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News August 28, 2017 Issue

Liquidity Risk Management First Steps: Define Program, Assign Responsibility

Thereís no time like the present for fund managers to start working on compliance with the SECís Liquidity Risk Management Rule. The compliance deadline may be months away, but wise firms will use that time to begin the compliance process by assigning responsibility and defining a program that matches their fundsí investment portfolios. Those that do will be well-positioned to tackle the additional compliance challenges that await. Those that donít may find themselves scrambling as compliance deadlines approach.

This challenge will be particularly acute for smaller shops, which "may not be that far along," said ACA Compliance Group director Erik Olsen, the author of an ACA white paper on the subject, Six Months into the Liquidity Risk Management Program Rule. "The larger shops Ė those with billions of dollars in assets under management Ė have not wasted time in beginning to prepare."

"Larger fund managers face more complexity in establishing their programs than smaller firms, but the challenges for firms of any size to the design, execution and confidence about the programís competence are to a large degree the same," said Willkie Farr partner and former SEC deputy chief of staff James Burns.

The SEC adopted the Liquidity Risk Management Rule in October 2016. The basic purpose of the Rule is twofold: first, to reduce the risk of a fund failing to meet its redemption obligations to shareholders, and second, to mitigate dilution of interests of remaining fund shareholders.

The obligations the Rule places on funds are significant, including establishing a liquidity risk management program, assigning the liquidity of their portfolio assets among four classifications, and determining their "highly liquid investment minimum" Ė the smallest percentage of net assets that must be placed in investments so liquid that they can be converted into cash within three business days. Funds with more than†$1 billion in net assets have until December 1, 2018 to comply with most of these requirements, while funds with less than $1 billion have until June 1, 2019 to comply.

Following are best practices that fund managers should consider as they begin their compliance efforts with the Liquidity Risk Management Rule. These best practices focus on initial steps such as defining a fundís liquidity risk management program and assigning responsibility for that definition, as well as for carrying the program out. (Future articles will provide help in complying with other elements of the Rule, including the use of sub-advisers, compliance with exchange-traded funds, and how to work with vendors.)

Assign responsibility

One of the first things a fund manager should do is decide which individuals will sit on the committee in charge of the liquidity program. Whether a committee or an individual, that body will be responsible for†administering the fund liquidity program. A committee is preferable, if only because of the input from different key players, Olsen said, but acknowledged that smaller funds may find it makes more sense to assign this†responsibility to an individual. Fund managers may task a current valuation or liquidity committee to take on this responsibility, or look to create a new committee or sub-committee.

It will be the administratorís responsibility to determine and implement the fundís liquidity program, classify the liquidity level of the fundís investments, and set the fundís highly liquid investment minimum, among other things. The administrator must also provide the board with a written report on the adequacy of a fundís liquidity program, including the highly liquid investment minimum, and the effectiveness of its implementation, Olsen said.

Please note that the Rule "does not allow for portfolio managers alone to be responsible for administering the liquidity program," Olsen said. "However, portfolio managers can be part of a committee approach in†administering the liquidity program."

Finally, "no new investment company regulation could happen without factoring in the chief compliance officer," he said. "In this case, the chief compliance officer, or his or her designee, appears best suited to be part of the liquidity committee, and not the sole liquidity†administrator, though the role of compliance on the committee may differ program by program."

Define your liquidity program

What this means, in a nutshell, is "figuring out who you are as a fund complex" in terms of liquidity, just how liquid your fundís investments are, and then "how your fund and the Rule fit together," Olsen said.

The supplemental information the SEC published along with the final Liquidity Risk Management Rule provide the beginnings of a decent road map," said Burns. "The agency is trying to provide some contours to its expectations without being overly prescriptive."

Begin with the knowledge that the Rule applies only to open-end mutual funds and ETFs, not money market funds. Then, consider the following steps:

  • Review the funds your firm has. "Are they large cap equities, emerging market equities, small cap equities, fixed income funds or something else?" asked Olsen. "Do you buy Treasuries, corporate bonds or bank loans? Assess your product line-up."
  • Determine how much illiquidity current investments create. You may find, in doing so, that your firm cannot continue to employ certain investment strategies if those strategies produce too much illiquidity. The Rule allows funds to have 15 percent of their investment in illiquid assets, the same percentage that has been the industry standard for years, but now, with the Rule, that percentage limitation is codified into regulation, Olsen said. "This means that 85 percent or more of your investments must be liquid in one form or another."
  • Classify your risks and set your fundís highly liquid investment minimum. In doing so, consider the steps below.

Classify the risks

The Rule requires funds to place all investments into one of four buckets:

  • Highly liquid investments. Under this classification, cash and any investment reasonably expected to be convertible to cash in current market conditions in three business days or less without the conversion to cash significantly changing the market value of the investment;
  • Moderately liquid investments. This classification is for any investment reasonably expected to be convertible to cash in current market conditions in more than three calendar days but in seven calendar days or less without the conversion to cash significantly changing the market value of the investment;
  • Less liquid investments. Under this classification, any investment reasonably expected to be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment, but where the sale or disposition is reasonably expected to settle in more than seven calendar days; and
  • Illiquid investments. This classification is for any†investment that may not reasonably be expected to be sold or disposed of in current market conditions in seven calendar days or less without the sale or disposition significantly changing the market value of the investment.

Determine the highly liquid investment minimum

The Rule itself is not prescriptive in this regard, so each fund must determine its own minimum liquidity level. As a result, you can expect differences among types of funds when it comes to determining the highly liquid investment minimum.

"Firms will need to decide how much flexibility they want to build into their own policies and procedures," said Burns.

Olsen describes this determination as "an art more than a science. You donít want to require too little liquidity so that potential investor redemption needs may not be met, but you donít want to require so much that it affects the returns investors get. You have to find the magic number in between too much liquidity and too little."

The agency does provide some factors that fund managers can use in determining the percentage. These include:

  • The fundís investment strategy and liquidity of portfolio investment during both normal and "reasonably forseeable" stressed conditions;
  • Short-term and long-term cash flow projections;
  • Holdings of cash and cash equivalents, as well as borrowing arrangements; and
  • For ETFs, the relationship between the ETFís portfolio liquidity and the way in which, and the prices and spreads at which, ETF shares trade.

"There is no right or wrong number when it comes to the highly liquid investment minimum," Olsen said.

"Doubtless there will be some early surveys conducted by the agencyís Office of Compliance Inspections and Examinations," said Burns. However, ultimately, he said, the asset management industry and the SEC will have to wait for a liquidity event to occur to see just how well the Rule and individual plans actually work Ė and "thankfully, liquidity events do not occur very often."