January 14, 2016
January 13, 2016
Mr. Brent J. Fields
Secretary
U.S. Securities and Exchange Commission
100 F Street, NE Washington, DC 20549
Mr. Fields:
As a financial professional and student of the markets, I wanted to make two points concerning the proposed liquidity risk management program, but I should first note that these views are my own and not necessarily the views of any particular firm or anyone else:
This proposal is fundamentally flawed, and since the SEC does not typically propose such flawed regulations, one of two factors (and hopefully not both) must be at work here: this proposal is either (i) a manifestation of a complete lack of understanding of liquidity in the markets or (ii) a thinly veiled attempt to satisfy the uninformed demands of the Financial Stability Oversight Counsel (FSOC)
The SEC lacks the statutory authority to issue these proposed rules.
Allow me to explain both points in turn:
The Proposal is Fundamentally Flawed Part 1: It doesnt work for fixed income
The idea of categorizing fund positions into specific buckets based on the perceived ability to convert them to cash without materially impacting the price is a sound one -- if it were universally possible. It's not.
Perhaps in the more liquid areas of equity markets, a fund could determine the relative liquidity of its positions based on historical volume. But equity markets are easy. There is a myriad of historical data that one can draw from to make the liquidity estimation. Further, equities are standardized -- an issuer typically has only one common share class outstanding (maybe a preferred). Here, in this simple world, we can mathematically determine days to cash. Let's do an example together.
Say my fund holds 250,000 shares of Company XYZ (ticker: XYZ). Now let's say XYZ has posted an average daily volume of 40,000 shares over the past three months. With this information I can bucket my position, but I still need to make an assumption or two. Let's say I assume that I can trade 20% of the volume without "materially affecting the market price." Now, we can do maths: 20% of 40,000 = 8,000 shares I can trade in a day. 250,000 / 8,000 = 32 days add 3 for settlement: 35 35 days to sell out my whole position. I can even bucket it:
0 shares in 1 business day
the next 8,000 in the 2-3 business day bucket
the next 24,000 in the 4-7 calendar day bucket
the next 64,000 in the 8-15 calendar day bucket
the next 120,000 in the 16-30 calendar day bucket and
the last 34,000 in the greater than 30 calendar day bucket.
Yay What fun Now lets try it for Company XYZ debt. Now, before we begin, debt is much more complicated. Each company could have dozens of individual debt CUSIPs out there, and buyers looking for Company XYZ debt may not be interested in my particular CUSIP. Further, theres no exchange, so data is much harder to come by. Lets see what happens:
Company XYZ is a high yield issuer, and I own $5.3 million of its 8.0% notes maturing in 2023 (CUSIP: XYZBND2023). Now lets say XYZBND2023 trades with an average daily volume of . . . um . . . yeah, okay. Wait, I can do this. The problem is I dont have a trading market. I can get around this by looking at TRACE data okay, based on that, I can see that the 2028 maturities (with a 6% coupon) traded in a $20 million lump three months ago. So that means every three months I can trade $20 million or not.
Well, we can still do this. Let me call a broker: Hey, Gordon, can I sell this XYZ 2023 paper? I can?? Great How much? Oh, you need to ask around. Ill hold. Oh, and also, tell me how many days it will take to trade it all and settle it based on these 6 categories click Gordon Gordon?
Oh well, I dont need him anyway. What Ill actually do is look at MY own trading experience in the high yield market and, effectively, make an educated guess. I know I sold some HY last week in the 2020-2025 maturity range, and I know that Company XYZ has posted good numbers in the past quarters, so its probably a good shot that I can get this $5.3 million sold in, say, a week, if not shorter after all, I was able to move $15 million in high similar paper last week. So, lets drop it all into the 4-7 calendar day bucket. Great Now I need to do this for the remaining 500 CUSIPS in my portfolio.
What Ive tried to illustrate with this (admittedly farcical) example, is that this bucketing wont work for fixed income with any accuracy. There are too many CUSIPS and too little data to possible bucket any position with any certainty beyond an educated guess. As a result, Im not going to make any portfolio construction or liquidity decisions based on my categorization of XYZBND2023 into the 4-7 day category. Its simply not reliable enough.
So, what can we do?
The Proposal is Fundamentally Flawed Part 2: It asks the wrong question.
The proposal asks the question: how long will it take to sell ALL of your position? If we are really concerned about a funds ability to pay redemptions, the question we need to ask is how much money can I raise in time to make good on my promise of daily liquidity at NAV?
Lets look at our buckets above and see what we learned. On the equity example, it sure seems like I learned something about my position. I learned it would take over 30 days to sell the whole thing, and I could sell bits and pieces of it along the way. Good, except I already knew that. I didnt need the bucketing exercise to tell me that it takes a good deal of time to liquidate a position that represents 30+ days of the average daily volume. I just did a back of the napkin estimate that it would take carry the one probably around 30+ days. The laddering information weve just painstakingly developed really adds nothing to the discourse.
This is because my XYZ position would be just one of many positions in my fund, and in equity land, Ill be able to access that first bit of liquidity (the 8,000 shares in the 2-3 business day bucket above) for a number of positions. What would be interesting is if I could add up all of those 2-3 business day buckets to see what % of my portfolio is available for redemptions.
Lets just assume I have a portfolio right here and, like those cooking shows where they just pull out the cooked version of the prepared food that should have taken 2 hours to gently rise, lets assume Ive done some analysis to this effect. Lets go back to the real question: how much of my portfolio can I sell to raise cash to make good on redemptions?
Analyzing my portfolio, I can see that I have 3% in cash, 97% in equities over 52 positions averaging around 5 times the daily volume of each issuer. That means I can probably sell (assuming again, less than 20% participation in market volume to minimize impact) an additional 4% on a single day (20% of 1/5 of the daily volume). Now, I know I have a 7% slice of my portfolio I can use to meet redemptions. Since my largest week of redemptions ever was only 3% of my portfolio, Im feeling pretty good.
Whats also neat is that since I can base my decisions on the whole portfolio, this works for fixed income too
Turning to my balanced fund, I can see that I have 3% in cash, 47% in equities over the same 52 positions in the same relative sizes (i.e. 5X average daily volume). Without repeating the maths we did above, I know I have an additional 2% I can convert to cash in 3 days. With respect to the remaining 50%, I can use my aggregate market experience to make a blanket guess that I can sell SOME of this corporate debt to someone within 3 days. Given the current markets, recent trading activity, the quality of my issuers, I could probably sell 10% within 3 days. What makes this easier is that I dont need to call Gordon to find out if theres a buyer for my XYZD2023s. I may be wrong about the XYZD2023s, but Ive got 100 positions – probably close to the mark in the aggregate. Now, I know I have a 10% slice of my portfolio I can use to meet redemptions. Im feeling pretty good here too
Notice how I didnt need to do any bucketing to come up with a rudimentary liquidity risk analysis and conclusion looking at the portfolio as a whole. The fact that I can sell 64,000 shares of XYZ in 8-15 days didnt come up that data is pointless – unless.
The Proposal is Fundamentally Flawed Part 3: It is answering a different question
As a liquidity risk management tool, the categorizations are useless, but as a gesture to FSOC that the SEC is serious about market liquidity, it may mean something. In fact, these categories are ready-made for computer consumption – I can almost hear DERA sharpening their utensils waiting to crunch these categories into some super-awesome findings. But I hope theyre not too excited.
This information is way to subjective to be of any value to data crunchers – even in the easy world of equities. In the example above, I just used the 20% market impact as a placeholder for without material impact to price, but I wouldnt use that in real life. In real life, Id use a lower number based on some market intelligence – a number that I could change for each analysis. In fact, everyone submitting this data will likely use a different number to model market impact.
In the fixed income side, forget it. There are way too many qualitative factors at play in estimating fixed income liquidity.
That said, if this proposal is really about showing FSOC how smartly the SEC can collect data, then just say so. I can run these numbers for you – but dont make me run my fund on it. None of this will be helpful Ive already given liquidity risk quite a bit of thought.
The SEC Lacks the Authority to Issue these Proposed Rules
Oh yeah, the SEC cant do this. Since we live in a constitutional democracy, laws have to be passed by Congress, and executive agencies can only adopt rules when they are enabled to do so by legislation (an oversimplification, but true). Theres no enabling legislation here.
From the release: The Commission is proposing new rule 22e-4 under the authority set forth in sections 22(c), 22(e) and 38(a) of the Investment Company Act. Lets read those together:
Section 22(c):
The Commission may make rules and regulations applicable to registered investment companies and to principal underwriters of, and dealers in, the redeemable securities of any registered investment company, whether or not members of any securities association, looking good so far to the same extent, covering the same subject matter, and for the accomplishment of the same ends as are prescribed in subsection (a) of this section
I hate it when they do that. Lets look at Section 22(a) now. Its long, so Im quoting in relevant part – The ends prescribed in subsection (a) are:
(1) a method or methods for computing the minimum price at which a member thereof may purchase from any investment company any redeemable security issued by such company and the maximum price at which a member may sell to such company any redeemable security issued by it or which he may receive for such security upon redemption, so that the price in each case will bear such relation to the current net asset value of such security computed as of such time as the rules may prescribe and
(2) a minimum period of time which must elapse after the sale or issue of such security before any resale to such company by a member or its redemption upon surrender by a member in each case for the purpose of eliminating or reducing so far as reasonably practicable any dilution of the value of other outstanding securities of such company or any other result of such purchase, redemption, or sale which is unfair to holders of such other outstanding securities and said rules may prohibit the members of the association from purchasing, selling, or surrendering for redemption any such redeemable securities in contravention of said rules.
Eeek. So, it looks like the SEC can pass rules for the accomplishment of computation of NAV and the timing of NAV calculations. Oh, and requiring liquidity risk management programs. Nah, just kidding. Thats not there. Sooo lets move on to the next one:
Section 22(e):
No registered investment company shall suspend the right of redemption, or postpone the date of payment or satisfaction upon redemption of any redeemable security in accordance with its terms for more than seven days after the tender of such security to the company or its agent designated for that purpose for redemption, except—
(1) for any period (A) during which the New York Stock Exchange is closed other than customary week-end and holiday closings or (B) during which trading on the New York Stock Exchange is restricted
(2) for any period during which an emergency exists as a result of which (A) disposal by the company of securities owned by it is not reasonably practicable or (B) it is not reasonably practicable for such company fairly to determine the value of its net assets or
(3) for such other periods as the Commission may by order permit for the protection of security holders of the company.
The Commission shall by rules and regulations OOO I was getting worried there wasnt even an enabling power in this section determine the conditions under which (i) trading shall be deemed to be restricted and (ii) an emergency shall be deemed to exist within the meaning of this subsection.
Drat. This one limits the SECs rulemaking to suspension of redemptions. Liquidity risk management isnt that. Fortunately, weve saved the best for last:
Section 38(a):
Subject to the provisions of chapter 15 of title 44 and regulations prescribed under the authority thereof, the rules and regulations of the Commission under this subchapter, and amendments thereof, shall be effective upon publication in the manner which the Commission shall prescribe, or upon such later date as may be provided in such rules and regulations.
Wait. I dont see ANY rulemaking authority there. Instead, it just says that the rules the SEC does pass, presumably pursuant to some rulemaking authority, can be effective as the SEC sees fit. Oh, and that the SEC can require funds to adopt liquidity risk management program. Ha Kidding again.
So, Im not seeing it. There doesnt seem to be any statutory authority here. Of course, the SEC did adopt 38a-1 under Section 38(a), but everyone wanted 38a-1 – it was championed by the ICI. Just because no one challenged it doesnt mean theres a new statutory rulemaking authority out there.
Conclusion
As I noted above, this proposal is a deeply flawed attempt at a liquidity risk management program requirement. If the SEC is trying to satisfy the whims of the banking regulators, lets say so, figure out what you need, and move on. Otherwise, I recommend taking this back to the store – it doesnt work.
Oh, and the SEC cant require these programs anyway.
Justin Banks
Concerned Citizen and Financial Professional