No. 2016-47
20 October 2016
To the Point
SEC — final rules
Rules on fund liquidity risk
management and swing pricing
The rules are
intended to
minimize the risk
that a mutual fund
would not be able
to meet requests
for redemptions in
times of stress
without negatively
affecting its NAV.
What you need to know
•
The SEC adopted a rule that requires registered open-end funds, including mutual
funds and exchange-traded funds but not money market funds, to establish a liquidity
risk management program and expand their disclosures about their liquidity and
redemption practices.
•
The SEC also gave open-end funds (except for money market funds and exchangetraded funds) the option to use swing pricing to adjust their net asset value for costs
associated with satisfying requests for shareholder purchases or redemptions
(e.g., trading costs) in certain circumstances.
•
The compliance date for the rule requiring liquidity risk management programs is
1 December 2018, for fund complexes with $1 billion or more in net assets or 1 June
2019, for smaller fund complexes. The effective date for the swing pricing rule will be
two years after it is published in the Federal Register.
Overview
The Securities and Exchange Commission (SEC) adopted final rules for registered open-end
funds, including mutual funds and exchange-traded funds (ETFs) but not money market funds,
that are intended to minimize the risk that a fund would not be able to satisfy its obligations
without negatively affecting its net asset value (NAV) if it is hit with a high number of
redemptions during periods of market turmoil.
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The SEC noted that the fund industry has grown significantly in the past 20 years and that
funds today pursue more complex investment strategies, such as fixed income and alternative
investment strategies, than they did in the past. These strategies focus on less liquid assets
that in times of market stress may be hard to sell without diluting the value of fund shares.
Mutual funds allow investors to redeem their shares daily and are required by law to pay
shareholders within seven days. ETFs allow daily redemptions from the fund only for certain
large market participants.
Key considerations
Liquidity risk management programs
The new rule requires registered open-end funds, including mutual funds and ETFs but not
money market funds, to adopt and implement a written liquidity risk management program.
Liquidity risk is defined as the risk that a fund could not meet redemption requests without
significantly diluting the interests of remaining investors.
The rule requires the funds to assess, manage and review their liquidity risk at least annually
considering applicable factors such as (1) investment strategy and liquidity during normal and
foreseeable stressed conditions, including whether the strategy is appropriate for an openend fund and whether the fund has a relatively concentrated portfolio or large positions in
particular issuers and uses borrowings and derivatives, (2) short-term and long-term cash
flow projections in normal and stressed conditions, (3) holdings of cash and cash equivalents
and borrowing arrangements and other funding sources and (4) additional factors that affect
only ETFs. The funds also must maintain certain records relating to their liquidity risk
management programs.
The rule also requires funds (except in-kind ETFs) to classify investments as highly liquid,
moderately liquid, less liquid or illiquid and to review their classifications at least monthly or
more often under certain conditions. The categories reflect the number of days a fund expects
it to take to convert the investment to cash without significantly changing the market value.
The periods range from three business days or less for a highly liquid investment (HLI) to
more than seven calendar days for settlement of a less liquid investment. Illiquid investments
are those a fund doesn’t expect to be able to sell or dispose of within seven calendar days
without significantly changing the market value.
Classification may be done by asset class except under certain circumstances, and a fund
must determine whether a trade of the size it would expect to make would significantly affect
the liquidity of the investment and therefore the classification. For derivatives they classify as
moderately liquid, less liquid or illiquid, funds must identify and disclose the percentage of
HLIs segregated to cover them or pledged to satisfy margin requirements.
Funds (except in-kind ETFs) must set a minimum percentage of net assets to be invested in
HLIs that are assets based on certain factors if they don’t primarily invest in these types of
assets. Funds must review this “highly liquid investment minimum” at least annually.
A fund also will be prohibited from acquiring an investment if, after the acquisition, its illiquid
investment assets will exceed 15% of its net assets. In addition, the rule requires funds that
are permitted to redeem in kind to establish policies and procedures regarding how and when
they will engage in such redemptions.
2 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016
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The rule requires that a fund’s board (and in some cases, also a majority of the independent
directors):
Funds will be
required to report
certain information
about their liquidity
to the SEC.
•
Initially approve the liquidity risk management program and the person(s) designated to
administer the program (e.g., the fund’s investment adviser or officer(s))
•
Review, at least annually, a written report prepared by the program administrator that
addresses the operation of the program, assesses its adequacy and effectiveness and
describes any material changes made to the program
•
Approve a change to the HLI minimum during any period in which a fund’s HLI assets are
below the minimum
•
Be notified by the program administration no later than its next regularly scheduled
meeting if the fund falls below its HLI minimum and be given a brief explanation of the
causes and extent of the shortfall and the actions taken in response, or be notified by the
program administrator within one business day if the shortfall lasts longer than seven
consecutive days and given an explanation of how the fund plans to achieve the minimum
within a reasonable time period
•
Be notified by the program administrator within one business day if the fund’s holdings of
illiquid investment assets exceed 15% of net assets and be given an explanation of the
extent and causes and how the fund plans to bring its illiquid investment assets to 15% or
less of its net assets within a reasonable period of time
•
Assess whether the plan to bring illiquid investment assets to a maximum of 15% of net
assets continues to be in the best interest of the fund if illiquid assets still exceed that
threshold 30 days after they first exceeded the threshold and repeat the assessment
every 30 days if illiquid assets continue to exceed 15% of net assets.
New reporting requirements
Funds are also required to report certain information about their liquidity to shareholders and
make certain confidential disclosures to the SEC as follows:
•
A fund must include monthly position-level liquidity classification information, its HLI
minimum and other information on new Form N-PORT that will be submitted confidentially
to the SEC and publicly disclose at the end of every quarter certain information, including
the aggregate percentage of its portfolio in each of the four liquidity categories.
•
A fund must confidentially report certain information to the SEC on new Form N-LIQUID
within one business day if (1) it exceeds the 15% illiquid investments limit, (2) it mitigates
such a situation or (3) the amount of HLIs falls below the fund’s minimum for more than
seven consecutive days.
•
A fund must include public disclosure of its policies concerning the time period for expected
payment of redemptions and methods used to meet redemption requests on Form N-1A.
•
Funds must publicly disclose their use of lines of credit, interfund lending and interfund
borrowing, and whether the fund is an in-kind exchange-traded fund, on new Form N-CEN.
How we see it
While funds will need to consider certain factors when setting an HLI minimum, they will
have the flexibility to base the minimum on their unique circumstances. That is, the rule
does not prescribe a minimum percentage of net assets.
3 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016
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Swing pricing
The rule gives registered open-end funds, except for money market funds and ETFs, the
option to establish policies and procedures to adjust their NAV per share by swing factors
expressed as a percentage of NAV when the level of net purchases or net redemptions
exceeds a specified percentage of NAV called the swing threshold.
Funds could use “swing pricing” to pass along to purchasing and redeeming shareholders the
costs of trading and mitigate dilution to other shareholders. Swing pricing could go into effect
only if the person or persons responsible for administering a fund’s swing policies determine
with “high confidence” that daily purchase and redemption activity (based on orders and
reasonable estimates) crossed the fund’s swing pricing threshold or thresholds, if the fund
chooses to establish multiple thresholds.
A fund must have policies and procedures for determining the swing threshold(s) that consider
factors such as historical investor flow in normal and stressed periods, the fund’s investment
strategy, liquidity, holdings of cash and cash equivalents, borrowing arrangements and other
funding sources, and transaction costs. A fund must establish an upper limit for its swing
factor(s), which may not exceed 2% of the fund’s NAV per share. When determining the swing
factor(s) and upper limit, the administrator must only take into account expected near-term
costs stemming from net purchases or net redemptions that occur on the day the swing
factor(s) is used (e.g., spread costs, transaction fees, borrowing-related costs).
A fund’s board, including a majority of independent directors, must (1) approve swing pricing
policies and procedures, (2) approve the swing threshold(s) and upper limit on the swing
factor(s) and any changes to these amounts, (3) designate the person(s) responsible for
administering swing pricing and (4) review at least annually a written report prepared by the
administrator that describes the adequacy and effectiveness of the fund’s swing pricing
policies and procedures and any material changes to those policies and procedures, among
other things. Funds also must keep certain records about swing pricing.
A fund will need to reflect its use of swing pricing in its financial statements and disclosures.
For example, capital share transactions will be based on the adjusted NAV if swing pricing has
been used. Funds will disclose the per-share effect of swing pricing in the NAV per share
rollforward, and the adjusted NAV will be disclosed as a separate line item in the financial
highlights. Funds will also have to disclose in the notes to the financial statements how they
determine whether the fund’s NAV per share will swing and the effects of swing pricing,
including the difference between ending US GAAP NAV and adjusted NAV, if applicable.
Funds will be required to disclose their US GAAP NAV in their balance sheets. However, if they
use swing pricing at period end, funds will be permitted to disclose adjusted NAV in their balance
sheets if they believe this information would be meaningful to users. In addition, US GAAP
NAV will be used when calculating total return in the financial statements, but funds will be
permitted to disclose total return calculated based on adjusted NAV or unadjusted NAV outside
of the financial statements, in other performance information.
Funds will be required to report certain information about their use of swing pricing and the
effect of swing pricing on total return on Form N-1A and the upper limit for swing factor(s) on
Form N-CEN.
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4 | To the Point Rules on fund liquidity risk management and swing pricing 20 October 2016