The U.S. Securities and Exchange Commission’s new liquidity rules mark the most ambitious ever initiative against investor dilution — the unfair costs an investor may suffer when assets are not liquid enough to meet redemption requests.
The balance struck by the SEC overall marks a loosening of the initial proposal. Overly complex rules may need arbitrary assumptions to fill the gaps in the data; mild recommendations may not adequately protect against dilution. The agency maneuvered the minefield of writing effective rules in this area — quite a challenge given the elusive nature of liquidity risk and the lack of appropriate data in less transparent markets, notably bonds.
Most U.S. mutual funds and ETF fund complexes will need to comply with the new rules by December 2018. As in the proposal, funds will be required to classify their investments in time-to-liquidation buckets, but the number of buckets has been reduced to four (highly, moderately, less, illiquid) from seven (six plus the former “15% standard assets”). Importantly, classification by broad asset classes will be permitted, when no investment-specific distinctions are deemed necessary.
As in the proposal, two limits are required: A highly-liquid (self-set) minimum limit of three days and a 15% illiquid asset maximum, replacing the 15% standard asset limit. The latter, however, is now part of the overall liquidity classification and no longer a stand-alone rule. Hence, the classification of an asset as illiquid may change with market conditions; the earlier classification instead was based on asset type only.
The most important difference regards the consequences of a limit breach. Unlike the proposal, which would have mechanically barred purchases of less liquid assets, the final rule empowers the fund board with the authority to decide what actions (if any, as in the case of a momentary liquidity drought) are to be taken to bring the portfolio back into compliance. In line with most commenters, we applaud this change, which prevents the rule from triggering costly flights to liquidity and unwanted benchmark departures. In a liquidity drought, the best thing to do may be nothing.
The proposed liquidity classification would have required funds to simulate the full liquidation of any position, possibly over multiple “time buckets.” In contrast, the final rule requires the fund to map any position onto a single time bucket depending on the size that the fund would anticipate trading. The rule also allows for the adoption of “swing pricing,” a dilution mitigating mechanism that penalizes values in the event of exceptionally large net redemptions.
What is still missing
Similar to the proposal, the rule doesn’t target basic investor dilution effects caused by significant average bid/ask spreads, when not balanced by entrance/exit fees. In these cases, each and every investment or redemption produces a slow but steady erosion in the net asset value, and in the long run generating a net transfer of wealth from long-term investors to short-term investors.
Funds can already impose entrance/exit fees, but for competitive reasons few are likely to do so absent a rule that requires it. The rule does not promote the adoption of fees nor transparency on average bid/ask spreads. Dilution is a disease with two causes: occasional large-scale rushed redemptions and ordinary round-trip transaction costs. The SEC has addressed the former, but not the latter.