On November 3, 2022, by a 3–2 vote, the U.S. Securities and Exchange Commission (SEC) proposed mandatory swing pricing of mutual fund shares, a hard close for transacting in fund shares, and a broad retake of the liquidity rule. Collectively, this package of changes would so fundamentally overhaul current practices that some observers question whether implementation is even possible. The proposals apply to all open-end investment companies (mutual funds), but not money market funds or exchange-traded funds (ETFs). Comments on the proposals are due within 60 days of publication of the proposed rules in the Federal Register.
Our Take. Many industry constituents have had positive experiences with swing pricing in non-U.S. markets, and there are supporters of mandated swing pricing in academia and among consumer and public interest groups. But given significant market structure obstacles, there has been broad-based industry concern with any effort to widely apply swing pricing in the United States.
Prominent industry voices were on defense almost immediately, calling the combination of swing pricing and a hard close burdensome on shareholder choice, difficult to operationalize, difficult to realistically assess from a cost perspective, and unsupported by the facts. One dissenting Commissioner called the rules a “tragedy” and an act of “hubris.”
For those trying to assess impacts, however, it is critical to see the full sweep of the rulemaking. Swing pricing and the hard close aside, the SEC proposes dramatic revisions to its (still new) mutual fund liquidity rule. Those amendments, by themselves, are far reaching and would jeopardize some product types and force reassessments of others.
Through it all, it will be important to watch the calendar. The 60-day comment period is short – and will be especially challenging given the year-end timing. But that is only the beginning in a process where political advocacy and litigation seem as likely as traditional policy debate. For example, the start of the Congressional Review Act lookback period (and with it, possible nullification by a new Congress of rules adopted within that period) comes as soon as May 2024, which will make that an important date. The SEC’s proposed transition periods of 12 months for the liquidity rule amendments and 24 months for swing pricing and the hard close also bear watching. Coupled with the 2024 election cycle, they present the possibility that the rules could face a new Administration and reconstituted Commission before their most significant changes take effect.
I. Historical Context
Swing pricing has been proposed before and repeatedly rebuffed. In 2016, the SEC adopted a voluntary swing pricing rule (as a provision of Rule 22c-1 under the Investment Company Act), which effectively became a dead letter, as no fund opted into its provisions. There also is a pending proposal from last year under which the SEC would mandate swing pricing for certain institutional money market funds, and for which industry opposition has been almost universal. The mutual fund liquidity rule (Rule 22e-4 under the Investment Company Act) is also well-trodden ground. In 2016, following a lengthy analysis of how mutual funds performed during the 2008 financial crisis, the SEC unanimously adopted the rule, which went through several rounds of revisions and delay before taking full effect in December 2019.
Nor is this the first time the SEC considered a hard close requirement, though that history is 20 years old; in the early 2000s, a hard close was on the table but not adopted.
But the most important historical context for the current rulemaking is March 2020, when uncertainty about the pandemic shook the financial markets. Faced with unprecedented market and economic disruptions, the full resources of the federal government were quickly brought to bear. The Federal Reserve responded with market interventions, Congress approved emergency appropriations, and the SEC provided emergency relief from a number of its rules.
While the worst aspects of that market turmoil quickly subsided, the SEC’s proposing release for the current rules presents the mutual fund industry as in a state of panic that March. The SEC says, for example, that during this period fund managers quietly requested emergency rules for special mutual fund redemption fees, antidilution charges that ETFs might charge their authorized participants, and — significantly —“emergency actions to facilitate funds’ ability to operationalize … swing pricing.” It is this backdrop that the SEC says set the stage for rulemaking.
II. Proposed Swing Pricing Requirement
Given those events, the SEC now believes that requiring mutual funds to implement swing pricing will be the most effective tool to address risks of shareholder dilution and reduce potential incentives for some investors (so-called “first movers”) to redeem quickly in times of market disruption and liquidity stress.
As proposed, the key concept underlying swing pricing is that a fund will adjust its net asset value (NAV) per share whenever the fund experiences net redemptions, or when net subscriptions exceed 2% of NAV, with that adjustment intended to allocate costs of the redemptions or subscriptions to the transacting shareholders. Because actual shareholder flows are inherently uncertain, it is a feature of swing pricing that investors will not necessarily know when their trades will be subject to a NAV adjustment (the “swing factor”) before they buy or redeem fund shares.
Important elements of the swing pricing proposal include the following:
Uniform application (mostly)
- Swing pricing generally will be applied uniformly by all types of mutual funds regardless of differences in their assets, size, or shareholder base, except that each fund’s swing pricing administrator will have discretion to set a market impact threshold below 1% of NAV and an inflow threshold below 2% of NAV. (The role of the administrator and the significance of these thresholds are described below.)
- Limited exceptions and special rules apply to certain market structures, such as master-feeder arrangements (where a feeder fund generally would not apply swing pricing) and the relatively few funds that operate with an exchange-traded share class.
Assessment of flows
- A fund with multiple share classes generally will determine whether it experienced net redemption or subscription activity across all share classes in the aggregate.
- Whether redemption and subscription levels will meet the applicable daily thresholds must be “estimated reasonably” and “with high confidence.”
- Calculation of redemption and subscription levels will exclude redemptions or purchases made in kind and not in cash.
Applying the swing factor
- When swing pricing is triggered, a fund will be required to adjust its NAV by a “swing factor” reflecting at least spread and transaction costs and stated as a percentage of NAV.
- If a fund has net redemptions for the period that exceed the “market impact threshold” (1% of NAV unless the swing pricing administrator selects a lower threshold), the swing factor also must include good-faith estimates of the market impact of selling securities to satisfy the net redemptions. Corresponding market impacts also will be included in the swing factor whenever the net inflow threshold (2% of NAV unless the swing pricing administrator selects a lower threshold) is met.
- There will be no “upper limit” on market impact cost estimates.
- Costs and market impact factors need not be calculated by reference to actual daily determinations of these inputs and instead can be based on good-faith assumptions and estimates made from time to time, but must be kept current and take into account “significant market developments.”
- Costs and market impact factors can be considered by type of security and then applied to all securities of that type (assuming the same or substantially similar characteristics) in the fund’s portfolio.
- Indications of flexibility aside, the SEC emphasizes that having “an accurate and fair transaction price is crucially important.”
The vertical slice approach
- A fund will determine the swing factor — and thus costs and, when applicable, market impacts — to apply by assuming it will transact in a pro rata amount of each security in its portfolio (a “vertical slice”), selling that vertical slice to satisfy its net redemptions or purchasing that vertical slice to invest its net subscriptions.
- A fund will use the vertical slice approach regardless of how cash is actually raised or deployed. In the case of net redemptions, the vertical slice approach will apply even if there is ready cash on hand to cover redemptions in full. Similarly, the vertical slice approach will ignore borrowing costs even if borrowings (as opposed to sales of securities) will be used to generate cash. In the case of net subscriptions, the vertical slice approach will apply even if incoming cash can be deployed in futures or other derivatives to obtain efficient market exposure pending specific application of proceeds. Notwithstanding these potential anomalies, the SEC considers the vertical slice approach to be objective and more straightforward to operationalize than alternatives.
Policies and procedures
- Every fund subject to swing pricing will establish policies and procedures to implement these requirements and provide information about its approach to swing pricing in its prospectus.
- Swing pricing policies and procedures will be managed by a designated “swing pricing administrator” (which must be the investment adviser or officer or officers). The activities of the swing pricing administrator must be reasonably segregated from portfolio management.
Role of the fund board
- A fund’s board will approve the policies and procedures, appoint the swing pricing administrator, and receive ongoing reporting.
- The SEC states that the proposals contemplate a board role in compliance oversight rather than involvement in day-to-day administration of a fund’s swing pricing program.
Prospectus and other public disclosures
- A fund that uses swing pricing must explain the meaning of swing pricing, the circumstances under which it will apply, and the effects of swing pricing on the fund and investors.
- All swing pricing NAV adjustments will be reported after the fact on a fund’s public Form N-PORT filings. In this regard, Form N-PORT filings will be made monthly with the SEC within 30 days of month-end and will be public within 60 days of month-end. This is a more frequent filing (and public posting) schedule than currently required.
- Various conforming and more technical changes also will be made throughout Form N-PORT and Form N-CEN.
- In addition to maintaining the swing pricing policies and procedures and board reports, funds will be required to maintain records in support of each swing pricing NAV adjustment.
Alternatives to Swing Pricing
The proposing release considers two alternatives:
- Liquidity fees. A liquidity fee would be more transparent than a swing pricing adjustment because it would not be embedded in the NAV. Such a fee could be “dynamic” (meaning it changes depending on the specific circumstances and costs that it seeks to address) or could be in a “default” or “simplified” amount that is either fixed or ratchets up or down according to relatively simple criteria. A liquidity fee also could be applied solely to redeeming or purchasing shareholders, as the case may be, in contrast to swing pricing, which becomes part of the NAV so applies to all trades regardless of direction.
- Dual pricing. Dual pricing contemplates quoting two prices: one for subscriptions (reflecting the cost of buying portfolio securities in the market) and one for redemptions (reflecting the cost of selling portfolio securities in the market).
The SEC asks for comments on whether these alternatives might have fewer operational or other burdens than the proposed swing pricing requirement while still achieving the same overall goals of reducing risks of shareholder dilution.
III. Proposed Hard Close
A central objection to swing pricing when the SEC proposed it to date has been operational, namely that swing pricing requires a fund to have a clear picture of its daily shareholder flows (subscriptions and redemptions) at the same time as it calculates its NAV (generally within a few hours of the 4 p.m. ET pricing time). In practice, that is simply not the case.
As background, mutual fund trade processes and infrastructure developed to accommodate a diversity of channels through which investors deal with funds. The basic operating principle today is that fund investors place their trades with an intermediary — such as a broker-dealer or their 401(k) plan administrator — before 4 p.m. and therefore receive that 4 p.m. price and trade date. The intermediary, however, is permitted to deliver the trade order (often batched with others across its platform) to the fund hours later, and for some channels the next morning.
The SEC acknowledges that the resulting informational “mismatch” — with flows known only much later than at NAV calculation — will make swing pricing effectively impossible for most firms. The solution the SEC proposes is a “hard close.” Under a hard close, only trades received by a fund firm (or a registered transfer agent designated in the fund prospectus or a registered clearing agency) at the firm’s trade cutoff time — presumably 4 p.m. for most funds — will receive that day’s price and trade date. This replaces the existing, flexible trade processes described above. All trades eligible for the proposed hard close, referred to in the proposed rule as an “eligible order,” would specify either a set number of shares in which the trade will transact or a set dollar value and must be irrevocable as of the next pricing time for the trade.
Important elements of the hard close proposal include the following:
Uniform application (mostly)
- The SEC proposes very few exceptions to the hard close requirements. Limited exceptions are proposed for certain unit investment trust and variable annuity transactions.
- A proposed exception will accommodate the practice of fund companies’ allowing same-day exchanges between funds (meaning a redemption from one fund followed by a concurrent, same-day subscription into another fund). Absent an exception, an exchange would not meet the hard close requirements, as the subscription value is not known prior to the NAV being struck for the shares of the redeeming fund, so that the subscription amount cannot be specified either by number of shares or value.
- Similar complications exist for many retirement-plan transactions that are dependent on a known NAV, such as plan loans or withdrawals. Those retirement-plan transactions now could take up to several days to implement instead of being possible on a same-day basis. Common “rebalancing” trades intended to effect reallocation of an investor’s assets across asset classes also will be made more challenging. There also will be issues for funds that invest in other funds. No exceptions or accommodations are proposed for these kinds of transactions.
- The rule will require prospectus disclosure on the new cutoff times and related effects on trades submitted through intermediaries.
Alternatives to a Hard Close
The proposing release considers and seeks public comment on three alternatives:
- Indicative flows. Under an indicative flow approach, intermediaries would be required to report estimated flows by a given time each day (e.g., 4 p.m. or 5 p.m. ET). Funds then would be permitted to rely on that reporting to assess net redemptions or subscriptions for purposes of swing pricing considerations.
- Estimated flows. Under an estimated flow approach, funds would be permitted to develop models to estimate net redemptions or subscriptions for purposes of swing pricing considerations.
- Later cutoff times for intermediaries. This approach essentially would be a modified version of what exists today. Instead of intermediaries’ being able to submit orders according to terms agreed between the intermediary and the fund, there would be a mandated intermediary cutoff time that might be several hours after the pricing time. Coupled with a pushback of the time by which funds complete calculation and dissemination of the 4 p.m. NAV to, say, 10 p.m., an intermediary cutoff time of 7 p.m. still might allow for assessment of actual flow information and application of swing pricing by that later NAV calculation time.
IV. Proposed Amendments to the Liquidity Rule
In proposing its amendments to the liquidity rule, the SEC first reviewed its understanding of how the liquidity rule functioned during the market turmoil of March 2020. Referring to the existing requirement to classify investments according to prescribed liquidity criteria, the SEC observes that “approximately two-thirds of funds did not appear to reclassify any investment held in both [February and March 2020] despite … market events.” (That said, reclassifications did increase and “stayed elevated for April 2020.”) In assessing why reclassifications did not occur in the volume or at the speed the SEC expected, the SEC notes that liquidity modeling uses trailing market data — so carries forward embedded data from prior periods, which can dampen the effect of current market movements — and also that the models “tend to assess liquidity based on relatively small sale sizes that do not … necessarily reflect … stress periods.” These observations shaped the SEC’s proposals to revamp the rule.
Important elements of the proposals — which are strikingly broad and varied for what is still a relatively new rule — include the following:
More frequent reclassifications
- Monthly liquidity classifications now will be required daily.
Removal of the option for asset-class based classifications
- The option of asset-class level classification approaches, available in the current rule, will be removed.
Mandated requirements for the rule’s value impact standard
- Key to classifying a security’s liquidity under the rule is whether a sale would “significantly change the market value” of the investment (known as the value impact standard). Currently, funds have considerable flexibility in defining what that means. The amendments will eliminate that flexibility. In its place would be two prescribed definitions: (i) For shares listed on a national securities exchange or foreign exchange, any sale or disposition of more than 20% of the average daily trading volume of those shares, as measured over the preceding 20 business days, would be deemed to meet the value impact standard; and (ii) for any other investment, any sale or disposition reasonably expected to result in a decrease in sale price of more than 1% would be deemed to meet the value impact standard.
- Under the current rule, funds have the flexibility to establish a “reasonably anticipated trade size” (known as the RATS standard) as part of their value impact testing. As proposed, assessments of liquidity will be required to assume the sale of at least 10% of each position each day (which the SEC acknowledges is akin to an “ongoing stress test”).
Measurement of the settlement period
- Also key to classifying a security’s liquidity under the rule is the number of days in which it takes to convert a security to cash. While there is mixed market practice as to when the count starts, the proposed rule will specify that the day of sale is the first day in the count. As an example, the proposed rule will require that a security sold on Monday will be “highly liquid” (convertible to cash in three business days or less) if it will settle and convert to cash by Wednesday.
- Calculation of when a foreign security is convertible to cash will be required to consider both time to settlement and any applicable conversion of the proceeds to U.S. dollars.
Elimination of the “less liquid” classification and automatic treatment of certain securities as illiquid
- The amendments will eliminate the “less liquid” classification category available under the current rule for certain extended settlement instruments, effectively treating these positions as illiquid.
- The amendments will treat as illiquid all fair-valued securities for which “unobservable inputs” are significant to calculating value, regardless of actual trading levels.
Mandated 10% highly liquid investment minimum
- All funds will be required to hold a minimum of 10% of their assets in “highly liquid investments.” Fund liabilities will count against (reduce) assets that otherwise would count toward the 10% minimum.
- Cash collateral associated with derivatives generally will be classified accordingly to the liquidity classification of the related derivative contract.
- For the first time, a fund will be required to publicly report the percentage of its assets in each of the liquidity rule’s three (revised) liquidity classifications. Liquidity classifications for individual securities will continue to be reported to the SEC on a nonpublic basis.
- New liquidity vendor information will be reported on Form N-CEN.
V. Compliance Dates
The release includes the following proposed compliance periods:
Swing pricing and the hard close
- Swing pricing and hard close requirements will be effective 24 months after the effective date.
Liquidity rule and reporting
- Liquidity rule and reporting changes will be effective 12 months after the effective date.
VI. Comment PeriodComments are due within 60 days after publication of the release in the Federal Register. This is a short comment period for these rules and will require commenters to begin work on their submissions immediately. The fact that the comment period runs through the year-end and over a number of significant U.S. holidays will be a further practical challenge.
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