Almost 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.
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.
- Primarily 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 CLASSIFICATION
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 highly-liquid 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.
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.
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 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.
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.
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.
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.
With two major pieces of regulation coming into effect this year, there is no respite for US asset managers.
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.
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.
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
- Assess basket methodology and impact to fund liquidity
- Confirm that basket is a ‘pro rata’ share of portfolio
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
This article was originally published in the 2017 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.