SEC to Mutual Funds: Get Your Liquidity in Order

New proposed rules from the US Securities and Exchange Commission requiring mutual funds to ensure they have the necessary liquidity and correct pricing to accommodate a potential onslaught of redemptions could pose operational and IT challenges for fund management firms.

That is the initial reaction from a group of ten fund management compliance, operations and legal experts contacted by FinOps Report to discuss the SEC’s recommendations. None of the ten have filed their opinions with the SEC, which wants feedback by late December.

Underlying the SEC’s proposal is the requirement that open-ended registered funds — mutual funds and exchange-traded funds — should have enough liquid assets on hand to sell quickly, in case of a rush of share redemptions. The regulatory agency also wants mutual funds to consider, but not necessarily implement, the concept of “swing pricing.” That is a way to calculate net asset value to protect long-term investors from being penalized in favor of active traders during a purchase or sale of a large quantity of shares.

According to a related report from the SEC, “Liquidity and Flows of U.S. Mutual Funds,” the SEC is attempting to contain the risk of funds having to sell off assets at “fire-sale prices,” if investors start panic selling during a market downtown. Its solution is to require funds to have sufficient liquid assets to match the investors’ cash demands. Such might be the case with bonds, if the Federal Reserve hikes interest rates. If a mutual fund or an ETF holds illiquid bonds, the price swings could be rapid and create a vicious cycle as the price drops cause a selling spree.

Assets are considered liquid when an investor can buy or sell large quantities of securities quickly at an expected price. According to industry practice, a security is now considered illiquid if it cannot be sold within seven days at the last price it was last traded within the seven days.

Making the Grade

To ensure sufficient liquidity, says the SEC, a mutual fund complex must create a liquidity risk management program which classifies each asset in one of six categories of liquidity based on the days required to convert it to cash, establishes a minimum percentage of net assets which can be liquidated in three days, and periodically reviews its liquidity risk. In addition, reforms under the proposed new Rule 22e-4 would put a 15 percent cap on investments in hard-to-trade assets.

Some of the largest US bond mutual funds have at least 15 percent or more of their money invested in such illiquid securities. Liquidity risk would be defined as the risk that a fund could not meet redemption requests under normal or stressed conditions without materially affecting the fund’s net asset value.

A fund’s board, including a majority of the independent directors, would have to approve the liquidity risk management program. Ongoing, the board would annually review a report on the program’s adequacy, prepared by the fund’s investment adviser or officer administering the liquidity program.

Open-ended fund management companies would also be required to document their liquidity procedures, including committed lines of credit, interfund borrowing and lending, and swing pricing to the SEC in an amended Form N1-A and new proposed forms N-PORT and N-CEN. In connection with the new reporting requirements, the SEC is re-opening the comment period for its previous reform entitled “Investment Company Reporting Modernization” released in May 2015.

Currently, mutual funds and exchange-traded funds are required to pay off any shareholders that ask to redeem their shares within seven days of receiving the request. While that timetable still applies, mutual funds and ETFs would still need to alter their investment strategies to accommodate the so-called “three-day” liquidity provision.

The SEC’s plan is a sharp departure from current practice. There is no extensive regulatory framework governing fund liquidity other than the seven-day deadline for mutual funds to hone redemption requests. Although the SEC had previously urged mutual funds to cap their investments in illiquid securities at 15 percent, there is no legal requirement for them to do so.

Real-Time Liquidity Analysis

In practical terms, the new liquidity management program will require changes to order management, trade execution and portfolio accounting systems. “The front-end order management and trade execution system will need to work in real-time with the compliance and portfolio accounting system to ensure that incorrect orders are not executed and that any market changes are picked up immediately by the the front end systems,” explains Ebbe Kjaersbo, product manager for investment operations technology firm SimCorp in North America. Such real-time monitoring allows the portfolio manager to monitor a fund’s liquidity throughout the day. The objective is to respond to market changes as they happen rather than relying on stale valuations from the previous day.

“If the price of an asset drops immediately during the day, the portfolio manager needs to react immediately to liquidate positions earlier than its peers.” says Kjaersbo. “Say, for instance, that the market opens two percent lower in the morning. How will the manager respond appropriately or effectively if it is using data that is off by two percent?”

Quick decisionmaking will be far easier for fund companies which have either tightly integrated front, middle and back office platforms or rely on a single system. Either way, the ideal scenario would be an investment book of record (IBOR) or a single uniform view of all transactions at all times.

Classifying assets in one of six categories is easier said than done. “Although mutual funds might be able to classify what percentage of their assets are liquid or illiquid, making a more narrow classification will require additional evaluation by portfolio managers with the rules programmed into the front middle and back offices by data management and IT specialists,” says Matthew Bromberg, a partner with the law firm of Reed Smith in New York and former managing director at BNY Mellon in charge of compliance for investment fund servicing.

The funds would be required to consider all the relevant liquidity factors such as trading frequency, volume, bid/ask spread and position size. Fund management firms typically do not classify assets by liquidity.

Playing With Swings

Even more complicated than creating a liquidity management program will be implementing swing pricing. Under the SEC’s proposed amendments to Rule 22c1, open-ended funds could adjust their net asset value upward or downward when purchases or redemptions of shares exceed a designated swing threshold or swing factor. The swing price would be implemented only when the threshold is exceeded. The swing price could end up being the net asset value on one day with the “adjustment” to the NAV eliminated the next day.

“The liquidity management rules will be hard enough to follow but swing pricing requires an entire set of new calculations, including the swing factor trigger,” says one operations manager at a US fund management firm. “That determination could become the subject of heated debate between portfolio management specialists and boards of directors who don’t want to harm other investors.”

Investors trading at a “swing price” are effectively paying the trading costs associated with their activity. Therefore, applying swing pricing to a fund’s traded NAV will allow mutual funds to avoid damaging remaining shareholders, while allocating expenses associated with a transaction in fund shares equitably, explains Bromberg.

It is unclear just how quickly the “swing” adjustment to the NAV would have to be made, but it is clear that the calculation would have to be completed before the end of the day when NAV’s are typically struck. “The new synthetic calculation would have to take into account not only the values of individual securities, as is currently the case, but also the market impact of the purchase or redemption,” explains Bromberg. “Fund boards would have to agree on the swing thresholds first and approve a new methodology for striking swing prices which differs from the current one for striking end of day NAVs.” The rules, including pricing models and data inputs, must be coded into any NAV calculation engines.

Bromberg says that he is expecting mutual fund and ETF complexes to propose more palatable alternatives to the SEC’s suggestions such as redemption fees or liquidity fees to active investors who make large purchases or sale of shares. The SEC has currently set a 2 percent ceiling on redemption fees which are paid directly to the fund. Yet another possibility: implementing the requirements only on liquid alternative funds, or mutual funds which have hedge-fund like investment strategies. Theoretically, such alt-liquid funds expose shareholders to greater risks associated with the illiquidity of portfolio securities based on the investment strategies.

For now, mutual fund and ETF complexes are trying to figure out just how much work — and cost — will be involved with the new SEC proposals before drafting their feedback. “Given that swing pricing will be too difficult and costly to implement, we will likely propose tighter redemption gateways — or a tiered system of redemption fees depending on the value of the redemption and the amount of time the investor held onto the shares,” says one compliance manager at a US mutual fund complex.

Says the compliance manager of another US fund management shop, “It’s time for us to gather our portfolio managers, operations managers and IT managers to determine whether our systems can meet the SEC’s liquidity management and swing voting requirements. We will then have to go to our boards with the recommendations for approval.”

Of course, chief executives and chief financial officers must also be included in the loop. “Someone has to sign off on the budget, after all, and our preliminary expectations are that we will have to add up to 20 percent of our current technology budget to accommodate new IT and disclosure requirements,” says the compliance manager.”