Treasury Urges Liquidity Rule Compliance Date Delay, No Classification Buckets
The Treasury Department’s recommendations that the SEC postpone at least one of the scheduled compliance dates for Rule 22e-4, the Liquidity Risk Management Rule, and eliminate the requirement that funds categorize assets into four liquidity classifications was an industry-friendly move that will likely find much applause in the asset management industry.
The recommendations, part of a report from the Treasury Department on the asset management and insurance industries, were among several recommendations and viewpoints that investment advisers and funds were likely to welcome. Others included:
Moving away from labeling entities as systemically challenged, and instead basing such evaluations on activities and products;
Recognizing that the characteristics of the asset management industry are different from banks, and that the SEC should remain the lead regulator;
Eliminating the stress-testing requirement for advisers and funds;
Revisiting the Derivatives Rule, proposed by the SEC last year but not yet adopted;
Adopting a new, "plain vanilla" Rule for exchange traded funds; and
Withdrawing the SEC’s proposed Business Continuity Rule
Initial industry reaction was swift and mostly positive. Investment Adviser Association president and CEO Karen Barr said that the IAA "appreciates the Treasury Department’s recognition of the critical role that asset managers play with respect to our economy, our capital markets, and the financial well-being of investors. We applaud the Department’s acknowledgement of the essential differences between banks and investment managers and the recommendation favoring activities-based regulation rather than imposing inapt prudential regulation on asset managers."
The Investment Company Institute said that "our initial impression is that the report makes several constructive recommendations. We stand ready to work with policymakers to help advance the report’s constructive recommendations."
"I think hitting the pause and rethink button on many of these issues is a development many will welcome," said Willkie Farr partner and former SEC deputy chief of staff James Burns. "With the benefit of the analysis and comments offered in response to proposed rulemakings, the agency should be better positioned to sit back and reassess whether to offer up more refined and nuanced solutions. As far as those rules recently put in place are concerned, the practical experiences of industry participants living with them or working to come into compliance suggest there is room to reevaluate the utility and efficacy of some of these new measures."
"The industry has had a chance to digest the Liquidity Rule and what it will be like to implement it, and has found that bucketing will consume the Rule beyond any rational expectation of benefit," said Shearman & Sterling partner Nathan Greene. "Now Treasury – which has no binding authority on the matter, but does reflect the view of the current Administration – has lent its credibility to this side of the argument."
In any event, he said, whether the Rule is revised or not, the SEC has made its point. "The industry is not going to think about liquidity in the same way again."
The Treasury Department’s recommendations came in the third of four reports from the Treasury addressing the U.S. financial system. The first two, already issued, addressed depository institutions (banks, savings associations, credit unions and more), and capital markets (debt, equity, commodities and derivatives, among others). The October 27 issuance of the report on the asset management and insurance industries marked the third. Still to come is the final report on non-bank financial institutions, financial technology and financial innovations.
The Liquidity Rule recommendations
Overall, the Treasury Department said that it "supports robust liquidity risk management programs and believes they are imperative to effective fund management and the health of the financial markets." Nonetheless, the Department wants to see a number of changes to the Rule. Following are its recommendations in more detail:
Compliance dates. The current dates for compliance with the Liquidity Rule are December 1, 2018 for asset managers with more than $1 billion in net assets, and June 1, 2019 for those with less than $1 billion in net assets. The Treasury Department urged that the first deadline be postponed, although it did not suggest a new date. It wants the SEC to drop its prescriptive-based approach (i.e., one with specific risk categorization requirements, see below) and instead adopt a principles-based approach. "Consistent with these recommendations, the SEC should take appropriate action to postpone the currently scheduled December 2018 implementation of Rule 22e-4’s bucketing requirement," it said.
Liquidity classification. The Treasury noted that "concerns have arisen regarding the Rule’s approach to measuring liquidity risk, and the costs involved in implementing the Rule. The Rule mandates an overly prescriptive asset classification or bucketing methodology despite the fluid, and sometimes subjective, nature of liquidity." Such a bucketing methodology, it continued, "may not help funds improve their current liquidity risk management programs." As a result, the report said, "Treasury rejects any highly prescriptive regulatory approach to liquidity risk management, such as the bucketing requirement. Instead, Treasury supports the SEC adopting a principles-based
approach to liquidity risk management rulemaking and any associated bucketing requirements."
Illiquid asset limitation. One of the items from the existing Rule that the Treasury apparently likes is the 15 percent limitation on illiquid assets that funds would be required to keep. This is not surprising, as longstanding SEC guidelines had generally favored such a limit. The Rule merely formalizes this figure.
Systemic risk and the SEC
A point made by the Treasury in its report is bound to please most asset managers, and that is a statement that investment advisers, funds and other parts of the asset management industry are different than banks and must be regulated differently – and that the SEC is in the best position to do that.
The Financial Stability Oversight Council’s evaluation of systemic risks over the past several years "shows fundamental differences between asset managers and prudentially regulated institutions such as banks," the Treasury said. While asset managers manage on behalf of clients, "they do not generally own the investments themselves," it said. "Furthermore, asset managers are legally separated from the funds – the assets and liabilities of the manager are distinct from assets and liabilities of the funds." The bank business model, on the other hand, "directly subjects the bank to the risks and obligations of its assets and liabilities."
Given these characteristics of the asset management industry, the Treasury said, "to the extent that systemic risks arise from the asset management industry, prudential regulation of asset management is unlikely to be the most effective regulatory approach for mitigating these risks." It noted that asset managers and investment funds, unlike banks, "are not highly leveraged and do not engage in maturity and liquidity transformation to the same degree that banks do through the use of bank deposits and other forms of credit."
In that regard, the Treasury noted that basing systemic risk on the basis of evaluations of entities is "not the best approach for mitigating risks from asset management." Instead, it said, primary federal regulators should focus on systemic risks arising from asset management products and activities, "and on implementing regulations that strengthen the asset management industry as a whole." It recommended that FSOC "look to the SEC to address systemic risks through regulation within and across the asset management industry" domestically.
This argument over prudential regulation of asset managers is one that has been going on for several years, particularly since the 2008 financial meltdown. SEC commissioner Michael Piwowar and others have criticized FSOC and the Financial Stability Board for seeking to treat asset managers like banks (ACA Insight, 8/15/16). They will most likely be pleased by the Treasury Department’s position on this issue.
Here’s a rundown of some of the other recommendations the Treasury Department made:
Stress testing. The Department "does not support prudential stress testing of investment advisers and investment companies as required by Dodd-Frank," the Treasury said. It instead supports legislative action to amend Dodd-Frank to eliminate the stress testing requirement for investment advisers and funds.
Proposed Derivatives Rule. The SEC in December 2015 proposed a Derivatives Rule (ACA Insight, 12/21/15) that would place risk management caps on the use of these financial instruments by mutual funds, ETFs, closed-end funds and business development companies. The Rule has not yet been finalized. The Treasury Department, in making recommendations here, said that while it supports the goal of modernizing the regulation of derivatives for funds, it has some concerns. "Treasury recommends the SEC consider a Derivatives Rule that would include a derivatives risk management program and an asset segregation requirement, but reconsider what, if any, portfolio limits should be part of the Rule," the Department said. "Any portfolio limits, if adopted, should be based on significantly more risk-adjusted measures of a fund’s derivatives than the current proposal." The Department also said that the SEC should reconsider the scope of the assets that would be considered qualifying coverage assets for purposes of the asset segregation requirements. The proposed Rule limits such qualifying coverage assets to cash and cash equivalents.
Exchange traded funds. The Department suggested that the SEC either re-propose or propose a new "plain vanilla" Rule for ETFs "that allows entrants to access the market without the cost and delay of obtaining exemptive relief orders, subject to conditions the SEC determines appropriate and in the public interest."
Business continuity planning. The SEC in June 2016 proposed a Business Continuity Rule that has not yet been finalized. The Treasury Department, while "strongly" endorsing the principle of "effective and robust business continuity planning by investment advisers and investment companies," said that there is an existing principles-based Rule already in place (Rule 206(4)-7, which, while identified as the Compliance Program Rule, also generally addresses business continuity) and that "there is no compelling need for additional rulemaking in this area." It recommended that the SEC withdraw the proposed Rule.