In a speech on December 11, 2014, SEC Chair Mary Jo White announced three broad “proactive initiatives” to address the risks of “increasingly complex portfolio composition and operations” in the asset management industry.
White amplified items on the SEC’s agenda, announced in November, and said that the SEC will consider new regulations to require stress testing and living wills for asset managers.
Acknowledging that long-term changes in the asset management business have created “new risks and challenges,” White said that new regulations should build on the “lessons of the financial crisis.”
White announced the initiatives for the $63 trillion asset management business in the context of rapid growth, noting that assets under management have doubled since 2004 alone, pointing to the increased complexity of products created in response to investor demands.
The SEC, she said, has focused in the past on controlling conflicts of interest, as well as enhancing reporting and disclosure regimes; it has also focused on issues related to private fund advisers. Now, she said, the SEC will begin initiatives focusing on portfolio composition and operational risks.
Enhanced data reporting. The SEC is considering new rules that would require standardized reporting for derivatives used by funds and securities lending. The data-collection efforts may extend to private funds.
- Our take: We can expect the SEC to require registered funds and private funds to report specific data more regularly, concerning derivatives holdings and securities lending activities. This data might be used for the SEC’s surveillance and enforcement efforts, in a manner similar to how the SEC plans to use data derived from public company financial reporting and audit trail information.
Controls on risks related to portfolio composition. White identified liquidity risks and the use of derivatives as key staff priorities. Registered funds must establish controls that identify and manage those risks.
Consistent with January 2014 guidance published by the Division of Investment Management, White said that the staff is concerned that mutual funds may have difficulty meeting redemptions if portfolios come under stress and are forced to sell securities at fire-sale prices, which in turn could drive down asset prices for other funds and other investors. The staff also is concerned that funds’ use of derivatives frequently results in “leveraged investment exposures and potential future obligations that can create risks.”
White called for a “comprehensive approach” to address risks related to liquidity and derivatives. While White was short on specifics, she said that the SEC’s staff is reviewing options such as updated liquidity standards, disclosures of liquidity risks, or limits on leverage created by use of derivatives.
- Our take: It is not clear what the actual rule proposals would look like. An educated guess is that the SEC will refine the definition of “liquidity” — that is, when a fund should consider an investment to be illiquid. The current definition is buried in instructions to Form N-1A and, most recently, the 2014 amendments to the money market fund rules. A new definition may be more market-oriented, taking into account the perceived tightening of the fixed income market and shrinking bond inventories. The SEC may also attempt to pull in the reins on leverage, or tighten asset segregation requirements. In any event, these proposals are likely to generate substantial controversy and public comment.
Transition planning and stress testing. Borrowing from the Dodd-Frank Act playbook, the SEC may require large asset managers to adopt the functional equivalent of “living wills” to ensure that clients’ needs are protected when an asset manager loses key personnel or plans to shut its doors. The SEC likely will require advisers to adopt “transition plans” to prepare advisers and their clients to deal with an “actual severe disruption in the adviser’s operations.”
The SEC will also implement a Dodd-Frank Act requirement by requiring annual stress testing by large broker-dealers, investment advisers and registered investment companies. The requirement would be based upon stress testing requirement for banks, and more recently, money market mutual funds.
- Our take: It appears that the SEC may attempting to control the debate over whether asset managers should be designated as “systemically important financial institutions,” or SIFIs, possibly in reaction to the controversial report on this topic published by the Office of Financial Research, at the direction of the Financial Stability Oversight Council. The SEC may be sending a message that it, rather than the federal banking regulators, is better positioned to address the systemic risks of asset managers. The requirements for living wills and stress testing should come as no surprise to observers of how regulations evolve, and indeed many funds and advisers have been moving in this direction. But these requirements undoubtedly will increase compliance costs, and take up real estate on crowded fund board agendas.