The Securities and Exchange Commission (SEC) has proposed a package of reforms designed to enhance effective liquidity risk management by open-end funds, such as exchange-traded funds and mutual funds.
The SEC’s liquidity reforms are designed to improve investor outcomes in products such as ETFs.
“Promoting stronger liquidity risk management is essential to protecting the interests of the millions of Americans who invest in mutual funds and exchange-traded funds (ETFs),” said SEC Chair Mary Jo White. “These significant reforms would require funds to better manage their liquidity risks, give them new tools to meet that requirement, and enhance the Commission’s oversight.”
The reforms come in response to widespread industry concerns that lower trading volumes, particularly in fixed income securities, could lead to a liquidity event as US interest rates rise and investors rotate out of bonds. This selling pressure could lead to dramatic price falls and unattractive exit values for investors making redemptions from funds.
According to the SEC, under the proposed reforms, mutual funds and ETFs would be required to implement liquidity risk management programs and enhance disclosure regarding fund liquidity and redemption practices. The proposal is designed to better ensure investors can redeem their shares and receive their assets in a timely manner.
Liquidity in the bond market has fallen since the global financial crisis as increased bond issuance has combined with lower trading volumes (the result of regulations impeding banks’ from holding bonds on their balance sheets). Historically banks have provided a market making service to investors, acting as a willing buyer and seller in the market, but the higher capital requirements put on banks by regulations such as Dodd-Frank have made this a much more costly endeavour and forced participants out of the practice.
The SEC’s new reforms ask that a fund’s liquidity risk management program contain multiple elements, including: classification of the liquidity of fund portfolio assets based on the amount of time an asset would be able to be converted to cash without a market impact; assessment, periodic review and management of a fund’s liquidity risk; establishment of a fund’s three-day liquid asset minimum; and board approval and review. In addition, the proposal would codify the 15 percent limit on illiquid assets included in current Commission guidelines.
Exchange-traded funds have provided an important secondary layer of liquidity in bond markets since 2008. iShares estimates that trading volumes in ETFs have risen over 700% over the period. One of the key benefits of ETFs is their ability to organise relatively illiquid securities into a standardised basket that trades like a stock on an intra-day basis. With buyers and sellers in the market, shares in the ETF can be exchanged with no trading in the underlying securities required. While the this structure facilitates liquidity, in the event of large redemptions and an absence of ETF buyers in the secondary market, market makers will need to buy ETF shares and sell the underlying securities in illiquid markets at what could be a considerable discount to fair value. With this in mind, it is of course of the utmost importance that investors consider the liquidity of the underlying holdings of an ETF.