The SEC recently released a rule proposal on liquidity risk management for mutual funds and exchange-traded funds (ETFs). If adopted, this rule proposal will require significant changes to fund operations, disclosure, and reporting requirements. The rule proposal also contains guidance that the SEC has provided to help mutual funds and ETFs manage their liquidity risk today.
Others, including the SEC, have ably summarized the rule proposal, and this summary is found below. The following are items that chief compliance officers and boards of directors may want to consider in addressing risk liquidity risk today:
- The SEC seems to believe that many funds may have been a bit lax in managing their “liquidity risk.” Specifically, the SEC stated that “while some funds and their managers have developed comprehensive liquidity risk management programs, others have dedicated significantly fewer resources to managing liquidity risk in a formalized way,” and then later stressed that “a mutual fund must adequately manage the liquidity of its portfolio so that redemption requests can be satisfied in a timely manner.” In other words, liquidity risk management is not only a regulatory compliance matter, but also a risk management matter, and should be taken seriously.
- The SEC views “liquidity risk” as “the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.” And the SEC states that it believes a fund must also consider “both expected requests to redeem, as well as requests to redeem that may not be expected, but are reasonably foreseeable,” when evaluating its liquidity risk.
- The SEC provided guidance on key factors to consider when assessing the “liquidity risk” of a fund. They are not an exhaustive list of factors, but an illustrative list: “(A) short-term and long-term cash flow projections, taking into account the following considerations: (i) the size, frequency, and volatility of historical purchases and redemptions of fund shares during normal and stressed periods; (ii) the fund’s redemption policies; (iii) the fund’s shareholder ownership concentration; (iv) the fund’s distribution channels; and (v) the degree of certainty associated with the fund’s short-term and long-term cash flow projections; (B) the fund’s investment strategy and liquidity of portfolio assets; (C) use of borrowings and derivatives for investment purposes; and (D) holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources.”
- The SEC noted that “as a practical matter, many investors expect to receive redemption proceeds in less than seven days as some mutual funds disclose in their prospectuses that they will generally pay redemption proceeds on a next-business day basis.” And then the SEC followed this up by noting that it believes a fund may have liability for failure to redeem on a next-business day basis when the prospectus states the fund generally or usually redeems on a next-business day basis.
- The SEC provided guidance on key factors to consider when assessing the liquidity of individual portfolio holdings. They are not an exhaustive list of factors, but an illustrative list: “(A) the existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants; (B) the frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange); (C) the volatility of trading prices for the asset; (D) the bid-ask spreads for the asset; (E) whether the asset has a relatively standardized and simple structure; (F) for fixed income securities, the maturity and date of issue; (G) restrictions on trading of the asset and limitations on transfer of the asset; (H) the size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and (I) relationship of the asset to another portfolio asset.”
With regard to derivative securities the SEC noted that “assets used by a fund to cover derivatives and other transactions would be liquid when considered in isolation,” but that when evaluating the overall liquidity of a fund, the fund would have to consider that such assets “are only available for sale to meet redemptions once the related derivatives position is disposed of or unwound.” So, a fund should “classify the liquidity of these segregated assets using the liquidity of the derivative instruments they are covering.”
- The SEC stated that it believes “that, as part of a fund's management of its liquidity risk, a fund that engages in or reserves the right to engage in in-kind redemptions should adopt and implement written policies and procedures regarding in-kind redemptions.” It expects that “these policies and procedures would address the process for redeeming in kind, as well as the circumstances under which the fund would consider redeeming in kind.”
- The SEC provided guidance on the use of borrowing arrangements and other funding sources as a liquidity risk management tool and the use of exchange-traded fund (ETF) portfolio holdings as a liquidity risk management tool. While the SEC generally seemed to endorse the thoughtful use of borrowing arrangements as a liquidity risk management tool, the SEC expressed some concerns about the use of ETF portfolio holdings as a liquidity risk management tool. The SEC noted that while ETFs may be useful in managing purchases and redemptions, “funds should consider the extent to which relying substantially on ETFs to manage liquidity risk is appropriate,” stating, for example, that “an ETF whose underlying securities are relatively less liquid ... may not be able to be counted on as an effective liquidity risk management tool during times of liquidity stress.”
The following is a summary of the rule proposal:
Liquidity Risk Management Programs
Proposed Rule 22e-4 would require mutual funds and other open-end management investment companies, including ETFs, to have a liquidity risk management program. The proposed rule would exclude money market funds from the requirements. The liquidity risk management program would be required to include multiple elements, including:
- Classification of the liquidity of fund portfolio assets
- Assessment, periodic review and management of a fund’s liquidity risk
- Establishment of a three-day liquid asset minimum
- Board approval and review
Classification of the Liquidity of Fund Portfolio Assets: Each fund would be required to classify and engage in an ongoing review of each of the assets in its portfolio. The classification would be based on the number of days in which the fund’s position would be convertible to cash at a price that does not materially affect the value of that asset immediately prior to sale. Proposed Rule 22e-4 would include factors that a fund would be required to take into account when classifying the liquidity of each portfolio position.
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.
Assessment, Periodic Review and Management of a Fund’s Liquidity Risk: Funds would be required to assess and periodically review their liquidity risk, based on specified factors. Liquidity risk would be defined 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 fund’s net asset value (NAV) per share. Proposed Rule 22e-4 would codify the 15 percent limit on illiquid assets included in current SEC guidelines.
Determination of a Three-Day Liquid Asset Minimum: A fund would be required to determine a minimum percentage of its net assets that must be invested in cash and assets that are convertible to cash within three business days at a price that does not materially affect the value of the assets immediately prior to sale.
Board Approval and Review: A fund’s board, including a majority of the fund’s independent directors, would be required to approve the fund’s liquidity risk management program, including the fund’s three-day liquid asset minimum. The board also would be responsible for reviewing a written report that reviews the program’s adequacy, provided at least annually from the fund’s investment adviser or officer administering the program.
Proposed, amended Rule 22c-1 would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.” Swing pricing is the process of reflecting in a fund’s NAV the costs associated with shareholders’ trading activity in order to pass those costs on to the purchasing and redeeming shareholders.
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 proposed amendments include factors that funds would be required to consider to determine the swing threshold and swing factor, and to annually review the swing threshold. The fund’s board, including the independent directors, would be required to approve the fund’s swing pricing policies and procedures.
Disclosure and Reporting Requirement Proposals
The following disclosure forms would be amended:
Proposed amendments to Form N-1A would require funds to disclose swing pricing, if applicable, and the methods used by funds to meet redemptions. Funds also would be required to file agreements related to lines of credit and reflect, as applicable, the use of swing pricing in the fund’s NAV per share in the financial highlights section of fund financial statements.
Proposed Form N-PORT
Form N-PORT, which was proposed by the SEC in May, would require a fund to report the liquidity classification of each of the fund’s assets based on the categories in proposed Rule 22e-4. Funds also would be required to disclose the three-day liquid asset minimum, in addition to the requirement proposed in May that funds report whether an asset is a 15 percent standard asset.
Proposed Form N-CEN
Form N-CEN, which was proposed by the SEC in May, would require funds to disclose information regarding committed lines of credit, interfund borrowing and lending, and swing pricing. The proposed amendments also would require ETFs to report whether they required an authorized participant to post collateral to the ETF or any of its designated service providers in connection with the purchase or redemption of ETF shares.