capital share transactions on the balance sheet date at the swing adjusted NAV, may also be meaningful to the users of the financial statements, as this NAV represents the actual net assets attributable to the fund’s remaining shareholders at year end.”

The letter proposes the following example: Consider a fund that has a December 31 year end and had net redemptions on December 31 that triggered swing pricing. The fund’s December 31 NAV before any swing pricing adjustment is $10.00 per share, based on $900,000 in net assets and 90,000 shares outstanding, and the fund’s December 31 adjusted NAV after applying a swing factor of 1% is $9.90. After the fund processes net redemption requests received on the balance sheet date for 9,600 shares at a NAV of $9.90, the fund’s US GAAP NAV is $10.01.”

Given the importance of both NAV measures, Ernst & Young recommends that the SEC evaluate (with outreach to users of the financial statements as appropriate) whether presenting two NAVs on the balance sheet would be useful or whether it would cause confusion and consider any alternatives for presenting the information … Since the unadjusted NAV (i.e., the NAV before any swing pricing adjustments) is a hypothetical measure that does not represent the actual net assets attributable to either the fund’s transacting or remaining shareholders at the balance sheet date, we believe that disclosure of the fund’s unadjusted NAV on its balance sheet would not be necessary and could cause significant confusion.”

NEXT: Alternatives managers weight in 

Given the sometimes tenuous relationship between the themes of “alternative investing” and “enhanced liquidity,” commentary submitted by several alternative investment managers is particularly informative.

One letter filed by the Managed Fund Association (which bills itself as the Voice of the Global Alternative Investment Industry) commends the “activities-based approach of the proposed rule and the proposed scope of application to open-end registered investment companies, given the particular liquidity risks they face.” Not surprisingly, the association warns that “mandating an overly rigid risk management framework could give rise to potential unintended consequences, including herd-like behavior that increases rather than mitigates system-wide liquidity risk.”

It seems the SEC is minding this worry, however. As the Managed Fund Associate puts it, “We agree with the Commission’s proposal to exclude private funds from the scope of the rule. As noted in the Commission’s release, private funds structure investors’ redemption rights in light of the strategy and liquidity of their portfolios and use a variety of liquidity risk management tools to manage and mitigate liquidity risk. Perhaps most importantly, private funds are not subject to regulations requiring prompt redemption and generally limit investor redemption rights to specific points in time, with advance notice requirements. These measures support a more stable capital profile than an open-end fund structure that has daily redemptions.”

The association concludes with a few warnings to the SEC, most notably that unlike banks, neither asset managers nor their investment funds have access to federal borrowing facilities. Therefore, fund managers already understand the “dire consequences of failing to appropriately manage liquidity risk and invest significant time and effort into ensuring that their liability profiles are appropriate given their asset mix.”

“We believe that it is critical for all managers to investment funds, private and registered alike, to tailor their liquidity risk management approaches to their strategies and assets,” the letter concludes. “As such, we believe that a prescriptive and potentially overly precise ‘one-size fits all’ approach to liquidity risk management and reporting, even with respect to rules that are limited to open-end registered investment companies, would not enhance risk management. In fact, we believe that such an approach could give rise to unintended consequences for markets by creating pro-cyclical forces that push asset managers into herd-like behavior. Accordingly, we encourage the SEC to ensure that its final rules provide sufficient flexibility to registered investment company managers in designing and implementing their liquidity risk management programs.”

NEXT: Support abounds, too 

Some groups providing commentary were much more friendly to the SEC’s goals and strategies. For example, the Americans for Financial Reform (AFR), a coalition of more than 200 national, state, and local groups “who have come together to advocate for reform of the financial industry,” strongly supports SEC action to improve oversight of potential liquidity issues in open-ended funds.

“Recent years have seen extremely rapid asset growth in fixed-income mutual funds, and even more remarkable growth in assets at ‘alternative’ funds,” AFR writes. “As the rule proposal documents, assets in fixed income funds more than doubled from 2008 to 2014, with inflows of over $1.3 trillion, and assets held by open-ended funds pursuing alternative investment strategies increased one thousand fold since 2005. A wide range of commenters, including regulators and academics, have raised concern about possible financial instability created by a disorderly exit from these funds. As certain fixed-income assets such as high-yield debt tend to be significantly less liquid than other classes of assets, and open-ended mutual funds have a statutory requirement to provide redemptions to investors within seven days, inadequate liquidity planning could lead to panic selling and financial contagion, as well as excessive investor losses.

“These concerns are not simply theoretical,” the letter continues, citing evidence that “fire sales by bond mutual funds during the financial crisis created harmful effects on both financial markets and real economy investment … More recent work by economists at the Bank of International Settlements has tracked the market impact of fire sales and cash hoarding by emerging market bond funds in response to redemption requests. Economists at the Wharton School have also documented that fixed income funds, particularly those which lack cash reserves, are particularly prone to investor runs that can fuel market instability and leave late-redeeming investors with significant losses.”

In recent months, these concerns have moved from academic journal articles to the front pages, AFR concludes, with the failure of the Third Avenue Focused Credit Fund, which recently suspended redemptions unexpectedly. “This failure was triggered by and also contributed to recent turbulence in the fixed income markets,” AFR warns. “By all accounts, Third Avenue was holding the great majority of its assets in illiquid distressed debt and had very limited cash reserves, a strategy that can increase returns but at the price of greatly increased risks for investors.”

AFR concludes the asset mix of the Third Avenue Fund “raises the question of whether and how the Commission has been effectively enforcing the long-standing liquidity requirement that a fund hold no more than 15% of its assets in ‘illiquid’ securities or loans.”