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From Securities Regulation Daily, September 22, 2015

SEC proposes liquidity risk management programs for mutual funds and ETFs

By Jacquelyn Lumb

The SEC commissioners have unanimously approved a proposal that would require mutual funds and other open-end management investment companies to adopt liquidity risk management programs. The programs, which must be board-approved, will be required to include a classification of the liquidity of portfolio assets, a periodic evaluation of a fund’s liquidity risk, and the establishment of a new three-day liquid asset minimum. While voting to issue the proposal, Commissioners Daniel Gallagher and Michael Piwowar expressed concerns about the three-day liquid asset minimum and a proposal to permit swing pricing in certain circumstances.

Classification requirement. Under the proposed classification requirement, a fund would determine the number of days in which its position would be convertible to cash at a price that would not materially affect the value of the asset immediately prior to sale. The proposal includes six liquidity categories, which range from one business day to more than 30 calendar days.

Liquidity risk. Liquidity risk would be defined as the risk that a fund could not meet redemption requests as expected under normal or stressed conditions without materially affecting the fund’s net asset value. The proposal would codify the current 15 percent limit on illiquid assets.

Liquid asset minimum. To determine the three-day liquid asset minimum, a fund would look to the 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 will not materially affect the value of the assets immediately prior to sale.

Swing pricing. Under the swing pricing proposal, open-end funds other than money market funds or exchange-traded funds, would be permitted to pass the costs of shareholders’ trading activity to purchasing or redeeming shareholders to protect existing shareholders from the dilution associated with those purchases and redemptions. The SEC noted that swing pricing has been used by pooled investment vehicles in some foreign jurisdictions.

The swing factor would be included in a fund’s net asset value once the level of net purchases or net redemptions exceeded a specified percentage. The swing pricing policies and procedures would be subject to approval by each fund’s board.

New disclosures. Under the proposal, the use of swing pricing would be reported on Form N-1A. The liquidity classification of fund assets would be reported on previously proposed Form N-PORT, and information about committed lines of credit, interfund borrowing and lending, and swing pricing would be reported on previously proposed Form N-CEN. ETFs would be required to report on Form N-CEN 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. The Commission will re-open the comment period with respect to the proposed amendments to Forms N-PORT and N-CEN.

Less liquid funds. SEC Chair Mary Jo White noted that funds have increasingly shifted to a range of investment strategies that rely on less liquid securities, including high-yield bond funds, emerging market equity and debt funds, and funds with alternative strategies. The staff has found a wide range of practices in the ways funds manage liquidity risks, some of which suggest the need for closer regulatory attention. She said the proposal will enhance funds’ ability to manage their liquidity risks, strengthen the securities markets, and better protect investors.

White added that the staff is developing recommendations with respect to the use of derivatives by funds, including appropriate limits on the leverage these instruments may create. She said the SEC hopes to consider a proposal before the end of the year.

Commissioner Gallagher. The open meeting was likely the last for Gallagher, who has announced his departure by October 2. He said he was pleased that the proposal focuses on a core Commission initiative. He was also pleased that it allows for a scaled compliance period for smaller funds, and it provides a longer comment period—90 days rather than 60.

Gallagher said he was concerned by the one-size-fits-all three day liquid asset minimum, and that swing pricing could cause disproportionate harm to retail investors. His preference would be for funds to have the flexibility to craft swing pricing based on thresholds that are most beneficial under their particular circumstances. He also questioned whether this potential radical shift in pricing would be understood by investors.

Commissioner Stein. Commissioner Kara Stein was pleased that the proposal would leverage Form N-PORT, the proposed monthly reporting form for mutual funds and ETFs, because it will allow for the use of structured data to identify trends, outliers, and trouble spots. She questioned, however, whether the proposal goes far enough with respect to funds that pursue more complex strategies. She urged commenters to provide their views on whether funds that pose redeemability concerns should be subject to tailored regulation.

Commissioner Piwowar. Piwowar said there may be preferable alternatives to the swing pricing proposal. His concern is that it could lead to gaming behavior and could increase the volatility of net asset values. This is an area in which the views of academic economists would be particularly helpful, in his view.

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