The complex nature of modern derivatives, combined with the increasingly global and interconnected nature of the financial ecosystem, has led regulators to place a higher burden on fund managers to know their liquidity position. 

The goal of the regulation

Since funds have long moved beyond just trading well-known and largely plain holdings into dealing with obscure bonds or OTC derivatives, regulators want to know that fund managers are properly monitoring and managing the liquidity of those securities as a way to mitigate the risk of another Financial Crisis-style meltdown.

One such new statute is the SEC’s rule 22e-4, with reporting requirements starting June 1, 2019 for large funds and December 1, 2019 for smaller funds.

The rule requires funds to classify their liquidity positions in one of the four buckets:

1. Highly liquid investments: These are classified as investments expected to be convertible to cash in three days under current market conditions without significantly impacting their market value.
2. Moderately liquid investments: Similar to the above except taking more than three days, but less than seven to be convertible to cash.
3. Less liquid investments: Any investment expected to settle in more than seven calendar days in current market conditions.
4. Illiquid investments: Any investment that can’t reasonably be expected to be sold or disposed of in current market conditions, within seven calendar days, without significantly impacting the market value of the investment.

Quantifying liquidity risk

Beyond categorizing their assets into these four buckets, asset managers covered by the rules will also be restricted from having more than 15% of the value of their portfolios in illiquid positions (as defined above) and they are required to set a minimum level of assets held within the liquid buckets.

Whether the new rules provide broad benefits to markets and the economy as a whole is still to be determined. What we do know is that they will become another compliance burden for fund managers. In fact, the “bucketing” aspect is something many managers don’t do and will need help from technology and outside vendors to comply with. In a comment letter to the SEC last November, the Investment Company Institute said the rule is “complex, and has no real antecedent in industry practice or regulation”. In a poll conducted by the ICI, 91 percent of respondents are considering working with vendors and most will seek help with bucketing in particular.

What does this mean?

This means managers will need to partner with a firm that has not only the expertise, but the technological capabilities, to help navigate these new regulatory waters. This is especially true for those trading in markets that are less efficient, either because of low liquidity or because they trade primarily over the counter, such as bonds.

Satisfying requirements

That’s why we’ve created an adjusted liquidity score that incorporates both the qualitative aspects of the real-world trading environment with the quantitative characteristics of a particular bond. That adjusted liquidity score is 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 number of days it will take to liquidate each position.

Having tools like this will become invaluable to your firm as the SEC’s new “bucketing” rules come into effect. Not only will it help with compliance, but the insight provided will allow you to gain a competitive advantage over other market participants still struggling with the added weight of operating in this new landscape.

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