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Learning from History: Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing

Nov. 2, 2022

The Importance of Liquidity Risk Management Programs

Mutual funds, ETFs and other open-end funds have become primary investment vehicles for the retirement and savings accounts of U.S. families.[1] Through these investments, shareholders can gain access to potentially broad and diverse portfolios easily and – relevant here – with guaranteed liquidity. Specifically, shareholders have a statutory right to receive payment within seven days upon seeking redemption of their investments (and, in some instances, even sooner).[2] Investors rely on this liquidity. As such, it is critically important that open-end funds have robust liquidity risk management programs in place. This is true in normal times, and especially important during times of market stress and volatility.

In addition to protecting shareholder redemption rights, effective liquidity risk management programs also address shareholder dilution, a problem that may arise when current fund investors bear the transaction costs of redeeming or incoming shareholders. Dilution was noted as a principal concern upon the enactment of the Investment Company Act,[3] and it remains a concern for the Commission today.

Lessons from the Recent Past

Today’s proposal draws from the lessons of recent history in at least two notable ways.

First, when the Commission amended Rule 22e-4 in 2018, it stated that staff would monitor and solicit feedback on our amendments, and would evaluate at least one full year’s worth of liquidity classification data.[4] Today’s proposal reflects that evaluation and, among other things, amends the classification framework, “highly liquid investment” minimums, and the frequency of liquidity classifications.

Additionally, today’s proposal incorporates lessons from actual times of stress. As the proposal notes, in March 2020, at the outset of the Covid-19 pandemic, most segments of open-end funds witnessed significant redemptions, and funds faced pressure to generate liquidity quickly enough to meet investor demand.[5] The release notes that this, along with other market factors, likely contributed to the dilution of fund share values. Ultimately, the Federal Reserve used its emergency powers to intervene.[6]

In light of these (and other) events, the Commission today proposes swing pricing and the hard close. Understanding that complex problems often have myriad solutions, the proposal lays out a series of alternatives to swing pricing, such as the imposition of liquidity fees or dual pricing; as well as alternatives to the hard close, such as indicative or estimated flows.

Some Questions for the Future

As the saying goes, “history does not repeat itself…but it often rhymes.”[7] With the benefit of hindsight, and looking toward the future, I am cognizant that we are not the only participants in this history lesson. We are also not the only ones who may have observations to draw from the events of March 2020 or from the implementation of Rule 22e-4. So, as the proposal does, I look forward to your careful consideration of the following:

  • In applying swing pricing to all open-end funds other than ETFs and money market funds, does today’s proposal have unintended consequences for the mutual fund market?
  • The proposal observes that there may be significant operational challenges involved in effecting the hard close, potentially for retirement plans in particular. Are those challenges surmountable and at what cost?
  • Are swing pricing and a hard close the best tools we have available to address dilution and liquidity in times of stress? If not, are the alternatives discussed in the release – such as imposing liquidity fees or relying on estimated fund flow information – sufficiently precise and palatable to meet our stated goals?

I want to recognize and applaud the staff involved in crafting this proposal. You have been thoughtful and responsive in considering many options and alternatives to addressing the potential concerns laid out today. So a resounding thank you to the staff in the Division of Investment Management, Division of Economic and Risk Analysis, the Office of the General Counsel, and the staff in the Chair’s office and the offices of my fellow Commissioners. With that, I support today’s rule proposal.

[1] Investment Company Institute 2022 Fact Book (noting, among other statistics, that 62.2 million U.S. households, and 108.1 million individuals, own U.S. registered funds; and that mutual funds made up approximately 58% of defined contribution retirement plans and 45% of IRA assets).

[2] 15 U.S.C. § 80a-22 (providing that registered investment companies must deliver payment upon redemption no later than seven days following the tender of such security). Open-end funds redeemed through broker-dealers must meet redemption requests within two business days. 17 C.F.R. 240.15c6-1. As the Commission noted when first adopting the Liquidity Risk Management Program Rule, “Redeemability is a defining feature of open end investment companies.” Adopting Release, Investment Company Liquidity Risk Management Programs, Release Nos. 33-10233, IC-32315 (2016).

[3] Proposed Release, Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT, Release Nos. 33-11130; IC-34746 (“Proposing Release”) (Nov. 2, 2022) at 7 and n. 3 (citing Investment Trusts and Investment Companies: Hearings on S. 3580 before a Subcomm. of the Senate Comm. on Banking and Currency, 76th Cong., 3d Sess. (1940), at 37, 137-145).

[4] Proposing Release at 17. Rule 22e-4 requires, among other things, assessment, management, and periodic review of a fund’s liquidity risk; classification of the liquidity of each of a fund’s portfolio investments; and, limitations on illiquid investments.

[5] For example, in March 2020, open end funds had outflows of nearly 329.4 billion, or 1.7% of prior period assets. Overall, by the end of the month, assets in open-end funds fell approximately 17% from December 2019. Proposing Release at 23, 25.

[6] See Proposing Release at 27 and n. 55; see also Ben S. Bernake and Janet Yellen, Former Fed Chairs Bernake and Yellen testified on Covid-19 and Response to Economic Crisis, (July 17, 2020).

[7] The phrase is often attributed to Mark Twain.

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