Now that you’ve seen what ACA Insight has to offer, don’t be without it. Subscribe now!

The weekly news source for investment management legal and compliance professionals

Current subscribers - please log in to the website in the upper right-hand corner

News September 28, 2015 Issue

Proposed Liquidity Management Rules Would Change How Mutual Funds Work

The SECís proposed set of liquidity risk management rules for mutual funds and†exchange-traded funds are likely, if adopted as written, to make major changes in how those funds, and the advisers who manage them, do business.

The proposed rule changes, adopted unanimously by the Commission and now in a 90-day comment period, would mandate that each fund create a liquidity risk management program, from which money market funds would be excluded. That program, along with other parts of the proposed rule reforms, would require:

  • Classification of fund portfolio assets into six buckets, based on the amount of time an asset would need to be converted to cash without a market impact;
  • Assessment, periodic review and management of each fundís liquidity risk;
  • Establishment of a three-day liquid asset minimum for each fund;
  • Board approval and review of each fundís liquidity risk management program; and
  • New disclosure and reporting requirements.

In addition, the proposed rule changes would allow open-end funds to use "swing pricing" in determining a fundís NAV. Under swing pricing, a fund could pass along the costs of trading activity to the purchasing and redeeming shareholders, thereby protecting existing shareholders from dilution of their share prices.

"Promoting stronger liquidity risk management is†essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds," said SEC chair Mary Jo White. "These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commissionís oversight."

"This is a very, very big deal," said Shearman & Sterling partner Nathan Greene of the proposed rule changes, and will require a lot of additional work for funds and their advisers. Unlike the changes to reporting and disclosure requirements that the SEC proposed in May (ACA Insight, 5/21/15), "this affects how they do business."

Given the significance of the proposed changes, "these proposals may encounter more scrutiny, or even headwinds, than the agencyís prior reporting and disclosure proposal Ė particularly, given new concepts like the three-day liquid asset minimum and the proposal to codify an approach for the 15 percent liquidity standard," Willkie Farr partner James Burns. "The broader liquidity management program proposal, and the† accompanying board review requirements, would likely require significant compliance efforts. Standing alone, they may appear manageable, but they could add†appreciably to the already significant burdens on fund professionals and oversight requirements for boards."

Whatís behind the proposed changes

There appear to be two drivers behind the proposed liquidity risk management rule reforms:

  • Control the impact of a run on mutual funds. Since the financial crisis of 2008, there have been concerns that mutual funds be fully prepared for such an event. The liquidity rule proposals are part of a larger set of reforms the SEC is pursuing to strengthen protections for investors. Others include the reporting and disclosure proposed changes announced in May, and expected new proposals addressing funds use of†derivatives, and for stress tests.
  • The turf war. Ever since passage of the Dodd-Frank Act, there has been concern among some in the asset management industry, including some SEC commissioners, that organizations like the Financial Stability Oversight Council and the Financial Stability Board seek to impose "prudential regulation" on asset managers, making them subject to the kinds of regulations imposed on banks. In offering these liquidity risk proposals for mutual funds and ETFs, the SEC at least twice in the proposal referred to itself as the "primary regulator" in this area. It is a position that finds a number of sympathizers in the securities†industry. "Regulation by the SEC is still viewed as preferable to incursions by banking regulators or†international coordinating bodies," said Burns.

The changes

Following is a rundown of some of the changes the proposed rule would make:

  • Classification of assets into six liquidity buckets. Funds would be required to classify and engage in an ongoing review of each asset in a fund portfolio. "Funds would be required to classify each asset position or portion of a position into one of six liquidity categories that would be convertible to cash within a certain number of days: one business day, 2-3 business days, 4-7 calendar days, 8-15 calendar days,†16-30 calendar days, and more than 30 calendar days," the SEC said. "Classifying assets into a liquidity hierarchy and making it public is a meaningful change," Greene said.
  • Assessment, periodic review and management of a fundís liquidity risk. These assessments and reviews would be based on a number of specific factors. The rule changes define liquidity risk as "the risk that a fund could not meet redemption requests that are expected under normal conditions or under stressed conditions, without materially affecting the fundís net asset value per share." This part of the proposed changes would also codify the 15 percent limit on illiquid assets currently included in SEC guidelines.
  • Determination of a three-day liquid asset minimum. Each fund would be required to determine what minimum percentage of its net assets must be invested in cash and assets convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale. The good news here: Each fund could determine that percentage on its own. The bad news: You have to devote the time and resources to determining the three-day percentage that is right for your firm. "You, in theory, could decide, ĎIím the fund that needs 1 percentí or ĎIím the fund that needs 25 percent,í but either way, thereís a lot of work involved," Greene said.
  • Swing pricing option. The proposed changes would "permit, but not require" open-end funds, except money market funds or ETFs, to use swing pricing. "A fund that chooses to use swing pricing would reflect in its NAV a specified amount, the swing factor, once the level of net purchases into or net redemptions from the fund exceeds a specified percentage of the fundís NAV known as the swing threshold," the SEC said. What this means, in effect, is that the NAV would rise or fall by taking into account a number of factors having to do with purchases and redemptions of fund shares, something that Greene described as a "complete and utter change in how mutual funds interact with their investors."