US ASSET MANAGEMENT:
NO REST FOR THE WEARY
By: Melissa McDonough
Increasing Investor Protection
A
lmost two years ago, the US Securities and
Exchange Commission (SEC) announced a
monumental five-part plan to enhance the
way Registered Investment Companies are regulated. The SEC’s focus on data is front and center
to this plan, which will require firms to provide
more frequent, complex, and detailed information
to the SEC.
Last year, US asset managers had to deal with transformational regulatory changes to Money Market
Funds. In October, right after those changes went
live, the SEC finalized two additional rules: liquidity
risk management and reporting modernization.
LIQUIDITY RISK MANAGEMENT
When proposed, the liquidity risk management rule
drew heavy criticism from the industry. The final
rule reflects feedback the SEC received from the
industry and has substantially changed from the
original proposals.
While a liquidity risk management program is still required, the revised rule is less prescriptive and allows
funds to tailor the program to match each fund’s assessed risk profile. Fund boards will have to review
and refresh their fund’s liquidity risk management
programs annually. Rather than the three-day liquid
asset minimum requirement as originally proposed,
each fund must identify a percentage of its net assets to be held in highly-liquid investments and create policies and procedures to correct for when the
portfolio falls below that percentage.
Liquidity bucketing also got a break in the final rule,
with the number of categories decreasing from six
to four. While funds will still have to bucket each security within the portfolio for Form N-PORT filings,
public information will now only be required to show
the percentage holdings, split across the four buckets. This was an addition to the final rule to appease
commenters who requested confidentiality, but still
meets the SEC’s desire for liquidity transparency.
Similarly, a fund will also be prohibited from holding
more than 15% in illiquid securities. If that threshold
is reached, the fund will need to determine procedures to bring the percentage of illiquid investments back into the threshold. When the threshold is
passed, it triggers board reporting and notification to
the SEC on a newly-created Form N-LIQUID.
SCOPE EXEMPTIONS
While ETFs are in scope, there are exemptions to
certain provisions of the liquidity rule for:
In-Kind ETFs: ETFs that meet redemptions
through in-kind transfers of securities, positions,
and assets other than a de minimis amount of
cash, and publish portfolio holdings daily.
2 P
rimarily Highly-Liquid Funds: Funds that “primarily” hold highly-liquid investments. The definition of “primarily” should be documented in
each fund’s liquidity risk management program.
INVESTMENT LIQUIDITY CLASSIFICATIONS
Highly Liquid
Moderately Liquid
Less Liquid
Illiquid
3 days or less
3-7 days
7 days or less
> 7 days
In-kind ETFs are exempt from the portfolio
liquidity classification and the highly-liquid
investment minimum as the liquidity risk for
funds that meet these criteria is different.
Primarily highly-liquid funds are not subject
to highly-liquid investment minimums as, by
definition, the fund’s holdings are in highlyliquid investments. These exemptions do
not exist in perpetuity, and funds will have to
constantly monitor if they meet the requirements for the exemptions. Thus, funds must
have a “Plan B” for how they will meet the
liquidity requirements on short notice.
SWING PRICING
The liquidity rules allow for open-end funds
to utilize swing pricing, which can prevent
significant dilution to existing investors by
allocating the impact of trading costs only
to those trading in or out of the fund. The
cost that those investors pay is adjusted
by a swing factor that is a direct addition or
subtraction to the dealing NAV per share
in which they transact. Unlike the liquidity
rules, swing pricing is optional, so there is
no immediate action required.
Due to the logistical challenges associated
with swing pricing in the US relating to timing (both late and incomplete orders), policy
administration, and the competing priorities
of the mandatory rules, it is not expected
that the majority of funds will implement
swing pricing right away. However, swing
pricing does provide a real advantage to
funds and investors so perhaps after asset
managers implement the required rules,
they will turn their focus to swing pricing.
REPORTING MODERNIZATION
The final rule for reporting modernization
was adopted almost as originally proposed,
with only a couple changes. The major
change to the final rule was the elimination
of e-delivery proposals. Under the e-delivery
Increasing Investor Protection
NO REST FOR THE WEARY
The first compliance date is right around
the corner, with the Rule S-X changes
within reporting modernization starting in
August 2017. Though there are many competing priorities, these rules are too complex to wait until the last minute.
proposal, a fund could have made reports
and other materials accessible to shareholders on its website instead of mailing
shareholders hard copies. However, due to
the heavy political influence from the paper
industry the proposal was abandoned. While
outgoing SEC Chair Mary Jo White indicated
that the SEC will revisit this specific proposal, it remains to be seen if it will be a priority
for her successor.
Asset managers should focus on how they
will comply with these new rules. The first
and most timely step is to understand the
requirements of the new rules. This will be a
time-consuming process and should not be
delayed. Firms must evaluate if they will use
an in-house solution or if they will leverage
a third-party service provider. Next, firms
need to decide how to source the available
data, identify data gaps, and assign ownership to internal and external parties to solve
those gaps. Managers should anticipate an
added layer of complexity and preparation
due to the heavy oversight required by fund
boards.
The other change to the proposal addressed industry concerns about confidential information. Despite the SEC’s desire
to make the information on the new forms
public, the final rule keeps more monthly
information confidential. Only quarterly filings are to be made public, similar to the
existing N-Q process. The adjustments
made in the final rule do not change the focus of the rule itself, which is timely reporting of complex information. This is also true
for liquidity metrics as the requirements
of the liquidity rule are also captured in the
new forms N-PORT and N-CEN.
With two major pieces of regulation coming
into effect this year, there is no respite for
US asset managers.
IMPLEMENTATION DATES
Liquidity Risk Management
Rule S-X changes
required for all funds
1 AUGUST 2017
Reporting Modernization
1 DECEMBER 2018
1 JUNE 2019
Funds with
> $1 billion in net assets
Funds with
< $1 billion in net assets
Funds with
> $1 billion in net assets
1 JUNE 2018
Funds with
< $1 billion in net assets
1 JUNE 2019
WHAT DOES THIS MEAN FOR ETFs?
Despite strong lobbying efforts from the industry, ETFs are in scope for
the final reporting modernization and liquidity rules. The SEC agreed that
ETFs leveraging in-kind security transfers for redemption orders pose
minimal liquidity concerns. However, it did determine that the potential for
wide bid/ask spreads for ETF shares or substantial differences between
the ETF’s market price and NAV warrants monitoring.
As a result, the SEC has tailored some of the rules specifically for ETFs.
ETF sponsors will not only need to adopt new policies and procedures for
existing products, but also consider the implications for products under
development. Below are key considerations for ETF sponsors as they prepare to comply with the new rules.
REPORTING MODERNIZATION
For the new N-CEN reporting requirements, a separate ETF section exists
to capture additional data on ETFs’ primary market activity with Authorized
Participants (APs). Specifically, the form includes:
•• Create/Redeem order volume, including dollar and share amounts
•• Collateral posted as part of these orders
•• Create/Redeem fees for both fixed and variable fees
•• In-kind ETFs, as defined under the liquidity rule, will be required to report their classification annually
To comply with the new requirements, ETF sponsors will need to review
their operational practices regarding in-kind redemption orders along with
the composition of their baskets. ETF sponsors may need to receive additional data from their fund distributors, order takers, and transfer agents in
order to meet the new reporting requirements.
By: Ryan Sullivan
EXEMPTIONS
ETFs using in-kind redemptions may be exempt from
categorizing securities according to liquidity and the highly-liquid
investment minimum. To be exempt from these provisions,
ETFs must:
•• Publish complete portfolio holdings daily
•• Determine and adhere to a stated de minimis cash component for redemption purposes (including cash-in-lieu names
and markets that do not permit in-kind transfers)
KEY CONSIDERATIONS FOR ETF SPONSORS
In-Kind ETFs
efine de minimis cash allowance, determine rationale
• D
for when cash would be used in a redemption,
and monitor the amount needed for settlement
• A
ssess foreign markets that prohibit in-kind transactions
and whether the required cash would exceed the
determined de minimis amount
• Identify and disclose other periods of market volatility
that may impact specific strategies and require
additional cash to meet redemptions
• A
dopt written procedures for all in-kind redemptions
consistent with the fund’s exemptive relief, which must
be approved by the Board
• R
ecognize that any cash amount in excess of the de minimis allowance may result in the loss of the exemption
Non In-Kind ETFs
LIQUIDITY RULES
Under the new liquidity rules, all ETFs will need to create a liquidity risk
management program with board oversight. ETF sponsors will need to:
•• Draft policies and procedures on the use of in-kind orders and confirm
adherence to the funds’ exemptive relief
•• Define and adhere to a de minimis amount of cash needed for redemption purposes
•• Review relationships between the liquidity of the ETF shares and underlying constituents:
- Bid/Ask spread
- Arbitrage process
- Market maker activity
• Document and separately classify assets based on
local trading practices and government action that may
impact the asset’s liquidity
• Source market-specific data and regulations to identify
these practices for classification purposes
For ETFs investing in less liquid asset classes, sponsors
will need to consider:
• The fund’s ability to divest within seven calendar days
•T
rade execution, including block size, market movement,
and impacts to overall asset liquidity
• Monitoring the liquidity of various asset classes as part
of their liquidity program
•• Assess basket methodology and impact to fund liquidity
•• Confirm that basket is a ‘pro rata’ share of portfolio
2017 | BBH Regulatory Field Guide |
4
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