Keynote Address: Regulating with our Eyes on the Future
Sept. 24, 2020
Investment Company Institute 2020 Virtual Securities Law Developments Conference
Good morning and thank you Dorothy Donohue for inviting me to speak with you today. I appreciate the opportunity to talk about how the Division is working to modernize the fund industry’s regulatory framework in a way that seeks to anticipate, or at least accommodate, future trends and developments.
Before I start, let me remind you that I am speaking today only for myself and not for the Commission, the Commissioners or the staff.
Now, let’s turn to the theme of my remarks today, Regulating with our Eyes on the Future. Last month, the Investment Company Act turned 80 years old. At the time of the Act’s adoption, the registered fund industry consisted of only 105 funds with $1 billion in assets. Now over 14,000 SEC-registered funds hold nearly $25 trillion in assets, including through two important fund structures that did not exist in 1940 - money market funds and exchange-traded funds (ETFs). In terms of assets, that is an annualized growth rate of 13%.
As the industry grew, it faced many changes and challenges, including the latest market disruption in March and April due to the COVID-19 global pandemic. That market disruption tested our capital markets and the asset management industry in new ways. Moreover, it was among the first true tests of the post-2008 reforms. Each significant event impacting the industry – the 2020 pandemic, the events of 2008, and others – has resulted in fundamental changes to the industry and the regulatory landscape. It is understandable that domestic and foreign regulators inevitably turn to the task of parsing through the events to better understand what happened, and to consider potential regulatory changes in response.
This is an appropriate exercise, for sure, but I also believe that it is critically important to avoid regulating the past. Regulatory updates that respond solely to the last event risk creating a regime that does not take into account new changes, risks and innovations that are occurring around us or have not yet occurred.
For these reasons, the Division’s philosophy in recommending changes to the asset management regulatory framework has been to seek forward-looking solutions. We do not recommend that the Commission consider reforms just to address issues that have already happened. Instead we focus on regulations that will balance flexibility to accommodate future changes with promoting resiliency to future crises. You can see that in our many initiatives in areas such as exchange-traded funds, derivatives and valuation.
To illustrate the need for forward-looking regulation, I would like to walk you through two case studies: money market funds and exchange-traded funds. Then, I would like to touch on two other related areas—pathways to aid effective regulation for a resilient industry and the role of staff statements in our regulatory regime.
Money Market Funds
Let’s start with money market funds. The Commission granted orders that permitted the first money market funds starting in 1978. As additional funds requested and received similar relief, the Commission codified the money market fund structure in 1983 by adopting rule 2a‑7. Over the next 30 years, the Commission amended the rule many times. The latest amendments in 2010 and 2014 sought to primarily address issues that arose during the 2008 financial crisis.
A perennial area of concern has been whether the structure of money market funds is able to withstand periods of market stress without some form of external support and without runs. The 2010 and 2014 amendments were designed to address this issue by reducing the risks of money market fund portfolios, addressing their susceptibility to heavy redemptions in times of stress, improving their ability to manage potential contagion from redemptions, and increasing the transparency of their risks. For example, the rule now permits non-government funds to impose a liquidity fee or gate to address certain liquidity conditions. The rule also now requires institutional prime and tax-exempt funds, whose investors historically have made the heaviest redemptions in times of stress, to transact at a “floating” NAV rather than a “stable” NAV, which all money market funds were permitted to use prior to 2016.
The COVID-19 market disruption tested these reforms. As the markets reacted to the impact of the pandemic, prime and tax-exempt money market funds experienced significantly heightened redemptions. In fact, the percentage of redemptions from certain funds during the height of the market turmoil was higher than what we saw in a similar time period in September 2008. Despite the significant reforms to rule 2a-7, once again, financial regulators stepped in with emergency measures to assist these funds.
I believe that it is critical for us to analyze the events in March and how the framework of rule 2a-7 may have either alleviated or contributed to any of the events that unfolded. For example, did the possibility of gates when a fund’s liquidity approached or passed certain limits drive market behavior? On the other hand, did the risk limitations imposed by the rule provide funds with the necessary liquidity to meet the heightened redemptions?
However, analyzing past dislocations should not be the only drivers of regulatory review and changes. Instead we also need to be forward-looking with a fresh eye, focusing on how to create a flexible framework that will interact smoothly with future market innovations, different market conditions, and investor reactions that we may not have already experienced. Most importantly, we should seek to construct a framework that provides structural resiliency and appropriate incentives during market stress while preserving the important role of money market funds in the short-term funding markets.
Let me move on to the second case study: ETFs. The Commission approved the first ETF in 1992 and granted over 300 exemptive orders over the last quarter century. Today, ETFs are nearly $5 trillion in assets and account for roughly 20% of registered fund assets.
Last year the Commission adopted rule 6c-11 to codify existing relief for ETFs. The rule also streamlined the regulatory framework by eliminating certain conditions and distinctions that were no longer necessary, such as between actively managed and index-based ETFs. The Commission then took further measures to innovate in this space by issuing orders that permit certain actively managed ETFs to operate without being subject to daily portfolio transparency. I believe that these orders allow for healthy innovation in ETF structures.
During March, ETF secondary market trading spiked to historic levels. At the same time, a number of ETFs, particularly in the fixed income space, experienced significant dislocations between their net asset value and their market price. We are already hearing theories on why this happened. Many noted that ETFs served as price discovery vehicles in markets where price transparency is not always available, including in certain fixed income markets. Some pointed to timing and pricing differences between ETFs’ shares and their underlying portfolio investments. Some asserted that the differential represented a liquidity premium—the price of getting out of the exposure – and others noted that widened spreads reflected market participants’ uncertainty as to pricing and liquidity. Still others suggested that structural flaws in the underlying fixed income markets played a meaningful role in exacerbating the dislocations.
While I won’t address the merits of any of these points as I believe doing so would be premature, I will note a few things that I hope are not lost as we work through what happened. First, the ETF structure was put through a significant test. ETFs played a critical role as market participants sought liquidity. And ETFs were able to meet redemptions, even with the high market volatility, unprecedented trading volumes and deterioration in overall liquidity.
Second, we should approach our analysis of events and any next steps in a multifaceted way. There continues to be intense innovation in the ETF industry and we want to support healthy innovation. Further, there are significant differences between the operation and the structure of ETFs and other types of funds. So when we look at all fixed-income funds and how they fared in March and April, I believe that we should keep these differences in mind to avoid a one-size-fits-all approach. Finally as I noted in our first case study, we should guard against conclusions and policy outcomes that focus solely on past events.
I hope you can see from these two case studies that while it’s critical to analyze and address historical events, it’s equally important to be forward looking and multifaceted in our approach to regulation.
Pathways to Aid the Effective Regulation for a Resilient Industry
So how do we do that? I believe regulations are most effective and support a resilient industry when there is enough flexibility to permit healthy innovations while also providing appropriate protections and oversight. There are many pathways to structure regulations in this manner, but I would like to touch on three: first, data-driven regulatory tools; second, risk management; and third, international engagement.
Let’s begin with data-driven regulatory tools. Structural resiliency will depend on whether appropriate risk guidelines, standardized limits, and reporting are in place. These regulatory tools are distinct from disclosure requirements, and are useful for both fund managers and regulators. Two recent regulatory initiatives – the liquidity rule and the proposed derivatives rulemaking – include these.
By way of example, let’s look at the proposed derivatives framework. The proposed rule would require a derivatives risk management program that includes guidelines tailored to the fund’s particular derivatives risk. The flexibility to develop a particular fund’s program would promote innovation and diversity among different funds and strategies, and would permit a fund to modify its risk guidelines as the market and its portfolio evolve. Most funds relying on the rule also would have to comply with an outer limit on fund leverage based on value at risk, or “VaR”. These standards are designed to constrain a fund’s leverage risk consistent with investor protection and, I believe, would promote resilience through effective risk management. The proposal also has key reporting elements such as breaches of the fund’s leverage limit and information about its derivatives exposure. Reporting would facilitate board oversight, enhance the Commission’s ability to oversee compliance, and provide the Commission and the public with greater insight into how funds’ use of derivatives impact fund portfolios.
In a nutshell, rules such as the derivatives proposal would provide data-driven regulatory frameworks that seek to balance flexible requirements that can be tailored to a particular fund’s risks with minimum standards and tools to promote resilience, strong oversight and informed market monitoring.
To be clear, developing data-driven regulatory tools does not take place in a vacuum but rather within a broader conversation about risk management. That is, once risks are identified, I believe that we should move to the inquiry of what risks are appropriate or can be tolerated versus what risks should be addressed and how. This is important for accomplishing the Commission’s three-part mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. We should not place capital formation over investor protection – nor vice versa. Instead we should seek balance. Investors in our capital markets should be able to take on risks – risk transfer is, after all, a centerpiece of the capital markets. At the same time, we must ensure that when investors take on risk, they do so having received appropriate disclosure.
Finally, let me touch on international dialog and engagement, which is increasingly an important consideration in forward-looking regulatory policy. The asset management industry is fundamentally interconnected with the broader U.S. economy and operates on a global basis. Regulation of the industry needs to take this into account. Market events, practices and regulatory decisions have effects beyond a particular industry and the borders of a home jurisdiction. For example, the European Union’s unbundling of payment for research, and its approach to requiring disclosure of how environmental, social and governance considerations factor into investment decisions, also impact U.S asset managers given their global presence. I believe engagement is necessary among international regulators in order to learn about the consequences of different regulatory approaches to an issue. This exercise can help us to address potential operational complexities and obstacles to financial innovation, and avoid higher compliance costs. For example, European UCITS use swing pricing as a liquidity risk management tool, which has not been operationalized in the U.S. I believe that information about the European experience, particularly during the recent market events, can help us understand how to make this an effective tool in the U.S. as well. This is why we engage extensively with foreign counterparts on both a bilateral level as well as through our membership on the FSB and IOSCO. And I would encourage asset managers and other stakeholders to engage in that dialogue when opportunities arise by offering their insights and experiences.
Before closing, I would like to switch gears to staff statements—another area where it is important to be forward looking to account for evolution in the industry. Division staff make their views known in many ways, including written statements, letters, and responses to frequently asked questions.
Division staff have been reviewing prior staff statements, and thinking about necessary changes in light of market or other developments. Staff statements are issued to address particular facts and circumstances, and are symbiotically tied to the market ecosystem at the time of issuance. As the markets and the industry evolve, it is important to examine whether prior staff statements continue to be relevant and consistent with the Commission’s overall regulatory approach.
That is what we are doing. Through this initiative, the staff withdrew letters that addressed investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms, and that addressed the intersection between state control share acquisition statutes and the Act’s voting requirements for closed-end funds. We also address staff statements as the Commission adopts or amends rules. For example, the staff withdrew a number of letters after the Commission adopted securities offering reform for closed-end investment companies and the new variable annuity summary prospectuses.
A new webpage lists and hyperlinks to staff statements that have been modified or withdrawn over time. But the webpage is not an exhaustive list. As you look at staff statements, I encourage you to think about whether the Commission has spoken recently in that space and whether the markets have significantly changed. If Commission statements look like they move in a different direction or provide pertinent information on the same subject matter, or if the markets have evolved since issuance, you should examine the impact of those developments on the staff statement. If you are unsure, call Division staff. Reconsideration of prior staff statements certainly will be a continued priority of the Division.
Let me close by thanking the staff of the Division for their extraordinary work and efforts in addressing the market disruptions while also continuing their great work on our priorities. As I had noted earlier this summer, we plan to make recommendations for next steps to the Commission on all of the outstanding proposals in our area, including fund of funds arrangements, funds’ use of derivatives, fund valuation practices, and investment adviser advertising and solicitation. We are also exploring ideas for updating the Commission’s guidance on e-delivery and to permit virtual board meetings under circumstances beyond those in the recent temporary relief related to COVID-19.
As we do so, we will of course look in the rear view mirror and understand what happened and why. But we will also keep our focus on regulatory solutions that are flexible, evergreen and take a holistic approach to build a more resilient framework going forward.
Thank you for your time today and I hope you enjoy the rest of the conference.
 This year I am joined by a number of my colleagues who are participating in panels, including David Bartels, Sarah ten Siethoff, and Samantha Brutlag. Please feel free to reach out to them after the conference. They and the entire staff of the Division are always eager to hear your thoughts on issues that matter to you.
 The Securities and Exchange Commission (“SEC” or “Commission”) disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
 See Division of Investment Management, United States Securities and Exchange Commission, Protecting Investors: A Half Century of Investment Company Regulation, May 1992, (“Redbook”), at xviii (“In 1940, the industry held only about two billion dollars in assets, including 105 registered management investment companies holding slightly more than one billion dollars in assets.”).
 See In the Matter of Daily Income Fund, Inc., et al. Investment Company Act Release No. 10451 (Oct. 26, 1978) [43 FR 51485 (Nov. 3, 1978)] (permitting funds to use the penny rounding method by computing their current price per share by rounding the fund’s NAV to the nearest one percent (i.e., the nearest penny)). See also In the Matter of Intercapital Liquid Asset Fund, Inc., et al. Investment Company Act Release No. 10824 (Aug. 8, 1979) (permitting funds to use the amortized cost method value their portfolio securities at cost plus any amortization of premium or accumulation of discount, rather than at their value based on current market factors).
 See Valuation of Debt Instruments and Computation of Current Price Per Share by Certain Open-End Investment Companies (Money Market Funds), Investment Company Act Release No. 13380 (July 11, 1983) [48 FR 32555 (July 18, 1983)], available at https://www.govinfo.gov/content/pkg/FR-1983-07-18/pdf/FR-1983-07-18.pdf. See also Investment Company Act Release No. 12206 (Feb. 1, 1982) [47 FR 5428 (Feb. 5, 1982)], available at https://www.govinfo.gov/content/pkg/FR-1982-02-05/pdf/FR-1982-02-05.pdf.
 See Money Market Fund Reform; Amendments to Form PF, Investment Company Act Release No. 31166 (July 23, 2014), available at https://www.sec.gov/rules/final/2014/33-9616.pdf (“2014 Adopting Release”); Money Market Fund Reform, Investment Company Act Release No. 29132 (Feb. 23, 2010), available at https://www.sec.gov/rules/final/2010/ic-29132.pdf (“2010 Adopting Release”). The amendments also addressed other market dislocations. Specifically, in the summer of 2011, the Eurozone sovereign debt crisis and an impasse over the U.S. Government’s debt ceiling unfolded, and during the fall of 2013 another U.S. Government debt ceiling impasse occurred.
 Rule 2a-7 requires non-government money market funds to impose a fee at 10% weekly liquid assets unless the board finds that not doing so is in the best interest of the fund. See 17 CFR 270. 2a-7(c)(2)(ii).
 For example, over the two-week period from March 11 to 24, daily data on MMF flows reported by iMoneyNet show that net redemptions from publicly-offered institutional prime funds totaled 30 percent (about $100 billion) of the funds’ assets. For comparison, in September 2008, the worst outflows from these funds over a two-week period were about 26 percent (about $350 billion) of assets.
 For example, the Federal Reserve’s liquidity facility made loans available to banks to finance assets purchased from prime and tax-exempt money market funds, and SEC staff positions addressed a money market fund affiliate’s purchase of securities from the fund under certain conditions. See Investment Company Institute, SEC Staff No-Action Letter (March 19, 2020), available at https://www.sec.gov/investment/investment-company-institute-031920-17a.
 See Precidian ETFs Trust, et al., Investment Company Act Release Nos. 33440 (Apr. 8, 2019) (notice) and 33477 (May 20, 2019) (order) and related application.
 See, e.g., SEC Asset Management Advisory Committee, Preliminary Recommendations of ETP Panel Regarding COVID-19 Volatility: Exchange-Traded Products (Sept. 16, 2020), available at https://www.sec.gov/files/prelim-recommendations-to-amac-on-etps.pdf (noting a number of factors could explain the divergences some exchange traded products experienced relative to their NAVs).
 See Investment Company Liquidity Risk Management Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016), available at https://www.sec.gov/rules/final/2016/33-10233.pdf; Use of Derivatives by Registered Investment Companies and Business Development Companies; Required Due Diligence by Broker-Dealers and Registered Investment Advisers Regarding Retail Customers’ Transactions in Certain Leveraged/Inverse Investment Vehicles, Investment Company Act Release No. 33704 (Nov. 25, 2019), available at https://www.sec.gov/rules/proposed/2019/34-87607.pdf (“2019 Derivatives Proposal”).
 See 2019 Derivatives Proposal.
 See id.
 See id.
 See Investment Company Swing Pricing, Investment Company Act Release No. 32316 (Oct. 13, 2016), available at https://www.sec.gov/rules/final/2016/33-10234.pdf (permitting a registered open-end management investment company (except money market fund or exchange-traded fund) to use swing pricing under certain circumstances).
 See Chairman Jay Clayton, Statement Regarding SEC Staff Views (Sept. 13, 2018), available at https://www.sec.gov/news/public-statement/statement-clayton-091318 (“The Commission’s longstanding position is that all staff statements are nonbinding and create no enforceable legal rights or obligations of the Commission or other parties. Statements issued by SEC staff frequently include a disclaimer underscoring the important distinction between the Commission’s rules and regulations, on the one hand, and staff views on the other.”).
 See id. (“More generally, our divisions and offices, including but not limited to the Division of Corporation Finance, the Division of Investment Management and the Division of Trading and Markets, have been and will continue to review whether prior staff statements and staff documents should be modified, rescinded or supplemented in light of market or other developments.”).
 See IM Information Update: Statement Regarding Staff Proxy Advisory Letters, IM-INFO-2018-02 (Sept. 2018), available at https://www.sec.gov/divisions/investment/imannouncements/im-info-2018-02.pdf.
 See Staff Statement on Control Share Acquisition Statutes, Staff Statement Division of Investment Management (May 27, 2020), available at https://www.sec.gov/investment/control-share-acquisition-statutes.
 See IM Information Update: Statement Regarding Withdrawal of Staff Letters Related to Securities Offering Reform for Closed-End Investment Companies Rulemaking (April 2020), available at https://www.sec.gov/files/im-info-2020-04.pdf; IM Information Update: Statement Regarding Withdrawal of Staff Letters Related to Updated Disclosure Requirements and Summary Prospectus for Variable Annuity and Variable Life Insurance Contracts Rulemaking (March 2020), available at https://www.sec.gov/files/im-info-2020-01.pdf. See also Offering Reform for Closed-End Investment Companies, Investment Company Act Release No. 33836 (April 8, 2020), available at https://www.sec.gov/rules/final/2020/33-10771.pdf; Updated Disclosure Requirements and Summary Prospectus for Variable Annuity and Variable Life Insurance Contracts Securities, Investment Company Act Release No. 33814 (March 11, 2020), available at https://www.sec.gov/rules/final/2020/33-10765.pdf.
 See Division of Investment Management Modified or Withdrawn Staff Statements (last updated June 11, 2020), available at https://www.sec.gov/divisions/investment/im-modified-withdrawn-staff-statements.
 For example, several staff no-action letters for funds and advisers include a representation that voting be conducted by an independent third party on some or all matters, and this summer the Commission supplemented its guidance regarding an investment adviser’s proxy voting responsibilities when proxy advisory firms assist with voting execution. See e.g., Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Investment Advisers Act Release No. 5547 (Jul. 22, 2020), available at https://www.sec.gov/rules/policy/2020/ia-5547.pdf; SPDR S&P Dividend ETF, SEC Staff No-Action Letter (Mar. 28, 2016); Morgan Stanley & Citigroup, SEC Staff No-Action Letter (May 29, 2009); Auction Rate Securities – IM Supplement to Global Relief Request, SEC Staff No-Action Letter (Jan. 6, 2009); Evergreen Investment Management, SEC Staff No-Action Letter (Feb. 13, 2002); First National Bank of Chicago, SEC No-Action Letter (Sep. 22, 1992).
 See Dalia Blass, Speech: PLI Investment Management Institute (July 28, 2020), available at https://www.sec.gov/news/speech/blass-speech-pli-investment-management-institute.
 See id.