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Statement on Open-End Fund Liquidity Risk Management Programs and Swing Pricing

Chair Mary Jo White

Sept. 22, 2015

Good morning, everyone.  This is an open meeting of the Securities and Exchange Commission on September 22, 2015 under the Government in the Sunshine Act.

The Commission will consider a recommendation of the staff to propose a new rule and amendments designed to strengthen the management of liquidity risks by registered open-end investment companies, including mutual funds and exchange-traded funds (or ETFs).

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Regulation of the asset management industry is one of the Commission’s most important responsibilities in furthering our mission to protect investors, maintain orderly markets, and promote capital formation.  The Commission oversees registered investment companies with combined assets of approximately $18.8 trillion and registered investment advisers with approximately $67 trillion in regulatory assets under their management.  At the end of 2014, 53.2 million households, or 43.3 percent of all U.S. households, owned mutual funds.   Fittingly, next Tuesday, we will reflect on our history of regulating funds and advisers at an event to celebrate the 75th anniversary of the Investment Company Act and the Investment Advisers Act.

We have seen all too clearly in recent years the very real impact that disruptions in the financial markets can have not just on individual investors and markets, but on the country as a whole.  One of my primary goals has been to work to reduce the risks of these disruptions, whether through our long-standing regulatory tools or the relatively new ones provided by the Dodd-Frank Act.  In pursuing this goal, a key initiative has been to expand and deepen our program to identify, monitor, evaluate, and – as appropriate – address risks in today’s asset management industry.  We began with a close focus on money market funds, and in July 2014 we completed major reforms that fundamentally changed the way these funds are structured and operate.

Last December, following these reforms, I outlined a comprehensive five-part plan to enhance the regulation of the risks arising from the portfolio composition and operations of funds and investment advisers.  This plan includes measures to enhance data reporting, strengthen the management of fund liquidity, better address risks related to funds’ use of derivatives, plan for the transition of client assets, and to stress test funds and advisers. 

Advancing the first step in implementing this program, the Commission proposed new rules in May to modernize the reporting and disclosure requirements for funds and investment advisers.  Today, we continue this important work by moving to strengthen the management of liquidity risks by funds relied on daily by millions of Americans.

Liquidity Risks in an Evolving Fund Industry

The defining feature of so-called “open-end” funds is that investors can redeem their shares on each business day and must receive their assets within seven days.  Many funds promise – and many investors expect – to receive their assets even more quickly.

Liquidity is therefore essential.  A fund must manage the liquidity of its portfolio to ensure that redemption requests can be fulfilled in a timely manner while also minimizing the impact of those redemptions on the fund’s remaining shareholders.  Poor liquidity management can dilute existing shareholders’ interests, negatively impact the value of the fund’s assets or the fund’s risk profile, or cause an ETF’s share price to diverge from the value of its underlying securities.  Changes in the modern asset management industry call on us to now look anew at liquidity management in funds and propose reforms that will better protect investors and maintain market integrity.

Today, mutual funds and other open-end funds have grown to hold more than $15 trillion of investor assets, and the fund industry has implemented new investment strategies to meet a range of demands from an increasingly diverse population of investors.  Among these strategies are ones that rely on securities that tend to be less liquid, such as high‑yield bond funds, emerging market equity and debt funds, and funds with alternative strategies.  Foreign bond and equity funds, for example, have grown steadily from approximately 11 percent of total industry assets in 2000 to more than 17 percent in 2014.  In addition, the assets of funds with alternative strategies grew from approximately $365 million to $334 billion from 2005 to 2014.

With such changes come new challenges.  These funds offer investors additional investment options, but they can also increase the complexity and potential risks of fund portfolios and operations.  Commission staff economists found, for example, that foreign bond funds and alternative strategy funds have historically experienced more unpredictable purchases and redemptions than the average mutual fund.  In some circumstances, this behavior could increase their liquidity risk by making it more difficult for a fund manager to plan to meet redemptions and more likely that the fund needs to sell assets in a manner that impacts the broader market. 

The Commission staff also has been studying the varying ways funds manage liquidity risk and the potential consequences for investors and the market.  While we have observed strong risk management practices at some funds, our observations suggest closer regulatory attention is warranted to ensure that all funds adequately manage liquidity risk.  For example, SEC staff economists have noted that a typical U.S. equity fund appears to sell more liquid assets to meet large redemptions, rather than selling a strip of the fund’s portfolio.  Their analysis also suggests that funds with lower portfolio liquidity experience a greater decrease in liquidity due to large redemptions.

Liquidity Risk Management Programs and Swing Pricing

The recommendation before us today builds on the SEC’s long experience with fund oversight to set forth a strong but versatile proposal that responds to current developments and enhances the ability of open-end funds to manage liquidity risks in a modern market environment.  Promoting stronger and more effective liquidity risk management is essential to reduce the risk that a fund will be unable to meet its redemption obligations, to minimize dilution of shareholder interests, and to address variations in practices among funds.

As the staff will detail, the proposal would require each open-end fund to establish a liquidity risk management program tailored to its specific portfolio and risks, permit a fund to use “swing pricing” under certain circumstances, and enhance disclosures about the liquidity of a fund’s holdings and its liquidity risk management practices.

Together, these rules should greatly enhance funds’ ability to manage their liquidity risks, strengthening our securities markets and better protecting investors.  The reforms will also improve the Commission’s ability to supervise funds and to monitor and address any liquidity risks that their activities may pose to the overall stability of the U.S. financial system.  These efforts will complement the ongoing efforts in the United States and abroad to further understand the risks that may be presented by certain activities and products of asset managers and other market participants.

Continuing to Advance a Broad Oversight Program for Asset Management

Today’s proposal marks another important step in our program to better address potential risks in asset management, and I look forward to the comments we will receive on these critical reforms.  As we work toward final rules here and on our May proposal for modernized data reporting, Commission staff continues to work hard to develop – among other measures – recommendations related to the use of derivatives by funds, including measures to appropriately limit the leverage these instruments may create and enhance risk management programs for such activities, recommendations we also hope to advance for the Commission’s consideration before the end of the year.

Through these efforts and others, we continue to further enhance our regulatory program to match the evolution of the asset management industry in the 21st century – and reduce the risks that a disruption in this space can pose to the broader financial system on which all Americans rely.

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Before thanking the staff and hearing their presentation, I would like to take a moment to thank Commissioner Dan Gallagher for his service at this, likely his last open meeting as a Commissioner.  Dan began his career with the Commission early—as an intern in fact.  He returned to the SEC in 2006 to work for Commissioner Paul Atkins and Chairman Chris Cox, and went on to lead the Division of Trading and Markets, working in the trenches during the financial crisis.   He became a Commissioner in 2011 and has added great value to all of the agency’s work.  Commissioner Gallagher, your contributions to the Commission have been many and lasting, and I thank you for your dedication, wit and friendship.  The Commission will not be the same without you.

Turning back to the business at hand, I would like to thank the Commission staff for applying their deep expertise of investment companies to this proposed rulemaking.  First, thank you to Dave Grim, the Director of the Division of Investment Management, and his team: Diane Blizzard, Sarah ten Siethoff, Melissa Gainor, Sarah Buescher, Naseem Nixon and Amanda Wagner.

Throughout this process, SEC economists from DERA provided economic analyses and invaluable input on data related to funds that was essential in formulating these reforms – work that includes a white paper we will also make public today.  From DERA, I want to specifically thank Director Mark Flannery, Christof Stahel, Timothy Riley and Jonathan Novak.

Great thanks also go to Annie Small, Meridith Mitchell, Lori Price, Robert Bagnall, Jill Felker and Monica Lilly from the Office of the General Counsel.  I would also like to thank my fellow Commissioners and all of our counsels for their engagement, support and comments on these recommendations.

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