Managers and sub-advisers to US retail funds have more to think about with respect to liquidity risk management. The staff of the Securities and Exchange Commission (the Staff) recently issued new guidance in the form of responses to frequently asked questions (FAQs) and a new interim rule (Interim Rule), which highlight the challenges confronting advisers and sub-advisers to US retail funds when applying liquidity risk management rules.1 The FAQs and Interim Rule follow on the heels of the SEC’s adoption of liquidity risk management requirements under new rule 22e-4 under the Investment Company Act of 1940 (the Rule), which represented a significant shift in liquidity considerations for most US retail funds (funds) (i.e., registered open-end management investment companies, including open-end ETFs but not money market funds).2 The FAQs and Interim Rule provide, respectively, guidance and a six-month delay in the effectiveness of many (though not all) of the rules. Prior to the delay, fund managers both large and small found themselves scrambling to find third-party service providers (service providers) to assist with the Rule's complex liquidity determinations; sub-advisers and international managers (particularly to a limited number of funds) were surprised to find themselves required to provide more granular detail about the liquidity of investments they oversee. As a result, the SEC has now extended certain implementation deadlines associated with the Rule into 2019. But managers, particularly sub-advisers with minimal exposure to US regulation, still face an uphill climb to comply. This alert outlines the impact of the liquidity rule with a particular focus on sub-advisers and international managers and offers practical insights about liquidity classifications.
In addition to discussing compliance concerns with industry participants, the Staff also has met with service providers who expect to assist fund groups in implementing the classification requirements of the Rule. Based on Staff engagement, we have observed that: (1) due to a lack of readily available market data for certain asset classes (e.g., fixed income), service providers have struggled to provide comprehensive coverage for asset classes in which may trade; (2) as service providers are still in the process of finalizing their Rule compliance products, funds may be delayed in evaluating and selecting appropriate service providers to assist in the fund’s implementation of the liquidity risk management program; and (3) the delegation of responsibilities related to liquidity determinations may broaden the scope of managers and sub-advisers that will be tasked with compliance for the Rule.
One of the primary difficulties managed and sub-advisers face will be building and implementing the necessary operational systems for determining the fund’s liquidity classifications. A recent survey of service providers highlighted the highly subjective nature of making such liquidity determinations, which, when run through multiple service providers’ models, may differ widely. The survey found that in certain scenarios where, depending on the service provider used, analysis of a large high yield bond fund’s portfolio resulted in ranges from 7% to 95% for the fund’s highly liquid bucket.3
The Liquidity Rule and the New FAQs
The Rule requires each fund to establish a liquidity risk management program. The rule directly applies to funds and requires that they periodically assess and manage their liquidity risk by, among other things, classifying each portfolio investment (including derivatives) according to their relative liquidity. While only funds are directly subject to the Rule’s requirements, the FAQs makes clear that the board of a relevant fund must approve a person to administer the risk assessment and management program (the Liquidity Program), which can include the fund’s investment adviser, sub-adviser or their respective officers.4 Although the FAQs confirm a fund’s ability to delegate Liquidity Program responsibilities to the fund’s sub-adviser(s), this delegation can introduce significant issues for such advisory entities. Sub-advisers with only limited exposure to US retail funds may find the Rule’s range of requirements (and the SEC's related guidance on factors to consider when assessing liquidity) particularly challenging. Because of these obstacles, nearly all fund complexes are expected to use service providers to some degree.5 But as discussed in more detail below, even these expert service providers have struggled to implement coherent and consistent programs when assisting their fund clients.
Expanded Range of Liquidity Considerations
Prior to the passage of the Rule, US fund managers' liquidity management focused, as a practical matter, on whether fund assets were sufficiently liquid to meet redemptions and on compliance with long-standing SEC guidance that open-end funds should not hold more than 15% of net assets in illiquid securities.6 A sub-adviser of a single investment sleeve in a fund portfolio might have found its obligations to the fund limited to a basic determination of which assets were illiquid. Now, funds must assign each investment (or, alternatively, asset classes) to one of four liquidity classifications, based on their reasonable expectation regarding how long it would take to convert such investment to cash:
- Highly liquid investments (cash or convertible to cash within three business days or less).7
- Moderately liquid investments (convertible to cash within three to seven calendar days or less).8
- Less liquid investments (may be sold within seven calendar days or less, but where the sale may settle in more than seven days).9
- Illiquid investments (may not be sold within seven calendar days or less).10
Factors to Consider When Evaluating Liquidity - Practical Examples
The Rule does not mandate that funds use any one particular factor to classify investments and instead opts for a principles-based approach to evaluating portfolio liquidity; the adopting release nonetheless outlined six factors that funds might use.11 These factors illustrate the highly subjective nature of liquidity determinations, introducing the potential for wide variations. With respect to one such factor, the Adopting Release notes, reasonably, that a high frequency of trades or quotes for an asset class or individual investment tends to indicate that a particular asset class or investment has relatively high liquidity.12 But trade volume varies widely by both exchange and country and may not provide a complete picture of liquidity. For example, the average trading volume of US., European and Australian stock exchanges may be a fraction of the volume of the Shanghai and Shenzhen Stock Exchanges, but issuers on those stock exchanges may be somewhat more likely to suffer from trading halts. As the SEC acknowledges, there is no perfect measure of liquidity, and funds may wish to consider the trade size.13 While the number of shares traded in the United States was not particularly high relative to other jurisdictions, the value of shares traded on the New York Stock Exchange was approximately USD 1.3 trillion as compared to the approximate USD 510 billion value of shares traded on the Shanghai Stock Exchange in December 2017. To further complicate matters, the Adopting Release notes that volatility should be considered as well.14
Even a sophisticated, technical analysis of such market factors would not be complete if securities are subject to transfer or repatriation restrictions. The classic example is securities issued under rule 144A of the Securities Act of 1933 (Rule 144A securities), which may trade on deep and liquid markets elsewhere while simultaneously subject to transfer restrictions in the United States.15 But US restrictions on investments similar to Rule 144A securities are not the only relevant sources of transfer restrictions; for example restrictions on foreign investors in China effectively limit who can buy and sell Chinese securities and may result in delays in repatriation of principal, income and gains from such securities.16 Finally, market holidays or seasonal fluctuations in trading can also affect liquidity (e.g., in advance of year-end holidays or dips during summer holidays). In the case of China’s financial markets, the market features two "Golden Weeks" when exchanges are closed for five consecutive business days per respective week. Simply by virtue of these holidays, equities listed only in China would arguably fall outside of the SEC's “highly liquid investments” and “moderately liquid investments” classifications because they could not be sold in under seven calendar days.17 Many managers instead carry higher cash positions and/or adjust their exposure to the Chinese market synthetically during these Golden Weeks. It remains unclear from the Adopting Release and the recent FAQs how the liquidity determinations of such investments should be managed under the Rule.
In general, the Rule as adopted requires a fund to consider “relevant market, trading, and investment-specific considerations” when making liquidity determinations.18 Although the SEC specifically declined to adopt an enumerated list of factors for consideration, it did state in the Adopting Release that each of the factors, as proposed, could “useful and relevant” in a fund’s liquidity determinations. As noted above, these other factors include the volatility of trading prices for the asset; the bid-ask spread of the asset; whether the asset has a relatively standardized and simple structure; for fixed income securities, the maturity and date of issue of the security; the size of the fund’s position in the asset relative to the asset’s average daily trading volume; and the relations of the asset to another portfolio asset.19 With these factors, managers of international portfolios may again find themselves on the more challenging side of the spectrum of liquidity determinations. For example, if any foreign exchange hedging is contemplated, certain currencies are subject to limits on exchange and/or repatriation; and derivative positions on issuers in such jurisdictions may be bespoke and therefore not cleared centrally. Liquidity measurements will therefore require some greater degree of complexity and/or discretion.
US managers of funds will, in many cases, already have developed sophisticated approaches to liquidity determinations. But for some international managers, these liquidity determinations may not fit neatly into their existing procedures. Managers, who may contract with sub-advisers precisely because they do not have experience with certain asset classes, may need greater assistance from sub-advisers than in the past. The expanded role for the sub-adviser in the process will likely require sub-advisers to have more direct input on the selection of service providers, such that the sub-adviser is in agreement with the service provider’s model for making liquidity determinations on the investments managed by the sub-adviser. Portfolio managers and traders will naturally have direct knowledge of liquidity and markets, but their experience must be combined with an awareness of legal and regulatory issues that affect liquidity anywhere a fund trades. In this respect, one of the primary challenges for managers will be the implementation of a comprehensive Liquidity Program that coordinates this information across the fund’s various internal operations.
Under the Rule, funds will be required to review the liquidity classifications of their investment portfolio at least monthly on an ongoing basis in connection with reporting the liquidity classification for each portfolio investment on Form N-PORT. Additionally, funds may be required to review their liquidity classifications on a more frequent basis if relevant market, trading, or investment-specific considerations are reasonably expected to materially affect an investment’s classification.20 For example, in recent years, certain stock exchanges have been subjected to unanticipated trading suspensions in order to stabilize financial markets, which, under the Rule, would likely represent a material change to an asset class’s liquidity that would have to be reviewed on a more frequent basis.
On Form N-PORT, funds will be reporting position-level liquidity information to the SEC on a confidential basis, which will not be released to the public, as had been considered under the proposed rule. Instead, under the Rule as adopted, a fund will be required to publicly report on Form N-PORT the aggregated percentage of its portfolio investments that fall into each of the four liquidity classifications.21 This information will only be disclosed publicly for the third month of each fiscal quarter with a 60-day delay.22
1Investment Company Liquidity Risk Management Programs; Commission Guidance for In-Kind ETFs, Release IC-33010 (Feb. 22, 2018).
2Investment Company Liquidity Risk Management Programs, Release IC-32315 (Oct. 13, 2016) (“Adopting Release”).
3Supplemental Comments on Investment Company Liquidity Risk Management Programs from the Investment Company Institute (Nov. 3, 2017) (“ICI Letter”).
5A survey by the Investment Company Institute indicated that 91% of managers were considering using a third-party service provider to assist. ICI Letter.
6This limit is 10% for money market funds, which are also subject to other distinct liquidity requirements.
11The Rule, as originally proposed, would have required funds to evaluate nine factors when classifying the liquidity of each portfolio position in a particular asset: (1) existence of an active market for the asset, including whether the asset is listed on an exchange, as well as the number, diversity, and quality of market participants; (2) frequency of trades or quotes for the asset and average daily trading volume of the asset (regardless of whether the asset is a security traded on an exchange); (3) volatility of trading prices for the asset; (4) bid-ask spreads for the asset; (5) whether the asset has a relatively standardized and simple structure; (6) for fixed income securities, maturity and date of issue; (7) restrictions on trading of the asset and limitations on transfer of the asset; (8) the size of the fund’s position in the asset relative to the asset’s average daily trading volume and, as applicable, the number of units of the asset outstanding; and (9) relationship of the asset to another portfolio asset.
12Adopting Release at 165.
13Adopting Release at 165.
14The Adopting Release identifies that there is an inverse relationship between volatility and liquidity, observing that a lack of liquidity tends to amplify price volatility. But it is worth considering whether this factor aids managers and their funds: if volatility is partly a function of illiquidity, there should be other, more direct measures of such illiquidity.
15The Rule replaces the long-standing approach to evaluating Rule 144A securities' liquidity-- one of many ways that the Rule may have knock-on effects outside of the US fund space.
16Most foreign investors invest in Chinese securities through certain market access programs (i.e., QFII, RQFII, Stock Connect, Bond Connect, and the China Interbank Bond Market program). Over time, the government has gradually reduced structural delays to repatriation of investment proceeds (e.g., lock-ups during the term of the market access programs), but administrative delays in repatriation may still occur. See for example, China liberalizes capital repatriation and allows CNY-FX hedging for QFII/ RQFII at this link.
17Note that off-exchange transactions are not necessarily a solution, either: certain market access programs (e.g., Stock Connect) permit off-exchange transactions in only limited circumstances.
18Adopting Release at 154-55.
20Adopting Release at 174
22Adopting Release at 179.