On November 2, 2022, the SEC proposed significant amendments to the liquidity risk management framework, including proposals to require swing pricing and additional public reporting. The SEC’s intent of the proposed rules is to enhance liquidity within open-end funds, excluding money market funds and ETFs, and reduce dilution of shareholder interests due to significant redemption activity, especially in times of market stress or significant market disruptions.
This proposal would amend rule 22e-4, rule 22c-1, and certain reporting and disclosure forms under the Investment Company Act of 1940. Below highlights some of the most impactful areas.
Swing pricing is the process of adjusting the price above or below a fund’s NAV per share to effectively pass on the costs stemming from shareholder purchase or redemption activity to the shareholders associated with that activity, rather than diluting remaining shareholders. For example, if the fund has a $100 NAV and the swing factor is 1%, an investor could redeem at $99. If approved, the proposal would require the following:
- A fund must estimate transaction costs of selling or purchasing a pro rata amount of its portfolio investments (or a “vertical slice”) to satisfy that day’s redemptions or to invest the proceeds from that day’s purchases. This must be pro rata across all investments. Rather than first considering more liquid investments, it would purchase/sell with lower transaction costs. Borrowing costs are excluded from the swing factor calculation.
- A fund must apply a swing factor on any day it has net redemptions. When net redemptions exceed 1% of net assets, the swing factor would also account for market impacts of selling a vertical slice of the portfolio to capture the dilutive effect of trading in response to large outflows. The proposal would also require a fund to apply a swing factor for net purchases only if net purchases exceed 2% of net assets or such smaller amount of net purchases as appropriate to mitigate dilution.
- The proposal would require orders to be received by an established cutoff time, or hard close, to receive a given day’s price to facilitate the receipt of timely flow of information to make swing pricing decisions.
Liquidity Risk Management
In addition to swing pricing, the SEC’s proposal attempts to enhance liquidity within funds by revising liquidity categories and increasing the amount of highly liquid assets held by funds. The amendment proposes the following:
- Funds must maintain highly liquid investments of at least 10% of net assets.
- Funds must incorporate stress into their liquidity classifications by assuming the sale of a stressed trade size, which would be 10% of each portfolio investment, rather than the rule’s current approach of assuming the sale of a “reasonably anticipated trade size” in current market conditions. Specifically, in assessing compliance with the fund’s highly liquid investment minimum, the fund would be required to: (1) subtract the value of any highly liquid assets that are posted as margin or collateral in connection with any derivatives transaction classified as moderately liquid or illiquid; and (2) subtract any fund liabilities.
- Funds must remove the “less liquid” investment category and treat these investments as illiquid. The less liquid category consists of investments that can be sold in seven calendar days but that take longer to settle, such as bank loans. For derivatives classified as illiquid, the value of margin or collateral posted for those transactions is applied against the 15% illiquid investment limit.
- Funds must classify all portfolio investments each business day, instead of at least monthly.
Additional Public Reporting
The proposal also focuses on enhanced and more timely public reporting. Specifically, Form N-PORT would be amended to require funds to report their aggregate liquidity classifications publicly, as well as the frequency and amount of swing pricing adjustments:
- Funds would have to file each month’s report within 30 days after month-end, with the report becoming public 60 days after month end.
- This change would apply to all registrants that report on Form N-PORT, including open end funds other than money market funds, registered closed-end funds and ETFs organized as unit investment trusts.
Regarding board responsibilities, the proposed rule states that the fund’s board of directors, including a majority of directors who are not interested persons of the fund, must:
- Approve the fund’s swing pricing policies and procedures;
- Designate the fund’s swing pricing administrator. The administration of swing pricing must be reasonably segregated from portfolio management of the fund and may not include portfolio managers; and
- Review, no less frequently than annually, a written report prepared by the swing pricing administrator.
Impact of Proposed Rules
While swing pricing is commonly used in Europe, it poses significant challenges to the current market structure in the U.S. Currently, U.S. intermediaries can generally submit trades to the fund up until 4 p.m. ET. The “hard close” would cutoff trading much earlier to allow the fund to assess the impact of subscriptions/redemptions. In addition, funds will face significant up-front costs associated with implementing policies and procedures, as well as ongoing costs associated with monitoring and administering swing pricing. Boards and management will also be required to commit time and resources to these efforts.
Outside of swing pricing, the proposed change to liquidity requirements could adversely impact certain funds that currently hold significant “less liquid” investments or don’t meet the proposed “highly liquid” threshold. All of the proposed changes would require substantial updates to existing systems used by intermediaries, transfer agents and other parties processing these trades.
We believe it’s possible the above changes can be implemented by the industry, as shown in Europe, and the SEC has pointed out the potential long-term benefits. However, we also expect significant additional costs and challenges for the industry as a whole in changing the market structure to comply with these rules.
This proposal is currently in the comment period, which is open for 60 days from publication in the Federal Registrar.
Contact Kevin Kray at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.