A Deeper Dive into the SEC’s Proposal

In November of last year, the Securities and Exchange Commission (SEC) issued a rule proposal that seeks to mandate how U.S. open-end mutual funds manage liquidity risk – just one in a torrent of regulatory proposals released by the SEC in recent months. As expressed in recently submitted comment letters from SIFMA, SIFMA AMG and a diverse set of stakeholders, the breadth of proposed changes to open-end fund liquidity risk management – without a compelling justification – warrants a holistic rethink.

Ideally, the SEC would hit the pause button on the proposal to allow pending engagement with the industry to assess the costs, benefits, and potential for negative consequences to retail investors and markets. SIFMA and its members remain committed to working with the SEC to find a better path forward.

SEC Commissioner Mark Uyeda expressed similar concerns recently, broadly about the SEC’s regulatory approach and also the liquidity proposal, noting “the SEC has been focused on rulemakings based on unrealistic expectations of how the world functions and how it ought to be” and referring to this approach as “the perils of regulation by theory and hypothesis.”

In this blog, we will unpack why the proposal is problematic based on the potential for negative impacts on investors and why action is unnecessary.

Key Points

• The SEC Adopted Liquidity Rules in 2018 – Why Revisit?
  • The current liquidity risk management programs (Rule 22e-4) only took effect in 2018. Revising a rule adopted so recently requires a compelling justification.
  • March 2020 market events are a testament to resilience rather than a basis for entirely re-imagining the operation of mutual funds.
• Mandating a “Hard Close” In Order to Require Swing Pricing Would Negatively Impact Retail Investors.
  • Adverse impacts and economic costs would negatively impact retail investors and introduce operational risks which are not worth bearing to mandate swing pricing.
  • Overhauling the efficient and well-established system of mutual fund operations would disadvantage retail shareholders who invest through retirement plans or other intermediaries.
• Re-Defining What “Illiquid” Means Will Adversely Impact Fund Holdings and Limit Strategies
  • Proposed changes to mutual fund management presume a worst-case market stress scenario for usual and ordinary markets and would adversely impact funds and limit strategies available to retail shareholders.
• The Potential Costs to Retail Investors and Market Structure are Material and Wide-Reaching

The SEC Adopted Liquidity Rules in 2018 – Why Revisit? 

The SEC recently proposed new rules for U.S. mutual funds relating to liquidity risk management builds on Rule 22e-4, an SEC initiative that took effect just over four years prior. The SEC points to the events of March 2020 to justify the need for additional regulation to “enhance” mutual fund resiliency, despite the fact no open-end mutual funds failed or were unable to meet shareholder redemptions during that market event. The SEC has not put forth data nor studies to support these broad changes and the overhaul of rules that have not been in effect for long enough to fully evaluate their impact or identify gaps in their effectiveness.

The proposal calls for a complicated process known as “swing pricing,” which – in simple terms – would mandate that funds ‘swing’ their daily share price – basically adjusting a funds’ net asset values to pass on funds’ trading costs to shareholders choosing to make a transaction that day.

This “swing pricing” mechanism would adjust the price based on a theoretical transaction cost. If a fund is required to sell assets to meet redemptions, it might incur transaction costs it would not have incurred otherwise. The existing rules permit but do not require mutual funds to utilize swing pricing. The recent proposal would make it mandatory.

Funds already have a wide variety of tools available to manage liquidity and anticipate redemptions, calling into question the need for the application of theoretical transaction costs on redeeming investors. Beyond the merits of a “swing price,” the SEC proposal would change the timelines for how mutual fund orders are handled. Having timely purchase or redemption information is required for a fund to know whether to invoke its swing pricing mechanism. Known as the “hard close,” the proposal would require all fund orders to be received by the fund before it calculates its daily net asset value – not just received by an intermediary as is currently the case.

Mandating a “Hard Close” In Order to Require Swing Pricing Would Negatively Impact Retail Investors

The SEC’s proposal mandates a “hard close,” which is a cut-off time when orders can no longer be executed at today’s price. The only reason for this is because the SEC believes it is a necessary step before requiring funds to use swing pricing. Revising the existing mutual fund architecture solely for the purpose of imposing a mandatory swing pricing regime in times of market stress requires a balancing of cost and benefits. While the SEC believes that the benefits are potentially significant, they have not provided quantitative data evidencing this claim. In fact, there are actual costs to shareholders and risks to the operational infrastructure, which could outweigh the unknown “upside.”

Retail fund shareholders typically invest through intermediaries. Those intermediaries will need to implement cut-off times earlier in the day to allow their processes to work and deliver orders. That means retail investors likely will be subject to much earlier deadlines than investors with the ability to invest directly with the fund. While the SEC downplays this difference, it creates a two-tier market where most retail investors are effectively unable to react to afternoon market events on a timely basis. Additionally, this has the potential to create confusion for investors and diminish the customer experience if different funds implement different cut-off times. This negative impact would be most felt by retail investors who rely on intermediaries for access to different fund families.

An unintended consequence of this proposal would be to have retail investors going direct without the advice of their trusted investment advisor who provides guidance and recommendations based on the client’s investment objectives and risk tolerance that would fit into their long-term financial plan.

A two-tier market would discourage the use of intermediaries – picking winners and losers between business models and creating incentives to move away from those who support retail investors is negative public policy. This calls into clear question the actual need for or wisdom of swing pricing. There is consensus among most if not all stakeholders that the adverse impacts, economic costs, and operational risks of a hard close are not worth bearing to implement swing pricing as a mandate.

Furthermore, this would create a disintermediation of intermediaries and the valuable services they provide to retail investors and the market including investment advice, exchange orders, financial planning, statements, and tax forms, which are part of the services offered to investors.

Open-End Mutual Funds Have a Long History of Effectively Managing Liquidity Risk

Mutual fund liquidity risk has historically been managed by individual mutual funds that consider their own portfolio compositions, flow behavior, and reasonable probabilities of market changes. Thousands of individual mutual funds and investment advisers have strong business incentives to strive for the ideal mix of return, risk, and liquidity. Millions of investors have voted with their wallets to invest in open-end mutual funds.

Fiduciary duty requires funds and advisers to act in the best interest of shareholders. Any rare issue or problem is clearly idiosyncratic based on a particular fund’s decisions rather than any inherent defect of the mutual fund concept. The proposal’s focus on March 2020 misses the mark; March 2020 was not an issue of individual funds mismanaging their own liquidity. March 2020 was a market-wide condition and not specific to open-end mutual funds. While open-end funds were impacted, fund sponsors and advisers diligently navigated through the choppy seas and took pride in taking care of their investors and shareholders.

Re-Defining What “Illiquid” Means Will Adversely Impact Fund Holdings and Limit Strategies  

The proposal would change how funds classify their holdings in terms of liquidity. Assuming worst-case “stressed” market scenarios that penalize funds for large holdings would result in holdings and funds appearing less liquid than merited. This conservative approach, proposed in the name of enhancing fund resilience, threatens to invent rather than identify a problem, which would at best be highly misleading. It would also artificially constrain strategies that operate every day without issues on the logic that an unknown future market environment may present liquidity challenges. Rather than giving more tools to manage liquidity stress, the SEC has chosen a specific path, complete with assumptions and value judgments.

The re-definition of “illiquidity” would also make assets “illiquid” that are traded freely every day but have settlement periods longer than seven days – which is common, most notably for bank loans.

The bank loan market is large and active and many fund sponsors offer bank loan strategies. While institutional investors could access these kinds of strategies through separate accounts or private funds, retail mutual fund shareholders would lose that investment avenue. A mutual fund gives retail investors the necessary scale and structure to make investments they would not be able to make on their own.

The Potential Costs to Retail Investors and Market Structure are Material and Wide-Reaching

The potential costs involved with this rulemaking are significant, even when setting aside the lack of necessity. Mutual funds built their Rule 22e-4 programs from scratch only a few years ago. Fund shareholders and advisers bore these expenses to meet a regulatory mandate and were made in addition to the investments already made for their own liquidity programs.

Fund shareholders will shoulder much of the cost of re-building programs to meet the new regulatory mandate, directly or indirectly. The trade-offs will take the form of lower rates of return due to holding higher cash buffers and lower-risk assets. Retail investors would lose access to strategies such as open-end bank loan funds.

Implementing swing pricing and revising the plumbing for fund redemptions and subscriptions would involve funds, transfer agents, intermediaries, recordkeepers, 401(k) sponsors and platforms, and more. These structural changes could severely impact smaller intermediaries providing services to retail investors in this area which would disadvantage the most vulnerable investors.

This infrastructure has been developed and refined over decades. Meaningful time and resources would be required to revise workflows and mitigate the substantial operational risks. In addition, many processes are interwoven among market participants, so any changes will require significant coordination across the market. Again, the SEC has put forth no data to support the need for these changes.

Conclusion

SIFMA strongly believes that vibrant capital markets serve investors, issuers, and economic growth and stability. There is much common ground among those working to buttress and strengthen the deepest capital markets in the world. As substantial as the ecosystem of mutual funds, investors and market participants are, solutions ought to be found through a more methodical dialogue. Changes of such magnitude warrant industry-wide initiatives and credible consideration of the benefits, costs, and risks.

The SEC has historically focused on ensuring investors have adequate disclosure, operate on a level playing field, and enjoy protection from bad actors. SEC Chair Gary Gensler is fond of proudly proclaiming that the SEC’s mission doesn’t pick winners and losers. However, the proposal to fundamentally change how open-end mutual funds operate in the United States does exactly that.

Instead of recognizing the breadth, depth and vitality of a mature and robust avenue for retail investors, the SEC’s recent proposal on mutual fund liquidity moves beyond the role of an impartial referee and seeks to change the rules of the game altogether. The very investors the SEC sets out to protect would bear the most adverse impact through opportunity costs of lower returns, more limited investment strategies, and reduced access to the markets. The SEC should go back to the drawing board and reconsider this proposal from its most basic level.

 

Kevin Ehrlich is Managing Director, Asset Management Group for SIFMA, where he focuses on investment adviser and investment company regulatory and compliance matters for asset managers. He brings a diverse background to his work with previous experience at Western Asset Management Company, Legg Mason and the Division of Trading and Markets at the U.S. Securities and Exchange Commission.

Related Resources

• Press Release

  SIFMA, SIFMA AMG Submit Comments on Swing Pricing and Open-End Fund Liquidity Risk Management Programs

• Comment Letter

  Open-End Fund Liquidity Risk Management Programs and Swing Pricing, Form N-PORT; Outsourcing by Investment Advisers (Joint Trades)