This week we return to our refresher series on liquidity risk rules around the world, and in particular, the rules in the United States. With the COVID-19 vaccine rollout well underway, and the end of crisis in sight, we thought we would look back at how the volatility last year caused by COVID impacted the US market and compliance with SEC liquidity rules.
Background
On 13th October 2016, the Securities and Exchange Commission (SEC) adopted legislative changes to the Investment Company Act of 1940, including:
- Fund Liquidity Risk Management Programs (new rule 22e-4)
- Investment Company Reporting Modernization (new and amended forms)
These reforms were designed to promote investor protection by reducing the risk that funds will be unable to meet their redemption obligations, elevating the overall quality of liquidity risk management across the fund industry, increasing transparency of funds’ liquidity risks and risk management practices, and mitigating potential dilution of non-transacting shareholders’ interests.
“The risk that a fund could not meet requests to redeem shares issued by the fund without significant dilution of remaining investors’ interests in the fund” – Rule 22e-4 definition of liquidity risk
The Liquidity Rule was originally scheduled to take effect on December 1, 2018 for “larger fund groups” and June 1, 2019 for “smaller fund groups”. On February 21, 2018, the SEC voted unanimously to extend the deadline for compliance with certain aspects of the Liquidity Rule by six months.
Fund Liquidity Risk Management Program
The US liquidity rule requires each fund to implement a written liquidity risk management program which includes:
- Assessment, management, and periodic review of the fund’s liquidity risk – funds are required to assess, manage, and periodically review their “liquidity risk” as defined above;
- Classification of the liquidity of each of the fund’s portfolio investment, as well as at-least-monthly reviews of the fund’s liquidity classifications – a fund must classify each of its portfolio investments into one of four liquidity categories – “highly liquid investments”, “moderately liquid investments”, “less liquid investments”, and “illiquid investments” based on the number of days within which the fund can reasonably expect an investment to be convertible to cash.
- Determining and periodically reviewing a highly liquid investment minimum – this requires funds to establish a minimum percentage of its net assets that the fund that must be invested in highly liquid investments. Additionally, the fund must implement policies and procedures for responding to a “shortfall” in the highly liquid investments;
- 15% Limit – Limiting the fund’s investment in illiquid investments that are assets to no more than 15% of the fund’s net assets; and
- Redemptions in Kind – For funds that engage in, or reserve the right to engage in, redemptions in kind, the establishment of policies and procedures regarding how they will engage in such redemptions in kind.
See our ATLAS liquidity risk training courses for in depth analysis of the US and EU liquidity risk requirements.
From a regulatory perspective, we’ll review some of the requirement firms have to meet during times of market stress.
Reflections from COVID-19
COVID-19 posed the most severe stress test for financial markets and institutions since the Financial Crisis of 2007-09. The resulting market volatility resulted in a number of potential issues facing fund managers when complying with the above SEC liquidity requirements.
Assessment, management, and periodic review of the fund’s liquidity risk
Each fund must assess, manage, and periodically review (with such review occurring no less frequently than annually) its liquidity risk, which must include consideration of a number of factors.
In circumstances such as what we witnessed last year with COVID-19, a fund may determine that it is appropriate for its liquidity risk to be reviewed more frequently than annually. This depends on the extent to which the required review factors vary based on market or sector-wide developments, as well as changes to the fund’s operations or other fund-specific circumstances.
Classification of the liquidity of each of the fund’s portfolio investment
A fund must consider the investment’s market depth in classifying the investment and review its portfolio investments’ classifications at least monthly. If changes in relevant market, trading, and investment-specific considerations are reasonably expected to materially affect one or more of its investments’ classifications, they must conduct this review more frequently.
The adverse market conditions we saw last year are an example of what can require a fund to reclassify an investment. Trading volumes may reduce and contract market depth. As the market depth reduces, the number of trading days may increase and warrant a reclassification.
Highly liquid investment minimum requirement
Funds are required to periodically review, no less frequently than annually, their highly liquid investment minimum. The SEC have noted that if a fund encounters extremely stressed market conditions, beyond those that were reasonably foreseeable during the period until the next review of the highly liquid investment minimum, that could increase its liquidity risk to unusual levels. In such circumstances, the fund should consider adjusting its highly liquid investment minimum at that time. Additionally, a fund should generally review its highly liquid investment minimum more frequently than annually if circumstances warrant.
Should a shortfall occur:
- It must be reported to the fund’s board of directors no later than its next regularly scheduled meeting with a brief explanation of the causes of the shortfall, the extent of the shortfall, and any actions taken in response;
- If the shortfall lasts more than 7 consecutive calendar day it must be reported to the board within one business day thereafter.
Limits on the fund’s investment in illiquid investments
The final rules codified the pre-existing 15% illiquid guideline established by the SEC. During a period of high market volatility, a fund should monitor closely whether there is a need to reclassify holdings as illiquid investments.
If a fund holds more than 15% of its net assets in illiquid investments, it must report such an occurrence to the fund’s board of directors within one business day of the occurrence. A private notification to the SEC on the form N-LIQUID (soon to be re-named as “Form N-RN”) must also be made within one business day.
How we can help!
Managers are continually under increased pressure from heightened regulatory scrutiny and ever-changing legislation. COVID-19 evidenced the increased workload investment managers are under during times of market stress, and in particular, the impact on market liquidity and meeting the SEC liquidity requirements. Our liquidity risk management solution can reduce this burden and increased workload, and assist firms with meeting these liquidity requirements in both times of market normality and stress. The Funds-Axis SEC Liquidity Risk Monitoring includes:
- Fund Liquidity Risk Assessment
- Liquidity Classification into the 4 SEC buckets of liquidity
– Automated Classification based on Asset Type
– Exception Process
– Market Depth Analysis - Stressed Liquidity Monitoring
- Derivatives – Liquid Cover Monitoring
- Ongoing Monitoring
– Monitoring the highly liquid investment minimum established for the fund
– Monitoring percentage in illiquid assets (restricted max 15% NAV)
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