Riding the wave and not getting wiped out[1] by liquidity risk (and the SEC)

It is somewhere between the SEC's proposal to require open-end funds and ETFs to establish liquidity risk management programs and where industry responses to the Proposal ended up, that the SEC will land when it issues final rules later this year or, most likely, in 2017 (or perhaps later given the SEC's recent track record).

The ostensible purpose of the Proposal which was first published in October last year is to ensure funds adequately measure and manage liquidity risk in order to ensure that non-redeeming shareholders, particularly during periods of market or asset-level stress, do not bear a disproportionate cost from redemption activities. These costs may be especially heightened in asset "fire sale" scenarios.

In response to the Proposal, comment letters flooded into the SEC from across the financial industry (including our own), during the 90-day comment period which ended in January. Having pored over hundreds of pages of comment letters, we recently published a summary of comment letters that covered some of the many controversial parts of the Proposal.

While many commenters rejected the most prescriptive aspects of the Proposal, there was broad support for the value of formal liquidity risk management programs. One can therefore expect, at the minimum, the final rulemaking will require funds to establish formal liquidity risk management programs. I will add that a key aspect of that Proposal, and one that our customers have sought our insight on, relates to the classification of portfolio assets by liquidity.

Right now is an opportune time for fund managers to review their liquidity risk management program as SEC's expectations for liquidity risk management and future final liquidity risk management rules appear to converge.

In advance of final liquidity risk rules, we note a pattern of increasing scrutiny and heightened expectations by the SEC toward liquidity risk management. There is, of course, decades-old existing Commission guidance providing that funds should "maintain a level of portfolio liquidity that is appropriate under the circumstance." This "circumstance" for funds appears to be evolving as the SEC has prioritized liquidity risk management in the past couple of years. The SEC Office of Compliance, Inspections, and Examinations ("OCIE") recently announced "liquidity controls" as an area of focus for their 2016 examinations, particularly for fixed income funds (registered investment companies, ETFs, and private funds alike) and broker-dealers. To quote OCIE staff, "examinations [in 2016 of both buyside and sellside fixed income market participants] will include a review of various controls in these firms' expanded [fixed income] business areas, such as controls over [among other things] liquidity management."

Moreover, during our recent webcast in partnership with TABB Group we noted the SEC Proposal found that funds with formal liquidity risk management programs, including liquidity scoring, were able to manage higher than normal fund redemptions without significantly altering the risk profile of the fund or materially affecting a fund's performance. In the absence of an industry standard for measuring liquidity (or regulations), formal liquidity risk management programs, including a systematic process to classify assets by relative liquidity, may therefore improve a fund's ability to meet redemption obligations without non-redeeming investors experiencing wipeout having to bear the costs of redemptions.

[1] In surfing parlance, to be "wiped out" means falling off, or being knocked off, a surfboard when riding a wave.

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This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.