SEC Rule 22e-4: Meeting Compliance Standards and Managing Liquidity Risk

Date: April 7, 2022
As we’ve learned from recent financial crises, unpredictable circumstances can cause the liquidity of traded financial instruments to nearly disappear. That lack of liquidity, coupled with the highly interconnected nature of modern derivatives, can lead to massive fund redemptions, naturally increasing the pressure to sell into thin markets, causing a rapidly spiraling cycle of collapsing prices.

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.

Rule 22e-4 is specifically aimed at quantifying liquidity risk in most mutual fund and ETF portfolios. The regulation requires funds to classify their positions as being in one of four buckets: highly liquid investments, moderately liquid investments, less liquid investments and illiquid investments1.

Just like the Liquidity Stress Testing framework authored by the EU’s ESMA, Rule 22e-4 has created a number of potential compliance problems for fund managers. To thrive amid these requirements, investment managers must have a quick and simple way to assess the true liquidity of their portfolios.

This is made more complicated by the simple fact that not all assets or markets are created equal. Compared to bond trading, which is often sporadic, for example, most public equities trade at a fairly high frequency. 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 the expertise to navigate these new regulatory waters.

22e-4-Blog-Quote-250x250Confluence helps portfolio managers address these challenges with a robust liquidity management platform that provides as much insight into bond holdings as it does for equities. The module leverages our combined quantitative and qualitative approaches to create an accurate representation of how the bond market handles liquidity.

Through Revolution, managers can 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 flow distribution can also be performed, as well as simulations of liquidation strategies.

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, 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.

We expect the rules issued across different regulatory frameworks to take some time to get aligned. 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 compliance expertise and robust technology, funds can meet the moment with precision, efficiency and peace of mind.


Disclaimer: The information contained in this communication is for informational purposes only. Confluence/StatPro is not providing, legal, financial, accounting, compliance or other similar services or advice through this communication. Recipients of this communication are responsible for understanding the regulatory and legal requirements applicable to their business.

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