Who Begets Liquidity?
The U.S. Securities and Exchange Commission is taking new and bold steps to ensure liquidity in the $68 trillion asset management industry with the passage of new rules regarding disclosure and holdings.
Of importance to investment firms and institutional traders is how the new SEC rules affect their ability to manage liquidity, the impact on ‘investable’ assets, decisions on when to buy and sell, as well as on holding smaller-cap stocks. The SEC has mandated that funds assess, manage, and periodically review their liquidity risk, based on specified factors. Liquidity risk would be defined as the risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund.
The SEC’s actions are a reaction to other governmental agencies, such as the Financial Stability Oversight Council, and the Department of Labor, who have been looking at the industry for more oversight. FSOC, a panel of the top financial regulators, has been studying asset management for its possible systemic risks. While the SEC has made multiple recommendations and is attempting to finalize completion of a package of rules, the one of particular importance is the rule that measures liquidity — both at the onset and on an ongoing basis — that affect managers of all sizes who hold positions. While SEC Chair Mary Jo White would rather have a more formal process to ensure asset managers can meet the liquidity needs of their clients, especially in the case of a market crisis, this most recent rule will impact the investment decisions of managers who hold positions in smaller companies that tend to be less liquid.
A Quick Review
In late 2014 Chair White laid out an ambitious overhaul of the asset management industry, with five initiatives: data reporting, liquidity risk management, derivatives in funds, transition planning, and stress testing. Since that time, the SEC has written rule proposals on all but stress testing.
On October 13 the SEC voted to adopt new rules that “would enhance disclosure regarding fund liquidity and redemption practices” as part of a fund’s liquidity risk management.
Under the new rules, a fund would be required to determine a minimum percentage of its net assets that must be invested in highly liquid investments — defined as cash or investments that are reasonably expected to be converted to cash within three business days — without significantly changing the market value of the investment. The fund also would be required to implement policies and procedures for responding to a highly liquid investment minimum shortfall, which must include board reporting.
Conversely, a fund would also be prohibited from purchasing illiquid investments if more than 15% of its net assets are already in illiquid assets. The SEC defines an illiquid investment as an investment that the fund reasonably expects cannot be sold in current market conditions in seven calendar days without significantly changing its market value.
The determination would have to follow the same process as the other liquidity classifications, and funds would have to review their illiquid investments at least monthly. If a fund breaches the 15% limit, the occurrence must be reported to the board, along with an explanation of how the fund plans to bring its illiquid investments back within the limit within a reasonable period of time, such as selling off part of its holdings. If it is not resolved within 30 days, the board must assess whether the plan presented to it is in the best interest of the fund and its shareholders.
The new rules and forms, and amendments to rules and forms, would be published on the Commission’s website and in the Federal Register. Most funds would be required to comply with the liquidity risk management program requirements on December 1, 2018, while fund complexes with less than a $1 billion in net assets would be required to do so on June 1, 2019. The final amendments, if adopted, would become effective 24 months after publication in the Federal Register.
Chair White commented that there has been a trend of open-end funds investing in less liquid strategies, which makes liquidity risk management even more important. She noted that last December an open-end fund suspended redemptions and planned liquidation after significant redemption requests and a substantial decline in net asset value over a six-month period. She stated that this event illustrated how investors can be harmed when a fund holding less liquid assets does not adequately anticipate increased redemptions.
Additionally, White said the final rule includes all the essential elements of the proposal, centered on a requirement for funds to establish a liquidity risk management program overseen by the fund’s board of directors. This could help more safely manage against ‘runs’ on a fund and lessen the harm caused to investors who redeem after more liquid assets have been sold by first movers.
Breaking the Bank
Chair White said that regulatory changes she announced in 2014 are meant to modernize the SEC’s regulatory regime to keep pace with the changes in the market. She emphasized the importance of enhancing reporting requirements, noting that they have not been updated in decades.
And despite the new protections being afforded investors and promoting market stability, many see the increased regulation as adding more costs to an already heavily burdened industry. Despite this, the asset management industry and Wall Street remains supportive of the Commission’s actions.
Robert Grohowski, general counsel for the Investment Adviser Association, said in an interview in The Hill that the cost of compliance will be huge.
“Lots of folks in the industry are feeling like they’re being asked to do a lot more in order to keep up,” Grohowski said. “There is a crushing cumulative cost of compliance with each rule.”
Another analyst at a brokerage house agreed. Whether it be adding the necessary staff, technology and/or capital there will be some form of outlay for the industry. He emphasized that this might be particularly troublesome for the smaller asset managers with assets under management of less than $5 billion.
“While mega-fund managers like BlackRock or Vanguard might not have trouble meeting these new reporting rules and adding or modifying their systems, smaller funds, such as those more regional in nature are sure to feel the squeeze,” said the analyst at the New York broker. “The larger managers by their sheer size can simply bear the cost or even pass it along to individual investors for a miniscule amount. The smaller funds just don’t have those economies of scale.”
So what really begets liquidity? In this case, it’s the SEC.
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