Assessing The Fund Operation Impact of the SEC’s Liquidity Risk Regulations

Inside View | Liquidity

May 3, 2016 – Bruce Runciman, Executive Director at AxiomSL

In September 2015, the SEC proposed a series of liquidity risk regulations impacting the operations of open-end funds, including mutual funds and exchange-traded funds (ETFs), in the U.S. The regulations were proposed to enhance the management of liquidity risks, reduce the risk that funds will be unable to meet redemption obligations and elevate the overall quality of liquidity risk assessment and management across the fund industry.

Under the proposed regulation, a fund’s liquidity risk management program would be required to contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund’s liquidity risk; establishment of a fund’s three-day liquid asset minimum; and board approval and review. In addition, the proposal provides a framework under which mutual funds could use “swing pricing” to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity.

Now that the comment period for the proposed regulations has closed, managers of open-end funds are examining the impact the proposed regulations may have on their operations; seeking clarity and guidance on how to structure fund operations to meet the new standards. To assist, we provide analysis of the key tenants of the proposed regulation and how each will impact regulatory management and reporting initiatives.

The classification of the liquidity of each of the fund’s portfolio assets will be based on the time an asset would be able to be converted to its cash value without causing a market impact. The stated target liquidity model is for all assets to be expressed into six “buckets” based upon their unique liquidity profiles. However, the determination of the liquidity profile by asset is a very subjective process and without a stated prescription for each liquidity profile, the assignment of assets will be different across funds or vendor solutions inhibiting comparability.

Fund managers will need to pay particular close attention to these prescriptions as comparability is a key objective of the SEC to enable their search for outliers to the liquidity profile adopted by a fund. This is one reason why assessment, periodic review and management of a fund’s liquidity risk is so important. Establishing these rules will include parameters that mandate the prescription of the way a fund will act upon anomalies in their risk profile on a prospective basis, such as determination of a minimum of the assets that must be held in three-day liquid assets, prohibition on acquiring a less liquid asset if size or compliance if the fund’s three day liquid asset pool is jeopardized and prohibiting a fund from acquiring certain illiquid assets if risk thresholds are crossed.

Further, the establishment of the three-day liquid asset minimum requires that the fund define the size and procedures to maintain a pool of “liquid assets” that would be available to satisfy redemptions. This means that a fund must understand the effect that market conditions and events might have upon the Fund’s liquidity and how it can dynamically change the liquid asset buffer required.

The swing pricing proposal in the proposed rules provide a mechanism to pass on the costs incurring to the fund stemming from purchases or redemptions activity to the shareholders. Fund managers must establish the program operationally and agree upon the swing threshold and how it is identified. This threshold may be based on inputs such as spreads, commissions, custody transactions charges and FX conversation costs. Once established, fund managers must then establish the governance layer over the program and name the Swing Pricing Committee to set and review factors, thresholds and results by quarter and determine whether there is a market condition requiring more frequent review.

A fund’s board of directors will oversee all of these rules. Under the proposed regulations, the management of liquidity risk must engage the board in a formal and well-defined firm-wide liquidity risk governance framework that starts at the top of the organization. This includes a dedicated risk sub-committee focusing on key liquidity risk control issues across the organization, reviews of the liquidity program’s adequacy and a review of the Annual Report from the officer administering the liquidity program approval of the Swing Pricing Policies and Procedures.

As with any regulatory initiative, fund managers should see the above as a starting point. According to Bloomberg Intelligence, finalization of these rules is likely to occur in the third quarter and then take 18 months to be implemented, so managers still have time to adjust. Adoption of the process and procedures required to meet regulatory compliance must fit inside of a fund’s operational framework in a way that is efficient and thorough. AxiomSL understands the challenges and provides funds a flexible, integrated, data-driven platform to deliver a solution to meet the new regulatory reporting requirements while ensuring full transparency and control.

For more information, please contact Bruce Runciman: brunciman@axiomsl.com or 1 212 248-4188 X 120