Client Alert: SEC proposes liquidity rules for mutual funds

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On September 22, 2015 the Securities and Exchange Commission (SEC) proposed new rules and amendments for open-end funds, which includes mutual funds. Proposed Rule 22e-4 would require funds to implement a liquidity risk management program that includes classification of positions and liquidity risk monitoring. With open-end funds, the choice of many individuals for savings, the SEC states that the liquidity of these funds has become pivotal, and thus a uniform standard for managing this risk is necessary. Additionally, the SEC revised Rule 22c-1 to allow for “swing pricing.”1 This allows the costs of redemptions to be passed on to the redeeming shareholders. The SEC believes that together these two changes will allow for greater stability of these investment vehicles.

Program Structure and Requirements

Rule 22e-4 will require funds to establish a written liquidity risk management program.2 The proposed rule defines liquidity risk as “the risk that a fund could not meet requests to redeem shares issued by the fund that are expected under normal conditions, or are reasonably foreseeable under stressed conditions, without materially affecting the fund’s net asset value.”3 The program will be responsible for classifying positions in assets and monitoring liquidity on an ongoing basis, periodic review of the overall risk, and management of the risk.4 The proposed rule also requires that the fund invest a portion of its assets that are convertible to cash within three business days. Board approval of the program, any material changes to it, and the three-day liquid asset minimum will be required.5  

Liquidity Classifications

The liquidity risk management program classifications of positions in assets will be done in terms of the number of days it takes to convert to cash, “at a price that does not materially affect the value of that asset immediately prior to sale.”6 The proposed rule creates six categories of liquidity:

  • 1 business day
  • 2-3 business days
  • 4-7 calendar days
  • 8-15 calendar days
  • 16-30 calendar days
  • More than 30 calendar days

The SEC states that these categories give funds greater flexibility versus a binary liquid or illiquid determination.7 In order to allow the classifications to be as precise as possible, the proposed rule allows for portions of a position to be classified in different categories.8 It is important to note that the proposed rule is requiring an assessment of the entire position’s liquidity, because the SEC believes this better captures the possibility of large scale redemptions.9  

The SEC provides some guidance about how to assess the liquidity of a position by citing what the staff considers to be “comprehensive liquidity analyses.”10 A liquidity risk management program should consider (with the acknowledgement that some factors are not relevant for certain assets): 11  

  • Existence of an active market for the asset
  • Frequency of trades or quotes
  • Volatility of trading prices
  • Bid-ask spreads
  • If the asset has a standardized and simple structure
  • For fixed income, maturity and date of issue
  • Restrictions on trading
  • Size of the fund’s position in the asset relative to the asset’s average daily trading volume, and the number of units of the asset outstanding
  • Relationship of the asset to another portfolio asset

Periodic Liquidity Classification Review

Once the classifications are made, a fund will be required to monitor the liquidity on an ongoing basis. The proposed rule requires that the above factors be considered as a part of this review, but otherwise does not prescribe any specific procedures.12 The proposed rule suggests tailoring the ongoing review to the portfolio’s holdings. If the classifications are likely to change because of market movements then there should be frequent analysis, whereas if the assets are stable then there can be less frequent analysis. The proposed rule does state that a fund should have policies and procedures in place which consider “market-wide developments, as well as security- and asset-class specific developments.”13  

Liquidity Risk Management

In order to manage its liquidity risk, the proposed rule will require a fund to invest a minimum percentage of its assets in three-day liquid assets14, restrict the fund from investing in less liquid assets if that would cause the fund to hold too many illiquid assets (based on the previous percentage), and “prohibiting a fund from acquiring any 15% standard asset if the fund would have invested more than 15% of its net assets in 15% standard assets.”15  

The liquidity risk management program will then take its holdings and classifications into consideration and assess the overall liquidity risk of the fund. The factors that should be considered include (again, not exhaustive):16  

  • Short-term and long-term cash flow projections (see proposal for more detail)
  • Fund’s investment strategy and portfolio liquidity
  • Use of borrowings and derivatives for investment purposes
  • Holdings of cash and cash equivalents, as well as borrowing arrangements and other funding sources

Similar to the periodic evaluation of assets, the proposed rule requires periodic review of the liquidity of the fund, but does not prescribe any specific requirements other than a review of the above factors.17 The proposal does suggest that “review procedures should include procedures for evaluating regulatory, market-wide, and fund-specific developments affecting each of the proposed rule 22e-4(b)(2)(iii) risk factors.”18 Finally, the proposed rule suggests that, in certain circumstances, the fund tie its overall liquidity risk assessment to its assessment of portfolio assets, in the event that one piece triggers the other.19  

Responsibilities and Record-keeping

The proposed rule requires a fund to designate the responsibilities of the liquidity risk management program to either the investment adviser or officers.20 The goal of the rules is to keep the liquidity risk management close to the investment function; however portfolio managers may not be solely responsible for it.21 A risk function, if it exists, may be appropriate for the management of the program. Additionally, the proposed rule discusses the use of third parties and sub-advisers and states that “the primary parties responsible for a fund’s liquidity risk management are the fund itself and any parties to whom the fund has designated responsibility for administering the fund’s liquidity risk management program.”22  

The proposed rule sets out a variety of recordkeeping requirements for funds, as well as changes in existing regulatory filings. The approval, subsequent material changes to, and any reports to the board must be maintained for five years.23 Additionally, how the three-day liquid asset minimum was determined must be documented and maintained.24 Finally, the proposed rule will make changes to previously established forms: N-1A, N-PORT, and N-CEN.25 Form N-1A would be amended to require a fund to disclose:

  • Number of days in which the fund will pay redemption proceeds to redeeming shareholders26  
  • The methods that the fund use to meet redemption requests27  
  • Any agreements related to lines of credit for the benefit of the fund 28

The goal of the proposed amendments is to create greater consistency across disclosures and increase the level of information available to the public regarding redemptions and redemption proceeds.

Next Steps

All of these rule changes have comment periods. The timing of these rules coming into effect will be tiered and depend on the effective date of the rule. Funds that are part of a fund complex with over $1 billion in net assets will have 18 months to comply with the rules (after the effective date).

1The rule discusses swing pricing in detail, see 80 FR 62326

280 FR 62287



580 FR 62323

680 FR 62292

780 FR 62293



1080 FR 62296

1180 FR 62297

1280 FR 62303

1380 FR 62303

14See 80 FR 62311 for a discussion of three-day liquid assets minimum and the factors associated with ascertaining the percentage.

1580 FR 62304. See 80 FR 62317 for the Commission’s discussion.

1680 FR 62305

1780 FR 62311



2080 FR 62324

2180 FR 62324


2380 FR 62325


2580 FR 62344. See 80 FR 62345 of the rule for N-PORT amendments. See 80 FR 62348 for N-CEN amendments




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