The Securities and Exchange Commission (SEC) has proposed a set of liquidity risk management requirements for registered open-end mutual funds and ETFs. The proposal is part of a broader SEC agenda to modernize the Investment Company Act of 1940 (’40 Act) and to address perceived systemic risk concerns relating to the asset management industry.
1. The proposal addresses liquidity concerns arising in a changing industry. The proposal is a response to recent changes in the asset management industry, including the growing presence of mutual funds in the fixed-income space (now holding nearly 20% of US corporate debt; up from 7% in 2005). This growth, coupled with increasing investments in illiquid assets, has caused regulatory concerns about funds’ ability to satisfy a large number of redemptions during market stress. Amplifying these concerns is the proliferation of new fund types (e.g., alternative funds, emerging market funds, and high-yield bond funds), some of which have already experienced unpredictable redemption patterns.
2. The Financial Stability Oversight Council (FSOC) is influencing the SEC. While the proposal cites investors’ ability to redeem shares in a timely manner as its primary driver, the proposal is also a response to FSOC’s systemic risk concerns. This comes as no surprise, since the FSOC is no longer pursuing systemically important designation for asset managers, and instead is relying on the SEC to address potential systemic risks in the industry.
3. The biggest impact will be felt by the front office. Portfolio management teams will need to compare existing liquidity risk management practices against the requirements in order to (a) address gaps, (b) develop a tailored liquidity analysis framework for each fund, and
(c) prepare detailed liquidity risk management programs for senior management and board approval. The middle and back offices will be less impacted, but firms and their service providers will still need to update investor disclosures and make necessary system changes (e.g., to enable monitoring of minimum liquidity levels and position-level liquidity categories, and in some cases adjust NAVs and performance calculations).
4. Swing pricing provides more flexibility for fund managers. The proposal allows (but does not require) funds to implement swing pricing as a mechanism to pass on costs associated with redemptions to those shareholders that are redeeming their positions, in order to protect remaining shareholders from NAV dilution. Under the SEC’s proposal, swing pricing, once net daily investor trading activity surpasses a pre-set percentage of the fund’s NAV, results in an adjustment to the fund’s NAV such that transacting shareholders effectively bear the impact of the fund’s trading costs. European fund shareholders are already familiar with this mechanism, as UCITS and other European funds have been utilizing versions of swing pricing for some time. Therefore, in our view, asset managers that operate UCITS or have a common investor base with UCITS are more likely to adopt swing pricing (indeed several large US managers with a global presence were a significant influence behind the rule proposal).
5. Approval of the liquidity risk management program necessitates a deeper understanding of risk for management and directors. The proposal requires mutual funds and ETFs (but not money market funds) to adopt formal liquidity risk management programs as approved by the board. After the initial approval of the program, the board should review a report from management on the program’s adequacy at least annually. This process will require management and directors to develop a deeper understanding of a fund’s shareholder base and their redemption activity under various scenarios (for mutual funds) and of the fund’s reliance on authorized participants (for ETFs). The benefits of effective liquidity risk management go beyond regulatory compliance. Therefore, funds should take this opportunity to put in place robust programs, rather than taking a check-the-box compliance approach. The Appendix to this post provides an overview of various elements of an effective liquidity risk management program.
6. Flexibility is provided with respect to the periodic risk assessment. As the basis for liquidity risk management, the proposal requires a periodic assessment of liquidity risk based on factors such as historic shareholder activity and portfolio liquidity. Although the proposal does not prescribe a specific assessment interval, fund managers should not view this flexibility as an implicit nod to infrequent assessments. This is especially true for funds with significant concentrations in illiquid assets (e.g., alternative mutual funds). We believe the SEC will expect these funds to perform liquidity risk assessment on a more continuous basis.
7. Portfolio liquidity assessment outliers will raise regulatory questions. In addition to assessing overall liquidity risk, the proposal requires that funds assess the liquidity of each portfolio position, and categorize the position into one of six different categories (based on the number of days it would take to liquidate the position). This information must be disclosed to the SEC on a monthly basis via the proposed new Form N-PORT. While funds have discretion in classifying their positions, categorizations that are very different from peers’ approaches will likely raise SEC questions. Therefore, we expect the industry’s categorization of similar positions to become standardized over time, as managers will try to avoid categorizations that are noticeably different from industry norms.
8. Shorter term liquid assets are required. As part of the liquidity risk management program, the proposal requires each fund to maintain a minimum amount of cash and other assets that can be converted to cash within three days to satisfy its immediate liquidity needs. The minimum amount is determined as a percentage of the fund’s net assets, based on factors such as projected cash flows and the fund’s access to third-party liquidity resources. This is notably more stringent than the existing ’40 Act standard requiring funds to make redemptions within seven days of receiving redemption requests. While the SEC rejected proposing an across-the-board minimum for all funds, the agency explicitly said that a zero percent minimum would not be acceptable. Also, similar to SEC’s other regulations, a fund that falls below its minimum liquidity threshold would not be required to immediately sell assets to restore the minimum, but rather would be prohibited from acquiring additional assets that would result in continued non-compliance.
9. The 15% cap on illiquid assets is now codified. The proposal codifies for the first time the 15% limit on holding of illiquid securities by mutual funds – i.e., securities which may not be sold in the ordinary course of business within seven days at the approximate carrying value. While the requirement itself is not new and has long been enforced via guidelines, the proposal provides valuable clarification around the definition of “illiquid.” More specifically, the proposal clarifies that a large position need not be deemed illiquid, as long as a standard portion of a large position may be sold within seven days at the approximate carrying value.
10. The compliance period is phased-in based on the asset manager’s size. The SEC has proposed a phased compliance timeline: 18 months after the rule’s finalization for larger fund complexes, and 30 months for smaller complexes. This phased approach reflects the SEC’s awareness of challenges that smaller funds may face in meeting the proposed requirements. However, we expect larger firms will request more time to comply in order to meet requirements for each fund. In addition, we anticipate that the SEC will look to harmonize these compliance periods with those that appear in the final version of Form N-PORT, which will contain the requisite liquidity disclosures.
While representing a significant step forward in the SEC’s overhaul of the industry’s regulatory framework, the proposed requirements are only part of the bigger picture. As such, their operational impact should be assessed in conjunction with other related measures, such as stress testing requirements which we expect to be proposed early next year.
The SEC will also propose rules regarding mutual funds’ use of derivatives and leverage (by year-end) and asset manager transition planning (by early 2016). These timings are ahead of earlier projections, given the earlier-than-expected release of last week’s liquidity risk management proposal.
Appendix – Elements of an effective liquidity risk management program
1. Governance and oversight – Effective risk management begins with strong board oversight. As a baseline, the proposal would require the board to periodically review and approve policy delegations and liquidity risk assessments. Though not explicitly required by the proposal, a properly effective governance structure should also include specific limits, e.g., minimum liquidity buffer and shocked redemption ratio guidelines. In addition, processes must be established to escalate any breach of such limits to the board level, including clear assignment of accountability and communication lines.
2. Liquidity profiling – The proposal’s requirement for robust and granular (i.e., position-level) quantitative analysis provides the foundation for effective liquidity risk assessment, monitoring, and management. While the rule allows flexibility in methodology, in-depth classification tools, such as days-to-liquidate analysis should be tailored to individual asset classes, supplemented with specialized methodologies (e.g., scoring) for more complex, less liquid instruments. Finally, historical redemption analysis should be performed to understand stressed and non-stressed market behavior as well as to capture market cyclicality.
3. Liquidity risk assessment – Under the proposal, liquidity risk assessment would include a range of factors such as investor profiles and the fund’s investment objectives, and would be supported by short-term and long-term cash flow forecasting. In addition to these requirements, a well-designed liquidity risk assessment process should also include liquidity stress tests that are linked to established liquidity limits. For example, the stress test should assess the redemption ratio under stress scenarios of various severities to determine whether the stressed redemption ratio stays above the level established by the board.
4. Liquidity management – The composition and size of the liquidity buffer should be aligned directly to the liquidity risk assessment results to ensure compliance with the proposed requirements while optimizing fund performance. The optimum mix of highly liquid securities, deposits, credit lines, derivative-based strategies, and other components of the buffer will depend on each fund’s return objectives, tracking requirements, and cash flow velocity, among other factors.
5. Internal controls – Although not explicitly stated by the proposal, compliance would require an effective internal controls structure. Key components of this structure include independent oversight (provided by independent risk management and/or internal audit reviews), and model governance (including validation of key risk measurement models). In addition, a data governance framework should be in place to ensure data validity and consistency as portfolio data travels through analytical environments and into internal and external reporting.
 Mutual funds are required to fulfill shareholder redemption requests within seven days. As a result, funds must maintain sufficient liquidity in order to meet redemptions, and to minimize the impact on remaining shareholders.
 FSOC’s concerns stem from the possibility of one or more funds having to quickly sell illiquid assets during market stress to satisfy redemption requests. The resulting fire sales could theoretically send asset prices into a tailspin, sending shockwaves throughout financial markets.
 See PwC’s A closer look, Asset managers: The SEC’s road ahead (May 2015).
 Authorized participants are financial institutions (e.g., banks and broker-dealers) that provide market making services for ETFs.
 These are funds that together with their related investment companies have net assets of $1 billion or more.
The preceding post comes to us from PwC and is based on their First Take, which is available here and was published on Sept. 28, 2015.