Making the RightAdjustments: Managing LiquidityRisk for SEC Rule 22e-4Compliance

Introduction

One of the many lessons learned from recent financial crises is that under unpredictable circumstances, the liquidity of traded financial instruments can nearly vanish.

As we saw in those instances, this lack of liquidity coupled with the highly interconnected nature of modern derivatives, can lead to massive fund redemptions, which naturally increases the pressure to sell into thin markets. The result? A rapidly spiralling cycle of collapsing prices.

As any veteran trader knows, quickly selling a large position can impact its price – the more of something one must sell and the less interest there is in it, the more the price will have to move in order to trade (“slippage” in industry parlance). But the relationship between volume and cost is by no means linear, so tripling the number of shares on offer does not triple the inevitable price hit that will follow.

For certain securities, there is always some liquidity. Traders can always get out of these positions – it’s just a question of how long they’re willing to wait and how much it will cost.

Informed by these lessons, securities regulators worldwide have developed rules that require fund managers to both measure and report on the actual liquidity of the instruments in their portfolios and the length of time it might take to sell them. In the U.S, this has taken the form of SEC Rule 22e-4, which requires that a minimum percentage of the investments comprising a fund’s portfolio be highly liquid. Compliance means analyzing large amounts of data and reporting on them in a timely manner, placing additional pressure on already strained operations budgets.

This article will explore the specifics of Rule 22e-4, the challenges it poses for fund managers today, and how these can be addressed through data management and robust analytics.

Navigate these new regulatory waters

Quantity to Comply

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 – Any investment reasonably expected to be convertible to cash under current market conditions within three business days, without significantly impacting the market value of the investment.
• Moderately Liquid Investments – Any investment reasonably expected to be convertible to cash under current market conditions in more than three but fewer than seven calendar days, without significantly impacting the market value of the investment.
• Less Liquid Investments – Any investment reasonably expected to be able to be sold or disposed of under current market conditions in seven calendar days or less, without impacting the market value of the investment, but to settle in more than seven calendar days.
• Illiquid Investments – Any investment that can’t reasonably be expected to be able to be sold or disposed of under current market conditions within seven calendar days, without significantly impacting the market value of the investment.

Moreover, 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.”

Just like the Liquidity Stress Testing framework authored by ESMA, Rule 22e-4 has created a raft of compliance headaches for fund managers. These include the development of a liquidity management strategy, monthly classification reviews (incorporating position size, market depth, trading and other investment-specific developments and considerations) and new reporting requirements.

This is made more complicated by the simple fact that not all assets or markets are created equal. 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 because share float is a known variable – the more a manager is trying to sell, the more it will probably cost in terms of price and/or time. 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. Markets for different bonds are highly variable,
even across multiple tranches of the same issue, and information is very sparse.

In fact, such markets can distort the obvious correlations between size, time and price slippage. The typical curves that represent these factors essentially reverse when dealing with fixed income positions – higher volumes of bonds result in lower price impacts, while small volumes have larger ones, at least for small issuances.

This inverse relationship to equity markets is a product of some of the unique characteristics of bond markets. 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. 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.

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. 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, to navigate these new regulatory waters.

Satisfy Requirements Through an Adjusted Liquidity Score

Confluence helps portfolio managers address these challenges by providing a robust liquidity management platform that provides as much insight into bond holdings as it does for equities.

Our module leverages our combined quantitative and qualitative approaches to create an accurate representation of how the bond market handles liquidity. We started by algorithmically determining each bond’s relative liquidity score from a wide range of market variables, including amount outstanding, bond age and size of the bond’s specific market. Next, we surveyed active traders in different areas of the fixed income markets – governments, high yield, corporates, structured debt and more – as well as in different currencies and issuer industries to create clusters with distinct liquidity profiles. We then asked these traders to quantify liquidity for representative bonds from each cluster, giving us a meaningful calibration from each bond’s relative liquidity score to the time and cost to liquidate it.

The result is an adjusted liquidity score that incorporates both the qualitative aspects of the real-world trading environment and the quantitative characteristics of the bond in question, which are then mapped to a relationship between volume and pricing impact to produce an estimate of the time required to liquidate. In other words, we produce a trade-calibrated estimation of the number of days it will take to convert each position into cash.

Through our Revolution platform, which many portfolio managers already rely on for tracking performance, attribution, risk and compliance, managers can easily satisfy the requirements for measuring, analyzing and reporting liquidity risks in stocks, bonds, funds and derivatives from within the same tool. In addition to serving as a solution for Rule 22e-4, the platform can calculate the time to liquidate all positions in each of the buckets across different regulatory regimes, worldwide. Analysis of the investors and their cash flows distribution can also be performed, as well as simulations of liquidation strategies.

Looking ahead: Progress toward robust liquidity and regulatory alignment

In terms of ensuring that liquidity remains accessible under any market conditions, both Rule 22e-4 in the U.S. and the Liquidity Stress Testing framework in the EU represent steps in the right direction.

While there are some differences (the EU calls for seven buckets instead of four, for example), in all cases fund managers are asked to subjectively account for relevant market, trading and investment-specific conditions when classifying and reporting on their assets and the buckets in which they reside.

Based on our decades of experience, we expect the rules issued across different regulatory frameworks to take some time to get aligned. And as always, the devil is in the details. No two funds will have the same portfolio makeup, so what’s relevant for one manager may simply be market noise for others.

The same goes for market depth requirements that call for managers to assess the degree to which selling a given proportion of the position would impact the liquidity characteristics of the remaining holding, as well as the potential impact to investors. At Confluence, we believe the goal of these regulations is to measure the likelihood a fund will get caught, as Warren Buffett famously said, swimming without a bathing suit when the tide goes out.

Clearly, 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