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News January 25, 2016 Issue

Liquidity Risk Management: Associations Want Proposed Rules Revised

Major securities industry associations want the SEC to slow down and revisit their proposed rules to manage liquidity risk. While they support the general principle of regulating liquidity risk, they find specific elements of the proposed rules problematic, among them how funds should classify such risks, a requirement that funds maintain a three-day minimum liquidity amount, and a swing pricing option.

The SEC, which proposed the rules this past September, opened a 90-day public comment period that ended January 13. Among those commenting were associations representing broad swaths of the industry, such as the Investment Company Institute, the Mutual Fund Directors Forum, and the Securities Industry and Financial Markets Association.

"The highly prescriptive liquidity classification scheme and three-day liquid asset requirement bear a striking resemblance to the asset-limiting or capital-classification schemes that banking regulators historically have imposed," ICI wrote in a January 13 summary comment letter. "In numerous cases – the U.S. savings and loan industry in the 1980s, for example, or the Basel I and Basel II capital standards – the conformity and correlation induced by those standards have undermined the resilience of banking institutions, to disastrous effect."

"It would be preferable to adopt a more principles-based approach," wrote the MFDF in its January 13 letter. "We believe that the Commission can ensure sufficient rigor by requiring the adoption of policies and procedures and subjecting those policies and procedures to board oversight without specifying in such detail what the product of those policies and procedures should be."

The "bottom line" in the associations’ letters is that "liquidity is important and deserves attention, just not this kind of attention," said Shearman & Sterling partner Nathan Greene. "The proposals assume liquidity can be calculated with more precision than is really the case and are simply too prescriptive and ‘one size fits all’ to work in practice. This is the first asset management-related rulemaking in some time to be met with widespread concern. Clearly the industry thinks that what’s at issue warranted a strong response."

"The letters point out some real challenges that could ensue if the Commission opts for overly rigid categorizations and approaches to liquidity management practices, and suggest instead how more flexibility would permit well-managed firms to continue their businesses without unnecessary encumbrances," said Willkie Farr partner James Burns. "They also, politely, point out some of the misconceptions that may have informed the release."

"While uniformity makes for easier administration by a regulator, commenters are making a strong case for why that could be quite deleterious in the context of this proposal," he continued. "Given the agency’s commitment to addressing cost benefit analysis, it will have to pay particularly careful attention to comments on this and the rest of the suite of asset management proposals announced over the past several months."

The SEC’s proposal

The proposed rule changes would require 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 mandate:

  • 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 fund’s liquidity risk;
  • Establishment of a three-day liquid asset minimum for each fund;
  • Board approval and review of each fund’s liquidity risk management program; and
  • New disclosure and reporting requirements.

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

The six buckets

Under the SEC’s proposal, funds would be required to classify and engage in an ongoing review of each asset in the fund’s portfolio. They "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 to 3 business days, 4 to 7 calendar days, 8 to 15 calendar days, 16 to 30 calendar days, and more than 30 calendar days," according to the agency.

But the associations aren’t buying it.

  • Investment Company Institute. The association suggested that the six-bucket classification system "directs funds toward a one-size-fits-all approach" with an "unproven methodology." It would give rise to "liquidity rating agencies," which would end up doing most of the classifications. "Instead of the six-category asset classification scheme, we recommend that the SEC require each fund to formulate policies and procedures to determine how best to assess, classify and monitor the liquidity of portfolio assets," ICI said.
  • Mutual Fund Directors Forum. "The type and amount of liquidity that a fund should have in its portfolio depends on a number of factors," the association said, "each of which tends to be unique to the fund in question." These factors, it said, may include the investment strategy used by the fund, how portfolio securities are likely to perform in both normal and stressed circumstances, the types of investors involved, and the level of redemptions expected. The MFDF suggested that the Commission instead consider a requirement that encourages funds to classify their securities into fewer baskets, or that requires funds to rank all securities across a broad spectrum of liquidity. "A more principles-based approach would be less expensive, would permit different funds to approach the question of liquidity risk management in a more nuanced manner more suitable to their individual circumstances, and would avoid many of the risks inherent in forcing the entire industry to address the liquidity of individual portfolio securities in a uniform manner," the association said.
  • Securities Industry and Financial Markets Association. The association, in its January 13 letter, criticized the proposed classification system as seeking to impose "a level of precision and granularity that is inherently incompatible with the nature of liquidity determinations in diverse markets. The proposed system is unprecedented, and thus untested …; would produce data conveying a false sense of exactitude and comparability, rather than information that is meaningful to understanding or managing liquidity risk; and would require massive initial and ongoing resources to implement, at the expense of far more effective classification systems currently used by fund groups with robust liquidity risk management programs in place." SIFMA suggested the SEC consider categorizing risk based on four degrees of liquidity, stretching from "highly liquid" to "illiquid." "In classifying the portfolio, funds would take into account appropriate qualitative and quantitative factors relevant to the type of asset and related markets," based on, among other things, guidelines the SEC could publish in the adopting release, it said.

The three-day liquid asset minimum

The SEC proposed that funds be required to determine the minimum percentage of net assets that 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, and have that amount available.

But the associations found fault here, as well, and suggested ideas of their own:

  • Investment Company Institute. Requiring "a cash cushion that in many cases would be larger than a fund would otherwise hold" would "distort portfolio management, hamper returns, and inflate tracking errors," ICI said. "We recommend that the SEC require each fund to formulate policies and procedures to determine how best to reasonably ensure that the fund has sufficient liquidity to meet redemptions under normal and reasonably foreseeable stressed conditions."
  • Mutual Fund Directors Forum. The association noted that the SEC proposal would not allow funds that fail to comply with the three-day minimum liquidity requirement to buy securities that it believes could not be liquidated in three days or less. The Commission should not take such action, it said, as the reason for a fund failing to meet the minimum threshold "may be related to transient market conditions that have affected the liquidity of existing portfolio securities, the results of a single large redemption that is unlikely to be repeated, or for other fund-specific reasons."
  • Securities Industry and Financial Markets Association. The requirement would "unnecessarily constrain a fund’s ability to employ its investment strategy and in some cases would actually increase liquidity risk," the association said. Instead, SIFMA recommended a liquidity risk management program that would require fund managers to evaluate whether it would be prudent to identify a target percentage of highly liquid assets that the fund should maintain in the context of the fund’s "liquidity risk profile." Funds would then determine whether to establish a liquid asset target and the amount of the target, based in part on guidelines provided by the SEC.

Swing pricing

The SEC would permit, but not require, open-end funds, except money market funds or ETFs, to use swing pricing, which would allow a fund’s NAV to rise or fall by taking into account a number of factors having to do with purchases and redemptions of fund shares. "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 fund’s NAV known as the swing threshold," the SEC said.

Allowing swing pricing would be a major change in how U.S. funds operate, and the associations made that clear in their comments.

  • Investment Company Institute. The association noted "significant differences in fund industry operational practices between Europe, where swing pricing is used, and the U.S., and the substantial operational barriers that those practices pose to swing pricing in the U.S." Failure to address those practices through widespread changes in market practices or by regulations, along with significant re-engineering of U.S. operations, will mean that "funds will not adopt swing pricing, even if the SEC authorizes it," it said.
  • Mutual Fund Directors Forum. "We do not object to it in principle," the association said, but only because the SEC proposed swing pricing as an option, not as a requirement. "Swing pricing raises both significant philosophical questions and difficult operational issues," among them that "the pricing of fund shares at net asset value is an almost-sacred principle under the Investment Company Act. … Since 1940, retail investors have come to expect that they will always transact with an open-end fund at NAV." Changing this may be difficult for retail investors to understand, particularly since it will impact prices sporadically, the MFDF continued. "The SEC should fully address whether it is fair to subject all investors transacting with a fund on a specific day to the costs imposed on the fund by a few investors engaging in large transactions with the fund." The association also raised the question of whether swing pricing can be implemented in the same manner in the U.S. as elsewhere, given the prominent role of intermediaries in the U.S. fund industry.
  • Securities Industry and Financial Markets Association. Operational challenges to implementing swing pricing were raised by the association in a separate January 13 letter devoted to swing pricing, making a number of recommendations, including that SEC work with SIFMA in exploring and implementing solutions to these challenges. Other recommendations included that any swing pricing option should follow the way it is practiced in Europe, where the practice has been accepted by investors; that swing pricing should not be used to determine an adviser’s asset-based performance fees; and that a safe harbor be created to protect the fund and any individuals associated with it in the event that the swing threshold is exceeded or if application of the swing factor is determined in accordance with the method set forth in the fund’s policies.