About the New Regulation
Mutual funds and exchange-traded funds (ETFs) can be redeemed daily, so managing fund-liquidity risk to meet redemption obligations without hurting those investors that remain in the funds has always been tricky, particularly during unforeseen market conditions and for certain fixed income strategies such as bank loans.
SEC Rule 22e-4, which came into force on December 1 last year,* will help the industry better manage liquidity risk going forward. The rule will benefit fund investors and help reinforce public confidence by requiring asset managers who offer mutual funds and ETFs to establish a robust and formalized program to manage liquidity and report liquidity limit breaches to the SEC and the fund board as needed. The collective industry effort to implement this regulatory reform in the last few years will promote more effective liquidity risk management and provide better public market liquidity transparency.
The rule requires classifying a fund’s holdings into 4 liquidity categories, based on the number of days the fund reasonably needs to raise cash to meet investor redemptions without significantly changing the market value of the remaining fund holdings. This liquidity classification criteria provides a standard framework to measure, manage and report liquidity.
The requirement for a formal liquidity risk management program and regular reporting to the SEC and the fund board means that investment managers have had to build or enhance their risk governance and oversight as an integral part of the fund investment management.
The rule also requires:
Ahead of the Curve
Beginning in 2016, State Street Global Advisors embarked on a significant enhancement project across multiple stakeholder functions – including investment, risk, investment oversight, compliance, product, legal, IT and operations – and we successfully completed the implementation in December 2018, ahead of the regulatory deadline. As a result of this multi-year undertaking, we’ve been enhancing our existing integrated liquidity risk management process, adopting liquidity classification requirements in the daily liquidity-risk monitoring, and further improving our liquidity-risk management governance and oversight. We have expanded the charter of State Street Global Advisors’ Liquidity Committee not only to oversee this regulatory implementation, but also to carry out the actual responsibilities of the Liquidity Risk Management Program Administrator.
What Does All This Mean for Investors?
In short, it means enhanced investor protection as well as other potential benefits.
Though quantifying liquidity risk as prescribed by the Rule into a single dimensional liquidity category could in some ways cause a false sense of precision — and may lead to some challenges with interpretation and monitoring fund liquidity levels against the established liquidity limits — this new regulation is well positioned to help the 40 Act Fund industry strengthen liquidity risk management, bring out more liquidity transparency and enhance investor protection.
For the first time, investment companies offering these funds will manage liquidity risk with an industry-wide consistent approach. In addition, regular and timely monitoring of fund liquidity at the individual fund holding level, combined with timely correction of any liquidity deterioration and resulting shortfall, will become formalized and integrated into fund investment and risk management operating guidelines.
As a result, investment managers of such funds, large or small, are required to establish or enhance their existing liquidity-risk-management framework to cover governance, measurement, monitoring and reporting processes. This should enable them to better handle various different market conditions in which there’s a potential mismatch between the promised liquidity terms of 40 Act Funds and the liquidity of the underlying assets in these funds.
Ultimately, that should also lead to improved vehicle evaluation and stronger 40 Act product offerings and results for investors in these funds.
* On December 1, 2018, a significant portion of this SEC liquidity rule became effective. The required Liquidity Risk Management Program, along with the liquidity classification requirements for a fund’s holdings, will go into effect on June 1, 2019 for large asset managers. For more information, see the final rule release at https://www.sec.gov/rules/final/2016/33-10233.pdf and FAQs at: https://www.sec.gov/investment/investment-company-liquidity-risk-management-programs-faq
The views expressed in this material are the views of Sebastjan Smodis and Tiffany Hu through the period ended 03/29/2019 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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