The U.S. Securities and Exchange Commission’s liquidity rule is designed to protect investors from incurring significant transaction costs when the assets in their mutual funds are not liquid enough to sustain funds’ redemption policies. But, in October, the Treasury Department threw a monkey wrench into the works: While supporting the adoption of liquidity risk management programs, it criticized the SEC’s proposed liquidity buckets, which require funds to categorize their assets into four groups based on the anticipated time needed to liquidate. Also, Treasury generally prefers a principles-based approach over any highly prescriptive form of liquidity regulation, such as the SEC’s.
Treasury called for a postponement and rethink of the regulation, known as Rule 22e-4, which is set to go into effect in December 2018. As institutional investors await clarity on the future of the regulation, MSCI seeks to help them establish prudent liquidity risk management practices. In 2013, MSCI launched a liquidity risk measurement framework called LiquidityMetrics, which enables institutional investors to assess the liquidity of portfolio across asset classes. Earlier this year, the tool was enhanced with the addition of fixed-income trade and quote data from IHS Markit.
During a recent webinar, Carlo Acerbi, managing director and head of MSCI’s risk management team, and Dan Huscher, executive director of fixed income pricing development at IHS Markit discussed the latest developments in the SEC rule and how investors can prepare for its implementation. The following excerpts are taken from the question and answer portion of the webinar.
What are your thoughts on the recently issued U.S. Treasury report?
Dan Huscher: Treasury supported liquidity risk management as a whole, including the 15% limit on illiquid assets. However, it rejected a highly prescriptive regulatory approach, such as bucketing, in favor of a more principles-based approach. At IHS Markit, we agree with the industry view that managing liquidity risk is a best practice and in line with asset managers’ responsibility to manage a portfolio that satisfies their obligations to meet redemptions. And many of them do so. Earlier this year, the International Organization of Securities Commissions (IOSCO) published a report indicating that over 90% of bond buyers consider liquidity when making an investment decision.
Carlo Acerbi: At MSCI we believe, as many do, that the SEC defined the right target but didn’t find the right solution. Investor dilution and fair treatment of shareholders has never been targeted by regulators prior to this rule. As a result, we have seen a lot of progress made on liquidity risk, largely due to this rule. However, time to liquidation, and bucketing in particular, have been highly criticized. The problem is managing transaction costs, while the solution is a time-risk measure. It’s not how long it takes to liquidate a position that matters but rather how much it costs. In addition, time to liquidation is a very noisy type of risk measure. It’s very hard to compare across asset classes, and in many cases it requires strong assumptions when data is limited.
Regardless of what the rule finally states, it should accommodate differences across fund strategies and asset classes. The principles-based recommendations would allow different types of funds to adopt different limits and risk measuring tools.
Are firms prepared to meet the SEC rule by December 2018?
CA: We generally see that most firms are ready to face the challenge in time for the December 2018 compliance deadline. While the debate about possible improvements to rules and methods goes on, it is clear to the entire industry that some form of protection against the risk of severe liquidity shortage events should be in place sooner rather than later. In addition, the current version of the rule remains the benchmark for any further exploration or advancement in regulation.
DH: In our conversations with clients, we have observed that many firms are still studying the regulation and taking a thoughtful approach about how to address it. Even though certain details of the rule are uncertain, it has started a larger conversation about liquidity risk management that will be ongoing.
What options does the SEC have?
CA: It is important for mutual funds to prepare for the possible scenarios ahead of us. So what are the possible scenarios?
- The SEC doesn’t delay the rule, nothing changes and the December 2018 deadline remains.
- The rule is delayed but nothing changes, which is very unlikely.
- The SEC delays the rule and issues a new but still very prescriptive rule. This is a likely possibility, in my opinion.
- The rule is delayed and the SEC follows the Treasury report recommendation on mandating a principles-based approach, possibly in line with IOSCO principles.
Regardless of which scenario is adopted, waiting is not an option. Funds will still have to set up liquidity risk management programs and will need good tools backed by good data. Doing nothing is not an option anymore, and there is no point waiting, even if the rule should get delayed.
DH: I agree that waiting is not the best option. Liquidity risk management is supported by regulators in general, so it’s better to start thinking about it now than before it gets too late.
Will the SEC’s approach to liquidity management be adopted globally?
CA: The SEC liquidity rule represents a pioneering experiment toward a more structured and more precisely targeted regulation. The international debate triggered by the rule created a pendulum, oscillating between highly prescriptive regulation and softer, principles-based guidelines. The tremendous progress generated by the debate has created more awareness of the objectives (mitigating dilution) as well as of the intrinsic limitations (data availability, market transparency) of any enforceable regulation. As a result, we believe that regulators worldwide will converge toward the best practices that are emerging from the debate. The first example is the [principles-based] initiative of the Monetary Authority of Singapore, which has launched a consultation for a “Liquidity Risk Management Framework” in close agreement with the IOSCO guidelines.
DH: Given the recent IOSCO consultations,1 we believe there may be an internationalization of liquidity risk-related reforms. Once the final reports are published, we expect many national regulators that are members of IOSCO to implement regulations reflecting the standards and best practices endorsed by IOSCO.
Liquidity risk management: What’s next? (recorded webinar; client access only)
LiquidityMetrics overview (client access only)
LiquidityMetrics methodology (client access only)
1 “Consultation on CIS Liquidity Risk Management Recommendations” and "Open-ended Fund Liquidity and Risk Management – Good Practices and Issues for Consideration."