SEC Rule 22e-4 has created a host of compliance headaches for fund managers, according to Confluence’s paper.
These include the development of a liquidity management strategy, monthly classification reviews and new reporting requirements.
According to the paper “Making the Right Adjustments: Managing Liquidity Risk for SEC Rule 22e-4 Compliance”, Rule 22e-4 is specifically aimed at quantifying liquidity risk in most mutual fund and ETF portfolios – particularly, the risk of a fund being unable to meet redemption requests without significant impact on its remaining investors.
The regulation requires funds to classify their positions as being in one of four buckets: Highly Liquid Investments; Moderately Liquid Investments; Less Liquid Investments; and Illiquid Investments.
Beyond categorizing their assets into the four buckets, asset managers subject to the rule are restricted from having more than 15% of the value of their portfolios in illiquid positions, and are also required to set a minimum level of assets held within the liquid buckets, called the “highly liquid investment minimum.”
“To thrive amid these burdens, investment managers must have a quick and simple way to assess the true liquidity of their portfolios,” Confluence said.
“This is made more complicated by the simple fact that not all assets or markets are created equal.”
“Compared to bonds, most public equities trade at a fairly high frequency – there is not a lot of time between ticks – and trades are executed electronically, meaning large volumes of information about each trade can be disseminated quickly to all participants,” according to Confluence.
“With bonds, trading is often sporadic, with large gaps in time and possibly significant price moves between ticks, and information flow is incomplete and/or slow.”
The paper argues that estimating the length of time it would take to sell one million shares of IBM into a “normal” market environment is a fairly simple exercise, however in markets that are less efficient (whether due to low liquidity or because they trade primarily over the counter, such as fixed income), this analysis can be much harder to perform.
According to the paper, brokers can also transact smaller volumes of bonds at a premium because they can take the tranche onto their own books without having a counterparty lined up, knowing they can dispose of it down the road as needed.
“Larger transactions, on the other hand, aren’t so simple to move, and thus are almost always done with a counterparty already in mind (i.e. a paired trade).”
Meanwhile, commissions are on a percentage basis and typically ratchet lower for larger trades, according to Confluence.
All of this points to the idea that in many cases, performing the extensive analysis required for fund managers to maintain Rule 22e-4 compliance in bond markets necessitates working with third parties that have not only the expertise, but also the technological capabilities.
The paper said that the ability to liquidate any asset depends on three things – how much of it is to be sold, how quickly it can be sold and the price that firms are willing (or required) to take – and then systemically tracking such exposure.
“Rule 22e-4 continues to represent a major step forward in this area, and by leveraging the compliance expertise and robust technology provided by partners like Confluence, funds can meet the moment with precision, efficiency and peace of mind,” the company said.
