[Federal Register Volume 87, Number 241 (Friday, December 16, 2022)]
[Proposed Rules]
[Pages 77172-77296]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2022-24376]
[[Page 77171]]
Vol. 87
Friday,
No. 241
December 16, 2022
Part II
Securities and Exchange Commission
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17 CFR Parts 270 and 274
Open-End Fund Liquidity Risk Management Programs and Swing Pricing;
Form N-PORT Reporting; Proposed Rule
Federal Register / Vol. 87, No. 241 / Friday, December 16, 2022 /
Proposed Rules
[[Page 77172]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 270 and 274
[Release Nos. 33-11130; IC-34746; File No. S7-26-22]
RIN 3235-AM98
Open-End Fund Liquidity Risk Management Programs and Swing
Pricing; Form N-PORT Reporting
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: The Securities and Exchange Commission (``Commission'') is
proposing amendments to its current rules for open-end management
investment companies (``open-end funds'') regarding liquidity risk
management programs and swing pricing. The proposed amendments are
designed to improve liquidity risk management programs to better
prepare funds for stressed conditions and improve transparency in
liquidity classifications. The amendments are also designed to mitigate
dilution of shareholders' interests in a fund by requiring any open-end
fund, other than a money market fund or exchange-traded fund, to use
swing pricing to adjust a fund's net asset value (``NAV'') per share to
pass on costs stemming from shareholder purchase or redemption activity
to the shareholders engaged in that activity. In addition, to help
operationalize the proposed swing pricing requirement, and to improve
order processing more generally, the Commission is proposing a ``hard
close'' requirement for these funds. Under this requirement, an order
to purchase or redeem a fund's shares would be executed at the current
day's price only if the fund, its designated transfer agent, or a
registered securities clearing agency receives the order before the
pricing time as of which the fund calculates its NAV. The Commission
also is proposing amendments to reporting and disclosure requirements
on Forms N-PORT, N-1A, and N-CEN that apply to certain registered
investment companies, including registered open-end funds (other than
money market funds), registered closed-end funds, and unit investment
trusts. The proposed amendments would require more frequent reporting
of monthly portfolio holdings and related information to the Commission
and the public, amend certain reported identifiers, and make other
amendments to require additional information about funds' liquidity
risk management and use of swing pricing.
DATES: Comments should be received on or before February 14, 2023.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's internet comment form (https://www.sec.gov/rules/submitcomments.htm); or
Send an email to [email protected]. Please include
File Number S7-26-22 on the subject line.
Paper Comments
Send paper comments to Vanessa A. Countryman, Secretary,
Securities and Exchange Commission, 100 F Street NE, Washington, DC
20549-1090.
All submissions should refer to File Number S7-26-22. This file number
should be included on the subject line if email is used. To help the
Commission process and review your comments more efficiently, please
use only one method of submission. The Commission will post all
comments on the Commission's website (https://www.sec.gov/rules/proposed.shtml). Comments are also available for website viewing and
printing in the Commission's Public Reference Room, 100 F Street NE,
Washington, DC 20549, on official business days between the hours of 10
a.m. and 3 p.m. Operating conditions may limit access to the
Commission's Public Reference Room. All comments received will be
posted without change. Persons submitting comments are cautioned that
we do not redact or edit personal identifying information from comment
submissions. You should submit only information that you wish to make
available publicly.
Studies, memoranda, or other substantive items may be added by the
Commission or staff to the comment file during this rulemaking. A
notification of the inclusion in the comment file of any such materials
will be made available on our website. To ensure direct electronic
receipt of such notifications, sign up through the ``Stay Connected''
option at www.sec.gov to receive notifications by email.
FOR FURTHER INFORMATION CONTACT: Mykaila DeLesDernier, Y. Rachel Kuo,
James Maclean, Nathan R. Schuur, Senior Counsels; Angela Mokodean,
Branch Chief; Brian M. Johnson, Assistant Director, at (202) 551-6792
or [email protected], Investment Company Regulation Office, Division of
Investment Management, Securities and Exchange Commission, 100 F Street
NE, Washington, DC 20549-8549.
SUPPLEMENTARY INFORMATION: The Commission is proposing to amend the
following rules and forms:
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\1\ 15 U.S.C. 80a-1 et seq. Unless otherwise noted, all
references to statutory sections are to the Investment Company Act,
and all references to rules under the Investment Company Act are to
title 17, part 270 of the Code of Federal Regulations [17 CFR part
270].
\2\ 15 U.S.C. 77a et seq.
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Commission reference CFR citation (17 CFR)
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Investment Company Act of 1940 (``Act'' or
``Investment Company Act''): \1\
Rule 22c-1............................... Sec. 270.22c-1.
Rule 22e-4............................... Sec. 270.22e-4.
Rule 30b1-9.............................. Sec. 270.30b1-9.
Rule 31a-2............................... Sec. 270.31a-2.
Form N-PORT.............................. Sec. 274.150.
Form N-CEN............................... Sec. 274.101.
Securities Act of 1933 (``Securities Act'')
\2\ and Investment Company Act:
Form N-1A................................ Sec. Sec. 239.15A and
274.11A.
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Table of Contents
I. Introduction
A. Open-End Funds and Existing Regulatory Framework
1. Liquidity Risk Management
2. Swing Pricing
B. March 2020 Market Events
C. Rulemaking Overview
II. Discussion
A. Amendments Concerning Funds' Liquidity Risk Management
Programs
[[Page 77173]]
1. Amendments to the Classification Framework
2. Highly Liquid Investment Minimums
3. Limit on Illiquid Investments
B. Swing Pricing
1. Proposed Swing Pricing Requirement
2. Amendments to Swing Threshold Framework
3. Determining Flows
4. Swing Factors
C. Hard Close
1. Purpose and Background
2. Pricing Requirements
3. Effects on Order Processing, Intermediaries and Investors,
and Certain Transaction Types
4. Other Proposed Amendments to Rule 22c-1
5. Amendments to Form N-1A
D. Alternatives to Swing Pricing and a Hard Close Requirement
1. Alternatives to Swing Pricing
2. Alternatives to a Hard Close
3. Additional Illustrative Examples
E. Reporting Requirements
1. Amendments to Form N-PORT
2. Amendments to Form N-CEN
F. Technical and Conforming Amendments
G. Exemptive Order Rescission and Withdrawal of Commission Staff
Statements
H. Transition Periods
III. Economic Analysis
A. Introduction
B. Baseline
1. Regulatory Baseline
2. Overview of Certain Industry Order Management Practices
3. Liquidity Externalities in the Mutual Fund Sector
4. Affected Entities
C. Benefits and Costs of the Proposed Amendments
1. Liquidity Risk Management Program
2. Swing Pricing
3. Hard Close Requirement
4. Commission Reporting and Public Disclosure
D. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
2. Competition
3. Capital Formation
E. Alternatives
1. Liquidity Risk Management
2. Swing Pricing
3. Hard Close Requirement
4. Commission Reporting and Public Disclosure
F. Request for Comment
IV. Paperwork Reduction Act
A. Introduction
B. Rule 22e-4
C. Rule 22c-1
D. Form N-PORT
E. Form N-1A
F. Form N-CEN
G. Request for Comment
V. Initial Regulatory Flexibility Analysis
A. Reasons for and Objectives of the Proposed Actions
B. Legal Basis
C. Small Entities Subject to the Amendments
D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Liquidity Risk Management Programs
2. Swing Pricing
3. Hard Close
4. Reporting Requirements
E. Duplicative, Overlapping, or Conflicting Federal Rules
F. Significant Alternatives
G. General Request for Comment
VI. Consideration of Impact on the Economy
Statutory Authority
I. Introduction
When the Investment Company Act was enacted, a primary concern was
the potential for dilution of shareholders' interests in open-end
investment companies.\3\ In addition, the ability of shareholders to
redeem their shares in an investment company on demand is a defining
feature of open-end investment funds.\4\ Section 22 of the Act reflects
these concerns and priorities. For example, section 22(c) gives the
Commission broad powers to regulate the pricing of redeemable
securities for the purpose of eliminating or reducing so far as
reasonably practicable any dilution of the value of outstanding fund
shares.\5\ Section 22(e) of the Act establishes a shareholder right of
prompt redemption in open-end funds by requiring such funds to make
payments on shareholder redemption requests within seven days of
receiving the request.\6\
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\3\ See 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 (stating that
among the abuses that served as a backdrop for the Act were
practices that resulted in substantial dilution of investors'
interests, including backward pricing by fund insiders to increase
investment in the fund and thus enhance management fees, but causing
dilution of existing investors in the fund) (statements of
Commissioner Healy and Mr. Bane).
\4\ See Investment Trusts and Investment Companies: Letter from
the Acting Chairman of the SEC, A Report on Abuses and Deficiencies
in the Organization and Operation of Investment Trusts and
Investment Companies (1939), at n.206 (``[T]he salient
characteristic of the open-end investment company. . .was that the
investor was given a right of redemption so that he could liquidate
his investment at or about asset value at any time that he was
dissatisfied with the management or for any other reason.''). An
open-end investment company is required to redeem its securities on
demand from shareholders at a price approximating their
proportionate share of the fund's net asset value (``NAV'') next
calculated by the fund after receipt of such redemption request. See
section 22 of the Act; rule 22c-1.
\5\ Section 22(c) of the Act authorizes the Commission to 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 related to the
method of computing purchase and redemption prices of redeemable
securities for the purpose of eliminating or reducing so far as
reasonably practicable any dilution of the value of other
outstanding securities of the fund or any other result of the
purchase or redemption that is unfair to investors in the fund's
other outstanding securities. See also section 22(a) of the Act
(authorizing a securities association registered under section 15A
of the Securities Exchange Act of 1934 (``Exchange Act'') similarly
to prescribe the prices at which a member may purchase or redeem an
investment company's redeemable securities for the purposes of
addressing dilution).
\6\ Section 22(e) of the Act provides, in part, that no
registered investment company shall suspend the right of redemption
or postpone the date of payment upon redemption of any redeemable
security in accordance with its terms for more than seven days after
tender of the security absent specified unusual circumstances.
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The open-end fund industry has grown significantly over the last
six years as more Americans rely on funds to gain exposure to financial
markets while having the ability to quickly redeem their
investments.\7\ At the end of 2021, assets in open-end funds (excluding
money market funds) were approximately $26 trillion, having grown from
about $15 trillion at the end of 2015.\8\ An estimated 102.6 million
Americans owned mutual funds at the end of 2021, up from an estimated
91 million individual investors at the end of 2015.\9\ Open-end funds
continue to be an important part of the financial markets, and as those
markets have grown more complex, some funds are pursuing more complex
investment strategies, including fixed income and
[[Page 77174]]
alternative investment strategies focused on less liquid asset classes.
For example, as of December 2021, bond funds had assets of more than $6
trillion, funds with alternative investment strategies had about $15
billion in assets, and bank loan funds had around $12 billion in
assets.\10\ Figure 1 below shows the amount of assets held by different
types of open-end funds.
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\7\ For purposes of this release, the term ``fund'' or ``open-
end fund'' generally refers to an open-end management investment
company registered on Form N-1A or a series thereof, excluding money
market funds, unless otherwise specified. Mutual funds and most
exchange-traded funds (``ETFs'') are open-end management companies
registered on Form N-1A. An open-end management investment company
is an investment company, other than a unit investment trust or
face-amount certificate company, that offers for sale or has
outstanding any redeemable security of which it is the issuer. See
sections 4 and 5(a)(1) of the Investment Company Act [15 U.S.C. 80a-
4 and 80a-5(a)(1)]. While a money market fund is an open-end
management investment company, money market funds generally are not
subject to the amendments we are proposing and thus are not included
when we refer to ``funds'' or ``open-end funds'' in this release
except where specified. Although unit investment trusts, like open-
end funds, issue redeemable securities, they are not included when
we refer to open-end funds in this release, unless otherwise
specified.
\8\ The $26 trillion figure is based on Form N-CEN filing data
as of Dec. 2021. Of the $26 trillion in assets, ETFs had $5.1
trillion in assets. See Investment Company Liquidity Risk Management
Programs, Investment Company Act Release No. 32315 (Oct. 13, 2016)
[81 FR 82142 (Nov. 18, 2016)] (``Liquidity Rule Adopting Release''),
at text accompanying n.1046 (estimating open-end fund assets of
approximately $15 trillion at the end of 2015).
\9\ See Investment Company Institute, 2022 Investment Company
Fact Book (2022) (``2022 ICI Fact Book''), at 44, available at
https://www.icifactbook.org/; Investment Company Institute, 2016
Investment Company Fact Book (2016), at 110, available at https://www.ici.org/fact-book. Retail investors hold the vast majority of
mutual fund net assets. See 2022 ICI Fact Book, at 48 (estimating
that retail investors held 88% of mutual fund assets at year end
2021). An estimated 13.9 million U.S. households held ETFs in 2021,
in addition to many institutional investors. See id. at 83.
\10\ Based on Morningstar data. Unless otherwise indicated, data
discussed throughout this section is based on Morningstar data. Bond
funds include funds that invest in taxable bonds (approximately $5.5
trillion in assets) and funds that invest in municipal bonds
(approximately $1 trillion in assets).
[GRAPHIC] [TIFF OMITTED] TP16DE22.000
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[GRAPHIC] [TIFF OMITTED] TP16DE22.001
Without effective liquidity risk management, a fund may not be able
to make timely payment on shareholder redemptions, and sales of
portfolio investments to satisfy redemptions may result in the dilution
of outstanding fund shares. Moreover, even when a fund is managing its
liquidity effectively, the transaction costs associated with meeting
redemption requests or investing the proceeds of subscriptions can
create dilution for fund shareholders. These concerns are particularly
heightened in times of stress or in funds invested in less liquid
investments. To that end, the ability of funds to meet investor
redemptions, while mitigating the impact of this redemption activity on
remaining shareholders, is an important aspect of the regulatory regime
for open-end funds.
Commission rules currently provide open-end funds with several
tools to mitigate dilution from shareholder purchase or redemption
activity and facilitate a fund's ability to meet shareholder
redemptions in a timely manner. These tools include a fund's liquidity
risk management program, the option to use swing pricing for certain
funds, the ability to impose purchase or redemption fees, and/or the
ability to redeem in kind.\11\ In March 2020, in connection with the
economic shock from the onset of the COVID-19 pandemic, U.S. open-end
funds faced a significant volume of investor redemptions.\12\ As
investors sought to redeem fund investments to free up cash during a
time of market uncertainty, open-end funds faced significant
redemptions and liquidity concerns.\13\
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\11\ See Liquidity Rule Adopting Release, supra note 8;
Investment Company Swing Pricing, Investment Company Act Release No.
32316 (Oct. 13, 2016) [81 FR 82084 (Nov. 18, 2016)] (``Swing Pricing
Adopting Release'').
\12\ See infra section I.B for a discussion of the fund flows
for different types of open-end funds during the Mar. 2020 period.
\13\ See infra section I.B discussing the events of Mar. 2020.
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In light of these events, we have reviewed the effectiveness of
funds' current tools for managing liquidity and limiting dilution,
including through staff outreach and review of information funds are
required to report to the Commission.\14\ We have identified weaknesses
in funds' liquidity risk management programs that can cause delays in
identifying liquidity issues in stressed periods and cause funds to
over-estimate the liquidity of their investments, as well as limited
use of tools such as redemption fees or swing pricing that are designed
to limit dilution resulting from a fund's trading of portfolio
investments in response to shareholder redemptions or purchases. As a
result, we are proposing amendments to enhance funds' liquidity risk
management to help better prepare them for stressed market conditions
and to require the use of swing pricing for certain funds in certain
circumstances to limit dilution. We believe the proposed amendments
would enhance open-end fund resilience in periods of market stress by
promoting funds' ability to meet redemptions in a timely manner while
limiting dilution of remaining shareholders' interests in the fund.
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\14\ The review consisted of outreach with funds, advisers, and
liquidity vendors that funds use to help classify the liquidity of
their investments. In addition, staff reviewed data provided on Form
N-PORT, Form N-CEN, and Form-RN.
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A. Open-End Funds and Existing Regulatory Framework
Open-end funds are a popular investment choice for investors
seeking to gain professionally managed, diversified exposure to the
capital
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markets while preserving liquidity.\15\ There are two kinds of open-end
funds: mutual funds and ETFs. Open-end funds offer investors daily
liquidity, but may invest in assets that cannot be liquidated quickly
without significantly affecting market prices. Since the 1940s, the
Commission has stated that open-end funds should maintain highly liquid
portfolios and recognized that this may limit their ability to
participate in certain transactions in the capital markets.\16\
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\15\ See Liquidity Rule Adopting Release, supra note 8. See also
supra note 9 and accompanying text (discussing an estimated number
of Americans who invest in mutual funds).
\16\ See Investment Trusts and Investment Companies: Report of
the Securities and Exchange Commission (1942), at 76 (``Open-end
investment companies, because of their security holders' right to
compel redemption of their shares by the company at any time, are
compelled to invest their funds predominantly in readily marketable
securities. Individual open-end investment companies, therefore, as
presently constituted, could participate in the financing of small
enterprises and new ventures only to a very limited extent.'').
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While the Act requires open-end funds to pay redemptions within
seven days, as a practical matter most investors expect to receive
redemption proceeds in fewer than seven days. For example, many mutual
funds represent in their prospectuses that they will pay redemption
proceeds on the next business day after the redemption. In addition,
open-end funds redeemed through broker-dealers must meet redemption
requests within two business days because of rule 15c6-1 under the
Exchange Act, which establishes a two-day (T+2) settlement period for
trades effected by broker-dealers.\17\
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\17\ The Commission has proposed to amend rule 15c6-1 to
establish a T+1 settlement period for broker-dealer trades. See
Shortening the Securities Transaction Settlement Cycle, Exchange Act
Release No. 34-94196 (Feb. 9, 2022) [87 FR 10436 (Feb. 24, 2022)].
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In terms of pricing, an order to purchase or redeem fund shares
must receive a price based on the current NAV next computed after
receipt of the order.\18\ Open-end funds typically calculate their NAVs
once a day. Purchase and redemption requests submitted throughout the
day receive the NAV calculated at the end of that day, which is
typically calculated as of 4 p.m. ET.\19\ These provisions are designed
to promote equitable treatment of fund shareholders when buying and
selling fund shares.
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\18\ Rule 22c-1 under the Act. The process of calculating or
``striking'' the NAV of the fund's shares on any given trading day
is based on several factors, including the market value of portfolio
securities, fund liabilities, and the number of outstanding fund
shares, among others. Rule 2a-4 requires, when determining the NAV,
that funds reflect changes in holdings of portfolio securities and
changes in the number of outstanding shares resulting from
distributions, redemptions, and repurchases no later than the first
business day following the trade date. As indicated in the adopting
release for rule 2a-4, this calculation method provides funds with
additional time and flexibility to incorporate last-minute portfolio
transactions into their NAV calculations on the business day
following the trade date, rather than on the trade date. See
Adoption of Rule 2a-4 Defining the Term ``Current Net Asset Value''
in Reference to Redeemable Securities Issued by a Registered
Investment Company, Investment Company Act Release No. 4105 (Dec.
22, 1964) [29 FR 19100 (Dec. 30, 1964)].
\19\ Commission rules do not require that a fund calculate its
NAV at, or as of, a specific time of day. Current NAV must be
computed at least once daily, subject to limited exceptions, Monday
through Friday, at the pricing time set by the board of directors.
See rule 22c-1(b)(1).
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A characteristic of open-end funds is that fund shareholders share
the gains and losses of the fund, as well as the costs. As a result,
there are circumstances in which the transaction activity of certain
investors leads to costs that are distributed across all shareholders,
unfairly reducing the value (or ``diluting'') the interests of
shareholders who did not engage in the underlying transactions. For
example, while redemption orders receive the next computed NAV, the
fund may incur costs on subsequent days to meet those redemptions,
because the fund may engage in trading activity and make other changes
in its portfolio holdings over multiple business days following the
redemption order. As a result, the costs of providing liquidity to
redeeming investors can be borne by the remaining investors in the fund
and dilute the interests of non-redeeming shareholders. Similarly, when
shareholders purchase shares in the fund, costs may arise when the fund
buys portfolio investments to invest the proceeds of the purchase, and
the fund and its shareholders may bear those costs in days following
the purchase request, diluting the interests of the non-purchasing
shareholders.
Transaction costs associated with redemptions or purchases can
vary. The less liquid the fund's portfolio holdings, the greater the
liquidity costs associated with redemption and purchase activity can
become and the greater the possibility of dilution effects on fund
shareholders. For example, during times of heightened market volatility
and wider bid-ask spreads for the fund's underlying holdings, selling
fund investments to meet investor redemptions results in greater costs
to the fund. Moreover, funds also incur transaction costs outside of
stressed periods. Although these costs would generally be smaller than
in times of heighted market volatility, they also are borne by fund
investors and, particularly over time, also can result in dilution.
In times of liquidity stress, there may be incentives for
shareholders to redeem fund shares quickly to avoid further losses, to
redeem fund shares for cash in times of uncertainty, or to obtain a
``first-mover'' advantage by avoiding anticipated trading costs and
dilution associated with other investors' redemptions. This perceived
advantage may lead to increasing outflows, further exacerbating the
effect on remaining shareholders and incentivizing increased
shareholder redemptions. Whether investors redeem because they need
cash or want to capitalize on a first-mover advantage, the remaining
investors in the fund may, particularly in times of stress, experience
dilution of their interests in the fund.
1. Liquidity Risk Management
In 2016, the Commission adopted rule 22e-4 under the Act (the
``liquidity rule'') to require open-end funds to adopt and implement
liquidity risk management programs. Rule 22e-4 was designed to address
concerns that open-end funds investing in less liquid securities may
have difficulty meeting redemption requests without significant
dilution of remaining investors' interests in the fund.\20\ Rule 22e-4
requires: (1) assessment, management, and periodic review of a fund's
liquidity risk; (2) classification of the liquidity of each of a fund's
portfolio investments into one of four prescribed categories--ranging
from highly liquid investments to illiquid investments--including at-
least-monthly reviews of these classifications; (3) determination and
periodic review of a highly liquid investment minimum for certain
funds; (4) limitation on illiquid investments; and (5) board oversight.
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\20\ See Liquidity Rule Adopting Release, supra note 8, at
section II.B.
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Funds are also subject to related reporting requirements. For
example, funds must report the liquidity classifications of their
holdings confidentially to the Commission on Form N-PORT. A fund also
must immediately report to the Commission on Form N-RN and to the
fund's board if its portfolio becomes more than 15% illiquid, as well
as if the fund breaches a highly liquid investment minimum
[[Page 77177]]
established as part of its liquidity risk management program for seven
consecutive days.\21\ While the compliance dates for specific
provisions of rule 22e-4 varied, most funds were required to be in
compliance with all requirements of the rule in 2019.\22\
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\21\ Form N-RN was previously titled Form N-LIQUID. See Use of
Derivatives by Registered Investment Companies and Business
Development Companies, Investment Company Act Release No. 34084
(Nov. 2, 2020) [85 FR 83162 (Dec. 21, 2020)] (``Derivatives Adopting
Release'').
\22\ Small entities were required to be in compliance with the
reporting requirements under Form N-PORT by Mar. 1, 2020. See
Investment Company Liquidity Disclosure, Investment Company Act
Release No. 33142 (June 28, 2018) [83 FR 31859 (July 10, 2018)]
(``2018 Liquidity Disclosure Adopting Release'').
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In 2018, the Commission adopted amendments designed to improve the
reporting and disclosures of liquidity information by open-end
funds.\23\ These amendments modified certain aspects of the liquidity
framework by requiring funds to disclose information about the
operation and effectiveness of their liquidity risk management program
in their shareholder reports instead of requiring funds to disclose
aggregate liquidity classifications publicly in Form N-PORT.\24\ Since
that time, some individual investors have stated that they care about
being able to redeem but do not need narrative information about how a
fund manages its liquidity, while some other commenters have suggested
that aggregate liquidity classifications would be more helpful than
narrative shareholder report disclosure.\25\ We recently removed the
narrative disclosure requirement because, in practice, it did not
meaningfully augment other information already available to
shareholders.\26\
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\23\ Id.
\24\ The Commission also adopted amendments to Form N-PORT to
allow funds classifying the liquidity of their investments pursuant
to their liquidity risk management programs to report multiple
liquidity classification categories for a single position under
specified circumstances. See 2018 Liquidity Disclosure Adopting
Release, supra note 22.
\25\ See infra notes 303 to 305 and accompanying text
(discussing these comments in more detail).
\26\ See Tailored Shareholder Reports for Mutual Funds and
Exchange-Traded Funds; Fee Information in Investment Company
Advertisements, Investment Company Act Release No. 34731 (Oct. 26,
2022) (``Tailored Shareholder Reports Adopting Release'') at nn.462-
472 and accompanying text.
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When the Commission adopted the 2018 amendments, it stated that
Commission staff would continue to monitor and solicit feedback on the
implementation of the liquidity framework and inform the Commission
what steps, if any, the staff recommends in light of this
monitoring.\27\ The Commission stated its expectation that this
evaluation would take into account at least one full year's worth of
liquidity classification data from large and small entities to allow
funds and the Commission to gain experience with the classification
process and to allow analysis of its benefits and costs based on actual
practice. As discussed below, we have had the opportunity since the
adoption of these amendments to evaluate the liquidity framework while
taking into account the data available to us regarding funds' liquidity
risk management programs.\28\ We discuss our evaluation of the current
liquidity framework throughout this release.
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\27\ See 2018 Liquidity Disclosure Adopting Release, supra note
22, at paragraph accompanying n.125.
\28\ See infra sections I.B and II.A.
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2. Swing Pricing
In 2016, the Commission adopted a rule permitting registered open-
end funds (except money market funds or ETFs), under certain
circumstances, to use swing pricing, which is the process of adjusting
the price above or below a fund's NAV per share to effectively pass on
the costs stemming from shareholder purchase or redemption activity to
the shareholders associated with that activity.\29\ When a shareholder
purchases or redeems fund shares, the price of those shares does not
typically account for the transactions costs, including trading costs
and changes in market prices, that may arise when the fund buys
portfolio investments to invest proceeds from purchasing shareholders
or sells portfolio investments to meet shareholder redemptions.\30\
Swing pricing is an investor protection tool currently available to
funds to mitigate potential dilution and manage fund liquidity as a
result of investor redemption and purchase activity.
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\29\ Swing Pricing Adopting Release, supra note 11; rule 22c-
1(a)(3).
\30\ See Swing Pricing Adopting Release, supra note 11, at
section II.A.1.
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The 2016 swing pricing rule requires that, for funds choosing to
use swing pricing, the fund's NAV is adjusted by a specified amount
(the ``swing factor'') once the level of net purchases into or net
redemptions from the fund has exceeded a specified percentage of the
fund's NAV (the ``swing threshold''). A fund's swing factor is
permitted to take into account only the near-term costs expected to be
incurred by the fund as a result of net purchases or net redemptions on
that day and may not exceed an upper limit of 2% of the NAV per share.
The rule also requires a fund that uses swing pricing to adopt swing
pricing policies and procedures that specify the process for
determining the fund's swing factor and swing threshold. The fund's
board must approve the fund's swing pricing policies and procedures,
the fund's swing factor upper limit, and the swing threshold. The board
also must review a written report on the adequacy and effectiveness of
the fund's swing pricing policies and procedures at least annually.
In the time since the adoption of the rule, no U.S. funds have
implemented swing pricing. While swing pricing has been a commonly
employed anti-dilution tool in Europe, including among U.S.-based fund
managers that also operate funds in Europe, U.S. funds face unique
operational obstacles in its implementation. When considering the
adoption of the 2016 swing pricing rule, the Commission received
comment letters articulating the operational issues that funds may
encounter if they implemented swing pricing.\31\ In response to the
concerns raised by commenters, the Commission adopted an extended
effective date to allow for the creation of industry-wide operational
solutions to facilitate the implementation of swing pricing more
effectively. In that release, the Commission stated that it had
directed Commission staff to review, two years after the rule's
effective date, market practices associated with funds' use of swing
pricing to mitigate dilution and to provide the Commission with the
results of its review.\32\ Since that time, we have evaluated market
practices associated with funds' lack of use of swing pricing, and this
release reflects that evaluation. Despite over five years passing since
adoption, the industry has not developed an operational solution to
facilitate implementation of swing pricing, nor have individual market
participants.\33\
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\31\ See Comment Letter of BlackRock on Open-End Fund Liquidity
Risk Management Programs; Swing Pricing; Re-Opening of Comment
Period for Investment Company Reporting Modernization Release,
Investment Company Act File No. 31835 (Sep. 22, 2015) [80 FR 62274
(Oct. 15, 2015)] (``2015 Proposing Release''), File No. S7-16-15;
Comment Letter of Dodge & Cox on 2015 Proposing Release, File No.
S7-16-15; Comment Letter of Pacific Investment Management Company
LLC on 2015 Proposing Release, File No. S7-16-15; Comment Letter of
Securities Industry and Financial Markets Association on 2015
Proposing Release, File No. S7-16-15. The comment file for the 2015
Proposing Release, where these comment letters can be accessed, is
available at https://www.sec.gov/comments/s7-16-15/s71615.shtml.
\32\ See Swing Pricing Adopting Release, supra note 11, at
section II.A.1.
\33\ After the Commission adopted the current swing pricing
rule, the industry formed working groups to explore potential
operational solutions to facilitate funds' ability to implement
swing pricing. See Evaluating Swing Pricing: Operational
Considerations, Addendum (June 2017), available at https://www.ici.org/system/files/attachments/ppr_17_swing_pricing_summary.pdf (``2017 ICI Swing Pricing White
Paper'').
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[[Page 77178]]
We understand that the industry has been unable to develop an
operational solution to implement swing pricing largely because funds
currently are unable to obtain sufficient fund flow information before
they finalizes their NAVs, a necessary precursor to determining whether
a fund needs to use swing pricing on any particular day. Generating
fund flow information involves a broad network of market participants
with multiple layers of systems, including, among others, funds,
transfer agents, broker-dealers, retirement plan recordkeepers, banks,
and the National Securities Clearing Corporation (``NSCC''). In
general, many mutual funds use prices as of 4 p.m. ET (or the ``pricing
time'') to value the funds' underlying holdings for purposes of
computing their NAVs for the current day. This time is established by
the fund's board of directors. Typically, investors may place orders to
purchase or redeem mutual fund shares with the fund's transfer agent or
with intermediaries as late as 3:59 p.m. ET for execution at that day's
NAV. When the transfer agent or an intermediary receives an order
before the pricing time, that order typically receives that day's
price. An investor who submits an order after the pricing time must
receive the next day's price.
While some investors may place orders by opening an account
directly with the fund's transfer agent, we understand that the
majority of mutual fund orders are placed with intermediaries, such as
broker-dealers, banks, and retirement plan recordkeepers.\34\ Some
intermediaries do not transmit flow details to the fund's transfer
agent or the clearing agency until after the fund has finalized its NAV
calculation and disseminated the NAV to pricing vendors, media, and
intermediaries (``NAV dissemination''). NAV dissemination tends to
occur between 6 p.m. ET and 8 p.m. ET. Indeed, the fund's transfer
agent or the clearing agency often do not receive a significant portion
of orders until after midnight--i.e., the next day.\35\ This
contributes to a mismatch between the extent of flow information funds
require to implement swing pricing and the flow information funds
currently have before the pricing time. For example, based on staff
outreach, we understand that some funds receive only around half of
their daily volume by 6 p.m. ET.\36\ We are also aware of a separate
review of funds' receipt of flow data for a quarter in 2016, which
found that only 70% of actual and estimated trade flow could be
delivered by 6 p.m. ET.\37\ Without sufficient actual or estimated flow
information before the fund finalizes its NAV, funds cannot implement
swing pricing because the determination of whether to swing the fund's
NAV depends on the size of net flows.
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\34\ In 2021, an estimated 18% of U.S. households owning mutual
funds purchased them directly from the mutual fund company. See 2022
ICI Fact Book, supra note 9, at Figure 7.8.
\35\ NSCC currently is the only registered clearing agency for
fund shares. A significant portion of mutual fund orders are
processed through NSCC's Fund/SERV platform. See Depositary Trust
and Clearing Corporation 2021 Annual Report, available at https://www.dtcc.com/annuals/2021/performance/dashboard (stating that the
value of transactions Fund/SERV processed in 2021 was $8.5 trillion
and the volume for this period was 261 million transactions). A part
of the platform, referred to as Defined Contribution Clearance &
Settlement, focuses on purchase, redemption, and exchange
transactions in defined contribution and other retirement plans.
This service handled a volume of nearly 154 million transactions in
2021. See id.
\36\ We understand based on staff outreach that the time by
which a fund receives flow information varies to some extent based
on the fund's investor base. For example, funds with large
investments by retirement plans generally receive a larger portion
of their flow information after 6 p.m. ET than other funds.
\37\ See 2017 ICI Swing Pricing White Paper, supra note 33
(stating that, for instance, intermediaries trading via traditional
Fund/SERV, such as traditional brokerage and managed account
activity, transmit orders to the fund by 7 p.m. ET but, with system
and procedural enhancements, processing and submission of orders as
actual trades might be able to occur prior to 6 p.m. ET). This paper
also suggested that 90% to 100% of trade flow (actual or estimated)
is required to apply swing pricing between 4 p.m. and 6 p.m. ET.
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B. March 2020 Market Events
In March 2020, at the onset of the COVID-19 pandemic in the United
States, most segments of the open-end fund market witnessed large-scale
investor outflows. Investors' concerns about the potential impact of
the COVID-19 pandemic led investors to reallocate their assets into
cash and short-dated, near-cash investments.\38\ The resulting outflows
from many open-end funds placed pressure on these funds to generate
liquidity quickly in order to meet investor redemptions. Equity and
debt security prices fell as yields rose. Uncertainty throughout the
U.S. economy and asset-price volatility rose, and credit spreads and
bid-ask spreads widened.\39\ The large outflows open-end funds faced
during March 2020, combined with the widening bid-ask spreads funds
encountered when purchasing or selling portfolio investments at that
time, likely contributed to dilution of the value of funds' shares for
remaining investors.\40\
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\38\ See SEC Staff Report on U.S. Credit Markets
Interconnectedness and the Effects of the COVID-19 Economic Shock
(Oct. 2020) (``SEC Staff Interconnectedness Report''), at 17 to 18,
available at https://www.sec.gov/files/US-Credit-Markets_COVID-19_Report.pdf. Staff reports and other staff documents (including
those cited herein) represent the views of Commission staff and are
not a rule, regulation, or statement of the Commission. The
Commission has neither approved nor disapproved the content of these
documents and, like all staff statements, they have no legal force
or effect, do not alter or amend applicable law, and create no new
or additional obligations for any person.
\39\ See id., at 3 and 6 to 8 (discussing that the market
structure of certain segments of the credit market contributed to
market stress in Mar. 2020, including reduced dealer inventories and
reluctance to accommodate customer demand in some cases). On Apr. 1,
2020, the Board of Governors of the Federal Reserve System
(``Federal Reserve'') made a temporary change to its supplementary
leverage ratio rule to allow banking organizations to expand their
balance sheets as appropriate to continue to serve as financial
intermediaries, stating that the rule's regulatory restrictions may
constrain the firms' ability to continue to serve as financial
intermediaries and to provide credit to households and businesses in
the face of rapid deteriorations in Treasury market liquidity
conditions and significant inflows of customer deposits and
increased reserve levels. See Federal Reserve Board Announces
Temporary Changes to its Supplementary Leverage Ratio Rule to Ease
Strains in the Treasury Market Resulting from the Coronavirus and
Increase Banking Organizations' Ability to Provide Credit to
Households and Businesses (Apr. 1, 2020), available at https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm.
\40\ We do not have specific data about the dilution fund
shareholders experienced in Mar. 2020 because funds do not report
information about their trading activity and the prices at which
they purchase and sell each instrument. However, European funds
experienced similar market conditions as U.S. funds and, to mitigate
dilution during this period, many European funds increased their use
of swing pricing and the size of their swing factors. See infra
paragraph accompanying note 60. European funds are subject to
regulatory regimes that differ in some respects from the U.S. regime
for open-end funds. We are not aware, however, of differences
between the regimes that would have significantly reduced dilution
for U.S. funds relative to European funds during this period, such
that European funds needed to use swing pricing to mitigate dilution
that U.S. funds were not experiencing due to regulatory or other
differences.
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Open-end funds are a large and important component of U.S. markets.
At the end of 2019, assets in open-end funds totaled $21 trillion.\41\
Fixed-income funds accounted for $5.3 trillion, or 25% of total open-
end fund assets.\42\ Bank loan assets were nearly $100 billion, or less
than 2% of total fixed-income fund assets. At the end of March 2020,
following the height of the COVID-19 related market stress, assets in
open-end funds (including ETFs) fell
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\41\ Of this amount, ETFs had assets of $4.4 trillion and other
open-end funds had assets of $16.4 trillion. Money market funds and
funds of funds are excluded from calculations relating to the size
and redemptions of open-end funds.
\42\ Fixed-income funds, excluding ETFs, had assets of $4.5
trillion, and fixed-income ETFs had assets of $800 billion.
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[[Page 77179]]
17% ($3.6 trillion) from $20.8 trillion in December 2019 to a total of
$17.2 trillion. Assets of open-end funds excluding ETFs fell 18% ($2.9
trillion) from $16.4 trillion to $13.5 trillion, and ETF assets fell
17% (approximately $760 billion) from $4.4 trillion to $3.7 trillion.
Of this amount, fixed-income mutual fund assets fell 5.5%, although
fixed-income ETFs' assets increased slightly.\43\ In addition, bank
loan fund assets fell by 30% in March 2020, or from $100 billion to $70
billion, compared to the level of assets reported in December 2019.
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\43\ Fixed-income funds, excluding ETFs, had assets of
approximately $4.1 trillion, while fixed-income ETFs' assets
increased slightly from Dec. 2019 levels to $830 billion.
[GRAPHIC] [TIFF OMITTED] TP16DE22.002
[[Page 77180]]
The market disruptions of the March 2020 period included
significant redemption activity in open-end funds.\44\ Throughout 2019,
net flows into open-end funds averaged approximately $32.4 billion, or
0.2% per month.\45\ During this same period, fixed-income funds
experienced a steady inflow of approximately $41.7 billion, or 0.9% per
month on average.\46\ In March 2020, however, open-end funds had
outflows totaling $329.4 billion, or 1.7% of prior period assets.\47\
The majority of these outflows were from fixed-income funds, which had
$286.6 billion in outflows.\48\ Taxable bond funds had outflows of
$241.7 billion (or 5.2% of prior period assets), of which, bank loan
funds had outflows of $12.4 billion (or 13.4% of prior period assets in
these funds).\49\ Municipal bond funds had $44.9 billion in outflows
(or 4.9% of prior period assets).\50\
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\44\ Open-end funds also experienced heightened outflows in
other stressed periods, such as the last quarter of 2008, but
outflows in March 2020 surpassed those witnessed in these other
periods. For example, during the last quarter of 2008, investors
withdrew $65 billion from bond funds. Total outflows for bond funds
during this period never exceeded 1.5% of total net assets. See ICI,
2009 Investment Company Fact Book, Figure 2.10 and accompanying
text, available at https://www.ici.org/system/files/attachments/2009_factbook.pdf (calculating net flows as a three-month moving
average of net flows as a percentage of previous month-end assets,
and excluding high yield bond funds).
\45\ Open-end funds (excluding ETFs) had average net flows of
approximately $4.8 billion (or 0.04% per month). ETFs had average
net flows of approximately $27.7 billion (or 0.7% per month).
\46\ Fixed-income funds (excluding ETFs) had inflows of $28.8
billion (or 0.7% per month on average). Fixed-income ETFs had
inflows of $12.5 billion (or 1.7% per month on average).
\47\ Open-end funds (excluding ETFs) had outflows totaling
$336.8 billion, or 1.7% of prior period assets. ETFs had inflows
totaling $7.3 billion, or 2% of prior period assets. The majority of
ETF inflows were for equity ETFs, which had $14.7 billion in
inflows. Allocation, alternative, commodity, and miscellaneous/other
ETFs had inflows of $13.2 billion. The inflows into some types of
ETFs were partially offset by outflows of $20.6 billion from fixed-
income ETFs.
\48\ Open-end funds (excluding ETFs) had outflows of
approximately $266 billion, and ETFs had outflows of approximately
$20.6 billion.
\49\ For open-end funds (excluding ETFs) this included outflows
of $223.3 billion (5.9%) for taxable bond funds (of which, bank loan
funds had outflows of $11.4 billion (13.6%)). For ETFs this included
outflows of $18.4 billion (2.2%) for taxable bond ETFs (of which,
bank loan ETFs had outflows of approximately $1 billion (11.2%))
\50\ For open-end funds (excluding ETFs) this included outflows
of $42.6 billion (5%) for municipal bond funds. For ETFs this
included outflows of $2.2 billion (4.3%) for municipal bond ETFs.
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[[Page 77181]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.003
During the period of market turmoil, bid-ask spreads spiked by as
much as 100 basis points for high-yield bonds and 150-200 basis points
for investment-grade bonds.\51\ In general, the bond market and bank
loan market experienced significant price declines in March 2020. The
price for 10 year U.S. Treasuries increased by roughly 4.6%. The price
of corporate bonds declined by 7%.\52\ The price of leveraged loans
decreased by roughly 13%.\53\ The heightened volatility and demand for
liquidity drove stress throughout the market, particularly in the bond
fund and bank loan fund markets. Price declines were not limited to
these markets, however. For example, the price for U.S. small cap
equities decreased by roughly 24%.\54\
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\51\ See SEC Staff Interconnectedness Report, supra note 38, at
37.
\52\ The decline in the price of corporate bonds is measured by
the BBG U.S. Corporate Bond Index.
\53\ The decline in the price of leveraged loans was measured by
the S&P Leveraged Loan Price Index.
\54\ The decline in the price of U.S. small cap equities was
measured by the Russell 2000 Total Return Index.
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[[Page 77182]]
Beginning in mid-March 2020, the Federal Reserve, with the approval
of the Department of the Treasury, used its emergency powers to
intervene by providing timely and sizable interventions in an effort to
stabilize the markets. The official sector interventions included,
among others, the Secondary Market Corporate Credit Facility,
introduced on March 23, 2020. This facility supported market liquidity
by purchasing in the secondary market corporate bonds issued by
investment grade U.S. companies, as well as U.S.-listed ETFs whose
investment objective is to provide broad exposure to the market for
U.S. corporate bonds.\55\
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\55\ See, e.g., Press Release, Federal Reserve Announces
Extensive New Measures to Support the Economy (Mar. 23, 2020),
available at https://www.federalreserve.gov/newsevents/pressreleases/monetary20200323b.htm; https://www.federalreserve.gov/monetarypolicy/smccf.htm (describing the Secondary Market Corporate
Credit Facility in particular).
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After the Federal Reserve announced that it would be using its
emergency powers for official sector interventions, market stress
relating to the COVID-19 pandemic began to subside. Assets in open-end
funds, including fixed income funds, began to increase. By December
2020, open-end fund assets had increased to $24 trillion, with fixed-
income funds (excluding ETFs) reaching $6 trillion in assets, and
fixed-income ETFs surpassing $1 trillion in assets.\56\ Bank loan fund
assets remained essentially unchanged, however, from March 2020 levels
and remained at $68 billion.
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\56\ From Apr. to Dec. 2020, fixed-income funds averaged $75
billion in inflows, or 1.4% per month. Ultrashort and short-term
bond funds experienced average monthly inflows of $16 billion and 2%
of assets over this period.
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Other Observations From March 2020
Beyond data evidencing the liquidity stress funds faced in March
2020, we also observed the stress through staff outreach to the
industry. During this period, fund managers discussed their liquidity
concerns with Commission staff and the potential need for emergency
relief. Fund managers explored various emergency relief actions. For
example, some fund managers requested emergency relief that would
provide additional flexibility for interfund lending and other short-
term funding to help meet redemptions, which the Commission
provided.\57\ Some managers suggested emergency relief to permit funds
to impose redemption fees that exceed 2% to mitigate dilution,
including fees that ETFs can charge authorized participants to cover
liquidity and transaction costs.\58\ Some fund managers that have
successfully used swing pricing in Europe urged the Commission to
explore emergency actions to facilitate funds' ability to
operationalize the Commission's current swing pricing rule. Some fund
managers also suggested there was a need for Federal Reserve
interventions. These discussions indicated that fund managers sought
additional means to quickly address liquidity and dilution concerns
during this period of financial stress.
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\57\ See Order Under Sections 6(c), 12(d)(1)(J), 17(b), 17(d)
and 38(b) of the Investment Company Act of 1940 and Rule 17d-1
Thereunder Granting Exemptions from Specified Provisions of the
Investment Company Act and Certain Rules Thereunder, Investment
Company Act Release No. 33821 (Mar. 23, 2020), available at https://www.sec.gov/rules/other/2020/ic-33821.pdf. Although the Commission
provided this relief for a period of time, we understand funds
generally did not use it.
\58\ ETFs typically externalize the costs associated with
purchases and redemptions of shares by redeeming in kind and by
charging a fixed and/or variable fee to authorized participants to
offset both transfer and other transaction costs that an ETF (or its
service provider) may incur, as well as brokerage, tax-related,
foreign exchange, execution, market impact, and other costs and
expenses related to the execution of trades resulting from such
transaction. The amount of these fixed and variable fees typically
depends on whether the authorized participant effects transactions
in kind or with cash and is related to the costs and expenses
associated with transactions effected in kind versus in cash. For
example, when an authorized participants redeems ETF shares by
selling a creation unit to the ETF, the fees that the ETF imposes
defray the costs of liquidity the redeeming authorized participant
receives. This, in turn, mitigates the risk of diluting non-
redeeming authorized participants when an ETF redeems its shares.
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During these conversations, several fund managers with operations
in both the U.S. and Europe discussed their experience with swing
pricing in Europe and indicated that swing pricing would have been a
useful tool for U.S. funds to have had in March 2020. Swing pricing was
widely used in several European jurisdictions during the March 2020
stressed period to reduce dilution from rising transaction costs.\59\
In these jurisdictions, some funds used partial swing pricing (where a
NAV adjustment occurs only if net flows exceed a swing threshold), some
funds used full swing pricing (where a NAV adjustment occurs any time a
fund has net inflows or net outflows), and some funds did not use swing
pricing. Many European funds increased their use of swing pricing and
increased the size of their swing factors during the stressed period.
For example, a voluntary survey conducted by the Bank of England and
Financial Conduct Authority of a subset of fund managers in the United
Kingdom (``UK'') indicated that the use of swing pricing more than
doubled from the last quarter of 2019 to the first quarter of 2020.\60\
Due to increasing transaction costs, several European funds lowered
their swing thresholds in March 2020, with some moving to full swing
pricing for net redemptions.\61\ Funds also increased the size of their
swing factors to account for the increase in liquidity and transaction
costs. For example, a survey of Luxembourg UCITS found that while the
average swing factor for the survey sample hovered around zero before
the turmoil, it increased by more than 100 basis points on average
during the market stress.\62\ The survey of UK-authorized
[[Page 77183]]
funds similarly found that the size of swing factors increased during
this period and that some funds that had capped the size of their swing
factors needed to temporarily remove these caps.\63\ In terms of the
effects of using swing pricing during March 2020, one study found that
swing pricing allowed surveyed funds to recoup roughly 0.06% of total
net assets on average from redeeming investors during three weeks of
elevated redemptions in March 2020.\64\
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\59\ Funds in countries such as Luxembourg, Ireland, the United
Kingdom, and the Netherlands had implemented swing pricing and it
was well-established market practice. In Mar. 2020, funds in some
countries, such as France, Spain, and Germany, had more recently
begun to employ swing pricing as an anti-dilution method. See
Lessons from COVID-19: Liquidity Risk Management and Open-Ended
Funds, BlackRock ViewPoint (Jan. 2021), available at https://www.blackrock.com/corporate/literature/whitepaper/viewpoint-addendum-lessons-from-covid-liquidity-risk-management-is-central-to-open-ended-funds-january-2021.pdf.
\60\ See Liquidity management in UK open-ended funds: Report
based on a joint Bank of England and Financial Conduct Authority
survey (Mar. 2021), available at https://www.bankofengland.co.uk/report/2021/liquidity-management-in-uk-open-ended-funds (``Bank of
England Survey''). The increase in the use of partial and full swing
pricing included the increase in the number of funds using swing
pricing as well as the increase in the frequency of its use for
funds that already used swing pricing. The survey also found that
some funds did not use swing pricing or other tools during the
period because, for example, net outflows of certain funds were
below levels at which they would consider applying swing pricing or
other tools.
\61\ See id. (stating that, out of a total of 202 surveyed funds
that were authorized to use swing pricing, 45 funds decided to
reduce their swing threshold during this period, including 18 funds
that switched temporarily to full swing pricing during the market
stress); ICI, Experiences of European Markets, UCITS, and European
ETFs During the COVID-19 Crisis (Dec. 2020), available at https://www.ici.org/doc-server/pdf%3A20_rpt_covid4.pdf (``Respondents
reported that some UCITS lowered their partial swing thresholds
during March to take into consideration the impact flows could have
on investors from increased transaction costs in underlying markets.
. . Some UCITS using partial swing pricing lowered their threshold
for redemptions to zero in March (which is equivalent to full swing
pricing) in response to market volatility that had caused bid-ask
spreads to widen on underlying securities.''); Claessens, Stijn, and
Lewrick, Ulf, ``Open-ended bond funds: systemic risks and policy
implications'' (Dec. 2021) available at https://www.bis.org/publ/qtrpdf/r_qt2112c.pdf (stating that, in a survey of 57 Luxembourg
actively managed bond UCITS based on a supervisory data collection,
these funds lowered swing thresholds on average from net outflows of
1% of total net assets before Mar. 2020 to less than 0.5% of total
net assets) (``Claessens and Lewrick''). See also CSSF Working
Paper: An Assessment of Investment Funds' Liquidity Management Tools
(June 2022), available at https://www.cssf.lu/en/2022/06/publication-of-cssf-working-paper-an-assessment-of-investment-funds-liquidity-management-tools/(``CSSF Paper'').
\62\ See Claessens and Lewrick, supra note 61; CSSF Paper, supra
note 61 (stating that ``[t]he average swing factor of the 42 bond
funds participating in the CSSF survey increased by more than 100
basis points on average during Mar. 2020 (the median and maximum
swing factor were 60 and 350 basis points, respectively)'').
\63\ See Bank of England Survey, supra note 60 (stating that of
the 17 surveyed funds that had a cap on their swing factors, which
ranged from 0.25% to 3%, 13 funds temporarily removed the caps in
response to heightened outflows and a few managers overrode the
caps). We also understand that in response to funds' requests to use
swing factors above their disclosed caps, some jurisdictions
provided guidance on when this is permitted. See Commission de
Surveillance du Secteur Financier, Swing Pricing Mechanism--FAQ,
available at https://www.cssf.lu/en/Document/cssf-faq-swing-pricing-mechanism/ (providing guidance for increasing the swing factor above
the maximum level identified in a fund's prospectus under certain
circumstances, and noting that typical maximum swing factors
observed in fund prospectuses are between 1% and 3%).
\64\ See Claessens and Lewrick, supra note 61.
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We also observed funds' liquidity risk management in March 2020
through funds' filings with the Commission and other staff outreach.
Specifically, during and following the market events of March 2020,
Commission staff assessed liquidity-related data reported on Forms N-
PORT and N-RN, as well as the development of liquidity risk management
programs through staff outreach to funds, advisers, and liquidity
classification vendors.\65\ Based on review of Form N-PORT filings for
February and March 2020, approximately two-thirds of funds did not
appear to reclassify any investment held in both months despite the
market events described above.\66\ We saw that reclassifications
increased from 25% of funds that held the same investment in both
January and February 2020 to 33% of funds in March 2020, and stayed
elevated for April 2020. We understand that many fund and liquidity
vendor classification models use data lookback periods of 30 days or
more that made them slowly adjust to changing market conditions,
leaving these firms unable to consider their classifications and
reclassify when market conditions changed quickly. In addition, we
understand that classification models generally tend to assess
liquidity based on relatively small sale sizes that do not necessarily
reflect the amount a fund may need to sell to meet heightened levels of
redemptions in stress periods, and most models do not automatically
adjust to a higher trade size when market conditions change. Moreover,
our data indicate that in March 2020 cash levels in the aggregate
increased and relatively few funds made use of borrowing to meet
redemptions, suggesting that funds generally were selling portfolio
assets to meet redemptions and potentially for other purposes, such as
to raise cash in anticipation of future redemptions. During March 2020,
more than a dozen funds (primarily fixed-income funds) filed reports on
Form N-RN. Most of these Form N-RN filings related to breaches of the
15% limit on illiquid investments.
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\65\ The Mar. 2020 data collected on Form N-PORT often was not
available to the Commission until June or July 2020 because a fund
files data covering each month of its fiscal quarter on Form N-PORT
no later than 60 days after the end of each fiscal quarter.
\66\ See infra note 128 (discussing that fewer equity funds
reported reclassifications of investments held in both Feb. and Mar.
2020 than fixed-income funds).
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Overall, the market events in March 2020 show how liquidity can
deteriorate rapidly and significantly. In the face of such rapid market
changes, liquidity risk management program features of some funds
adjusted slowly, making them less effective during the stress period
for managing liquidity risk. Additionally, tools, such as swing
pricing, that may have helped open-end funds limit dilution as both
transaction costs and redemptions rose were unavailable because of
operational challenges, although these tools were used in other
jurisdictions during this period.
C. Rulemaking Overview
In March 2020, some open-end funds were not prepared for the sudden
market stress that arose after many years of relative calm and, as the
market stress and outflows grew, several funds began to explore
emergency relief requests or suggest a need for government intervention
in an effort to withstand or alleviate liquidity stress, address
dilution, and improve overall market conditions. The period of market
stress in March 2020 was relatively brief ending upon Federal Reserve
interventions, and no funds sought to suspend redemptions during this
period. We believe there are meaningful lessons from this period that
our rules should reflect, while also recognizing the possibility that
future stressed periods--whether specific to certain funds or the
markets as a whole--may be more protracted or more severe than March
2020, particularly absent Federal Reserve action. Fundamentally, we
believe funds should be better prepared for future stressed conditions,
which can occur suddenly and unexpectedly, and should have well-
functioning tools for managing through stress without significantly
diluting the interests of their shareholders. We are proposing
amendments to rules 22e-4 and 22c-1 that are designed to achieve these
key objectives and to reflect our experience with the rules since they
were adopted, as well as supporting amendments to Form N-PORT and other
reporting and disclosure forms.
Specifically, recognizing that it can be difficult to predict when
market stress will occur, the proposed amendments to rule 22e-4 would
require funds to incorporate stress into their liquidity
classifications by assuming the sale of a stressed trade size, which
would be 10% of each portfolio investment, rather than the rule's
current approach of assuming the sale of a ``reasonably anticipated
trade size'' in current market conditions. Requiring a fund's
classification model to assume the sale of larger-than-typical position
sizes may better emulate the potential effects of stress on the fund's
portfolio, similar to an ongoing stress test, and help better prepare a
fund for future stress or other periods where the fund faces higher
than typical redemptions. The proposal also would establish other
minimum standards for classifying the liquidity of an investment, which
are designed to improve the quality of classifications by preventing
funds from over-estimating the liquidity of their investments and to
provide clearer guideposts for liquidity classifications, reflecting
the more effective practices we have observed.
In addition, we propose to remove the less liquid investment
category and to treat these investments as illiquid. The less liquid
category consists of investments that can be sold in seven calendar
days but that take longer to settle. For example, many bank loans take
longer than seven days to settle. The proposed amendment is designed to
reduce the mismatch between the receipt of cash upon the sale of assets
with longer settlement periods and the payment of shareholder
redemptions. This would better position funds to meet redemptions,
including in times of stress. Currently, treating these investments as
``less liquid''--as opposed to ``illiquid''--allows funds to invest in
these assets beyond the 15% limit on illiquid investments,
notwithstanding that ``less liquid'' investments settle beyond the
statutory seven-day period to pay redemptions. We are also proposing to
amend the definition of illiquid investment to
[[Page 77184]]
include investments whose fair value is measured using an unobservable
input that is significant to the overall measurement. We understand
many funds classify these investments as illiquid today.
We also propose to require daily liquidity classifications. We
believe this change would promote better monitoring of a fund's
liquidity and an ability to more rapidly understand and respond to
changes that affect the liquidity of the fund's portfolio, including
the fund's compliance with its highly liquid investment minimum and the
rule's limit on illiquid investments.
As another means to prepare funds for stressed conditions, we are
proposing to amend the highly liquid investment minimum provisions in
the rule to require all funds to determine and maintain a minimum
amount of highly liquid assets of at least 10% of net assets. This
aspect of the proposal is designed to ensure that funds have sufficient
liquid investments for managing heightened levels of redemptions.
Finally, we are proposing amendments to how the highly liquid
investment minimum calculation and the calculation of the 15% limit on
illiquid investments take into account the value of assets that are
posted as margin or collateral for certain derivatives transactions to
reflect that the fund cannot access the value of posted assets to meet
redemptions until the fund is able to exit the derivatives
transactions.
In addition, to reduce shareholder dilution during stress and other
periods, we are proposing to amend rule 22c-1 to require all open-end
funds, other than ETFs and money market funds, to implement swing
pricing. Today, no fund has implemented swing pricing, and funds rarely
use redemption fees to address dilution other than in the case of
short-term trading of fund shares, meaning shareholders may experience
dilution both in normal and stressed conditions, particularly when
purchases or redemptions are large or when funds invest in markets with
high transaction costs relative to other markets.\67\ We believe swing
pricing is an important and effective tool for dynamically addressing
such dilution by recognizing that costs associated with shareholder
purchases and redemptions rise as net flows increase and liquidity and
transaction costs grow.
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\67\ Based on an analysis of fund prospectuses, approximately
551 open-end funds (or around 4.6% of funds) state that they apply
redemption fees under certain circumstances for at least one share
class of the fund. Approximately 3.3% of fund classes have a
redemption fee, or 0.6% of net fund assets.
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In addition to proposing mandatory swing pricing, we are proposing
to amend the swing pricing framework in rule 22c-1 to apply lessons
learned from March 2020, including information about the European
experience with swing pricing during that period. Specifically, we
propose to amend both when and how a fund would adjust its NAV, which
would vary depending on whether a fund has net purchases or net
redemptions. Rather than require funds to determine their own swing
thresholds, we propose to specify the amount of net inflows or net
outflows that would trigger a pricing adjustment in the rule, informed
by an analysis of historical flow amounts.
In addition, we propose a specific method of calculating the swing
factor price adjustment, which would require a fund to make good faith
estimates of the transaction costs of selling or purchasing a pro rata
amount of its portfolio investments (or a ``vertical slice'') to
satisfy that day's redemptions or to invest the proceeds from that
day's purchases. Under the proposal, a fund would be required to apply
a swing factor on any day it has net redemptions. When net redemptions
exceed 1% of net assets, the swing factor would also account for market
impacts of selling a vertical slice of the portfolio to capture the
dilutive effect of trading in response to large outflows better. We
believe trading in response to small levels of net inflows is less
likely to have a dilutive effect than trading in response to net
outflows and, as a result, we propose to require a fund to apply a
swing factor for net purchases only if net purchases exceed 2% of net
assets. In addition, we propose to remove the 2% swing factor upper
limit from the current rule because we are proposing a more specific
framework for determining swing factors, some European funds used swing
factors above 2% in order to mitigate dilution in March 2020, and we
received requests for emergency relief in the United States during this
period to allow funds to charge redemptions fees exceeding 2% to
mitigate dilution. The proposed swing pricing amendments are designed
to reduce the dilution of an investor's interest in a fund that is
caused by the redemption or purchase activity of other investors in the
fund and to fairly allocate the costs associated with redemption and
purchase activity. These amendments also may reduce potential first-
mover advantages that might incentivize early redemptions to avoid
anticipated trading costs and dilution associated with other investors'
redemptions.
To operationalize the proposed swing pricing requirement and
provide other benefits, we are also proposing to amend rule 22c-1 to
require that the fund, its transfer agent, or a registered clearing
agency receive purchase and redemption orders by an established cut-off
time to receive a given day's price (a ``hard close''). Specifically,
for an order to be eligible to receive a day's price, these designated
parties would have to receive the order before the pricing time, which
is typically 4 p.m. ET. The proposed hard close would facilitate the
receipt of timely flow information to inform swing pricing decisions.
In addition, we believe it would help prevent late trading and reduce
operational risk.
To promote transparency related to fund liquidity and use of swing
pricing, we are proposing amendments to Form N-PORT to require funds to
report their aggregate liquidity classifications publicly, as well as
the frequency and amount of swing pricing adjustments. With respect to
liquidity disclosure, this amendment is designed to provide investors
with meaningful information about fund liquidity, taking into account
that our proposed amendments to the liquidity classification framework
should result in more objective and comparable liquidity
classifications across funds.\68\ As for the proposed swing pricing
reporting requirements, we believe the proposed frequency and size
information would allow investors to better understand the operation
and effects of swing pricing.
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\68\ In certain cases, investors consume reported information
indirectly through other data users. These other data users can
include, for example, regulators such as the Commission, fund
analysts, and third-party data providers. Throughout this release,
references to consumption of information by investors include
indirect consumption by investors enabled by other data users.
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We also propose broader changes to Form N-PORT to require all
registered investment companies that report on the form, which include
open-end funds (other than money-market funds), registered closed-end
funds, and ETFs registered as unit investment trusts, to file monthly
reports with the Commission within 30 days of month-end. These monthly
reports would subsequently be publicly available 60 days after month-
end. These proposed amendments would require filers to provide the
Commission with more timely information and would provide investors
with access to monthly rather than quarterly information. We observed
in March 2020 that timely and full disclosure can be particularly
important
[[Page 77185]]
during and immediately after stress events. Finally, we propose
amendments to Forms N-PORT, N-CEN, and N-1A to, among other things,
conform to our other proposed amendments and to improve entity
identifiers.
Taken together, these proposed amendments are designed to provide
investors with increased protection regarding how liquidity in their
funds is managed, thereby reducing the risk that funds will be unable
to meet redemptions and mitigating dilution of the interests of fund
shareholders. These reforms also are intended to give investors
information to make more informed investment decisions, and to give the
Commission more timely information to conduct comprehensive oversight
of an ever-evolving fund industry.
II. Discussion
A. Amendments Concerning Funds' Liquidity Risk Management Programs
1. Amendments to the Classification Framework
Rule 22e-4 currently requires a fund to classify each portfolio
investment based on the number of days within which it reasonably
expects the investment would be convertible to cash, sold or disposed
of, without significantly changing its market value.\69\ Under this
framework, funds must, using information obtained after reasonable
inquiry and taking into account relevant market, trading, and
investment-specific considerations, classify each portfolio investment
into one of four liquidity classifications: highly liquid, moderately
liquid, less liquid, and illiquid.\70\ A fund may generally classify
and review its investments by asset class unless the fund or adviser
has information about any market, trading, and investment-specific
considerations that it reasonably expects to significantly affect the
liquidity characteristics of an investment compared to the fund's other
portfolio holdings within that asset class.\71\ In classifying its
investments, a fund must analyze the number of days that it reasonably
expects it would take to sell, or convert to cash, portions of a
position in a particular investment or asset class that the fund would
reasonably anticipate trading (the ``reasonably anticipated trade
size'') without significantly changing its market value (``value
impact'').\72\ A fund must review its liquidity classifications at
least monthly in connection with reporting the liquidity classification
for each investment on Form N-PORT, and more frequently if changes in
relevant market, trading, and investment-specific considerations are
reasonably expected to materially affect one or more of its
investments' classifications.\73\
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\69\ In-kind ETFs are included when we refer to ``funds'' or
``open-end funds'' throughout this release when discussing rule 22e-
4, except in the sections discussing classifying the liquidity of a
fund's investments and the highly liquid investment minimum
requirement, from which in-kind ETFs are excepted. See proposed rule
22e-4(a) (defining ``in-kind ETF'' as an ETF that meets redemptions
through in-kind transfers of securities, positions, and assets other
than a de minimis amount of U.S. dollars and that publishes its
portfolio holdings daily); see also rule 22e-4(b)(1)(ii) and 22e-
4(b)(1)(iii). In-kind ETFs do not present the same kind of liquidity
risks as other funds because the redeeming shareholder typically
bears the direct costs associated with its liquidity needs. See
Liquidity Rule Adopting Release, supra note 8, at paragraphs
accompanying n.842.
\70\ See rule 22e-4(b)(1)(ii).
\71\ See rule 22e-4(b)(1)(ii)(A).
\72\ See rule 22e-4(b)(1)(ii)(B) (requiring a fund to determine
whether trading varying portions of a position in sizes that the
fund would reasonably anticipate trading is reasonably expected to
significantly affect its liquidity). The definition of each
liquidity category sets out the number of days in which a fund
reasonably expects to sell, or convert to cash, an investment
without significantly changing its market value. See rule 22e-
4(a)(6), rule 22e-4(a)(8), rule 22e-4(a)(10), and rule 22e-4(a)(12).
\73\ See rule 22e-4(b)(1)(ii).
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The liquidity classifications are integral to rule 22e-4. Among
other things, these classifications help a fund monitor its liquidity,
including compliance with the fund's highly liquid investment minimum
and the 15% limit on illiquid investments.\74\ The fund's
classifications also provide liquidity information to the Commission
and, under our proposal, to the public.
---------------------------------------------------------------------------
\74\ See rule 22e-4(b)(1)(iii) and rule 22e-4(b)(1)(iv).
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The current rule allows funds considerable discretion in how funds
determine the classification of investments.\75\ Funds may choose which
investments to classify individually or by asset class, with the
composition of asset classes determined by the fund. Funds also may use
different reasonably anticipated trade sizes and have different
standards for evaluating value impact. Through staff outreach, we
observed that funds had varied approaches in their classifications
processes. The proposed amendments to the liquidity classifications are
intended to better prepare funds for future stressed conditions. For
example, the reasonably expected trade sizes and value impact standards
some funds and liquidity classification vendors used tended to over-
estimate a fund's liquidity in March 2020 because they considered
relatively smaller trade sizes or used value impact methodologies with
longer lookback periods.
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\75\ See Liquidity Rule Adopting Release, supra note 8, at n.163
and accompanying text (stating that the primary goals of the
liquidity rule program requirements were to reduce the risk that
funds would be unable to meet redemption and other legal
obligations, minimize dilution, and elevate the overall quality of
liquidity risk management across the fund industry while at the same
time providing funds with reasonable flexibility to adopt policies
and procedures that would be most appropriate to assess and manage
their liquidity risk).
---------------------------------------------------------------------------
Based on our observations from March 2020 and our review of funds'
liquidity risk management practices and classifications, we are
proposing amendments to the classification framework. The proposed
amendments would provide additional standards for making liquidity
determinations, amend certain aspects of the liquidity categories, and
require more frequent liquidity classifications. Specifically, we
propose to provide objective minimum standards that funds would use to
classify investments, including by: (1) requiring funds to assume the
sale of a set stressed trade size, rather than the rule's current
approach of assuming the sale of a reasonably anticipated trade size in
current market conditions; and (2) defining the value impact standard
with more specificity on when a sale or disposition would significantly
change the market value of an investment. We also propose to remove
classification by asset class. These proposed amendments are designed
to improve the quality of classifications by preventing funds from
over-estimating the liquidity of their investments, including in times
of stress, and to provide classification standards that are consistent
with more effective practices the staff has observed. In addition, a
more objective and comparable framework for how funds classify the
liquidity of their investments would enhance the Commission's ability
to analyze trends across funds' classifications and establish the
groundwork for classification information that investors could use to
analyze and compare funds.
We also propose to remove the less liquid investment category,
which would reduce the number of liquidity categories from four to
three, and expand the scope of the illiquid investment category. We
believe these changes would reduce the risk of a fund not being able to
meet shareholder redemptions. Finally, we propose to require daily
classifications, which we believe would promote better monitoring by
liquidity risk program administrators of a fund's liquidity and an
ability to more rapidly understand
[[Page 77186]]
and respond to changes that affect the liquidity of the fund's
portfolio.\76\
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\76\ See rule 22e-4(a)(13) (defining ``person(s) designated to
administer the program'', in part, as the investment adviser,
officer, or officers responsible for administrating the program).
---------------------------------------------------------------------------
Table 1 sets forth the primary proposed changes to the rule's
liquidity classification framework, which are described in more detail
below.
Table 1--Proposed Changes to the Liquidity Classifications
------------------------------------------------------------------------
Liquidity classifications
and related terms Current rule 22e-4 Proposed rule 22e-4
------------------------------------------------------------------------
Definitions
------------------------------------------------------------------------
Highly Liquid Investment.... Any cash held by a Any U.S. dollars
fund and any held by a fund and
investment that the any investment that
fund reasonably the fund reasonably
expects to be expects to be
convertible into convertible to U.S.
cash in current dollars in current
market conditions market conditions
in three business in three business
days or less days or less
without the without
conversion to cash significantly
significantly changing the market
changing the market value of the
value of the investment.
investment.
Moderately Liquid Investment Any investment that Any investment that
the fund reasonably is neither a highly
expects to be liquid investment
convertible into nor an illiquid
cash in current investment.
market conditions
in more than three
calendar days but
in seven calendar
days or less,
without the
conversion to cash
significantly
changing the market
value of the
investment.
Less Liquid Investment...... Any investment that Removed.
the fund reasonably
expects to be able
to sell or dispose
of in current
market conditions
in seven calendar
days or less
without the sale or
disposition
significantly
changing the market
value of the
investment, but
where the sale or
disposition is
reasonably expected
to settle in more
than seven calendar
days.
Illiquid Investment......... Any investment that Any investment that
the fund reasonably the fund reasonably
expects cannot be expects not to be
sold or disposed of convertible to U.S.
in current market dollars in current
conditions in seven market conditions
calendar days or in seven calendar
less without the days or less
sale or disposition without
significantly significantly
changing the market changing the market
value of the value of the
investment. investment and any
investment whose
fair value is
measured using an
unobservable input
that is significant
to the overall
measurement.
Convertible to Cash/U.S The ability to be The ability to be
Dollars. sold, with the sale sold or disposed
settled. of, with the sale
or disposition
settled in U.S.
dollars.
------------------------------------------------------------------------
Related Concepts
------------------------------------------------------------------------
Assumed Trade Size.......... Sizes that the fund 10% of the fund's
would reasonably net assets by
anticipate trading. reducing each
investment by 10%.
Value Impact Standard....... Significantly Significantly
changing the market changing the market
value of the value of an
investment. investment means:
(1) For shares
listed on a
national securities
exchange or a
foreign exchange,
any sale or
disposition of more
than 20% of average
daily trading
volume of those
shares, as measured
over the preceding
20 business days.
(2) For any other
investment, any
sale or disposition
that the fund
reasonably expects
would result in a
decrease in sale
price of more than
1%.
------------------------------------------------------------------------
a. Stressed Trade Size and Significant Changes in Market Value
i. Replacing Reasonably Anticipated Trade Size With Stressed Trade Size
Currently, when a fund makes liquidity classifications under rule
22e-4, it must determine whether trading varying portions of a position
in a particular portfolio investment or asset class, in sizes that the
fund would reasonably anticipate trading, is reasonably expected to
significantly affect its liquidity.\77\ This determination of a
reasonably anticipated trade size helps a fund analyze market depth.
For example, if a fund anticipates trading a large investment position
relative to the market's total trading volume, the size of the trade
might affect liquidity and price.\78\
---------------------------------------------------------------------------
\77\ See rule 22e-4(b)(1)(ii)(B).
\78\ See Liquidity Rule Adopting Release, supra note 8, at
paragraphs accompanying n.440 and n.450.
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Using a small reasonably anticipated trade size to analyze market
depth leads to a more liquid classification, as a smaller position can
be sold more quickly without significantly affecting the investment's
liquidity than a larger position. In contrast, using a larger
reasonably anticipated trade size would often lead to less liquid
classifications. Under the current rule, a fund may determine its own
reasonably anticipated trade size, and we have observed wide variation
in practice.\79\ From staff outreach, we observed that funds may
consider a variety of different factors, such as their flow history,
flow trends of other similar funds, and shareholder makeup and
concentration,
[[Page 77187]]
and a fund may weigh the importance of those factors differently to
determine what it would reasonably anticipate trading. We believe that
using a reasonably anticipated trade size based on these, or a subset
of these factors, may not help funds prepare for future stressed
conditions. Even if a fund increased its reasonably anticipated trade
size during periods of stress, the resulting adjustments in the fund's
liquidity risk management may be too late to help the fund prepare for
the stressed environment and, thus, may have limited utility.
---------------------------------------------------------------------------
\79\ See SEC staff Investment Company Liquidity Risk Management
Programs Frequently Asked Questions (Apr. 10, 2019) (``Liquidity
FAQs''), available at https://www.sec.gov/investment/investment-company-liquidity-risk-management-programs-faq for discussion of
factors funds may consider in determining reasonably anticipated
trading size. The Commission has observed that many funds have set
reasonably anticipated trade size values at 3%. Others have set
values of below 3% and up to 100%, signifying wide variation.
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In response to the variability in funds' reasonably anticipated
trade sizes and the potential ineffectiveness of small trade sizes in
helping a fund prepare for stress, we propose to require funds to
assume the sale of a set stressed trade size. Specifically, for a fund
to determine the liquidity classification of each investment, we
propose that it must measure the number of days in which the investment
is reasonably expected to be convertible to U.S. dollars without
significantly changing the market value of the investment, while
assuming the sale of 10% of the fund's net assets by reducing each
investment by 10%.\80\ The proposed stressed trade size may result in
funds classifying fewer investments as highly liquid, and may increase
the number of investments that are subject to the 15% limit on illiquid
investments. These changes, in turn, may lead some funds to rebalance
their portfolio holdings to comply with the proposed changes, which
could negatively affect the performance of these funds. However, a lack
of preparation for higher than normal redemptions also can negatively
affect fund performance when such redemptions occur.\81\ We believe
that requiring a fund's classification model to assume the sale of
larger-than-typical position sizes would better emulate the potential
effects of stress on the fund's portfolio, similar to an ongoing stress
test, and help better prepare a fund for future stress or other periods
where the fund faces higher than typical redemptions.
---------------------------------------------------------------------------
\80\ The liquidity classifications define the number of days as
business days for highly liquid investments or calendar days for
illiquid investments. See Table 1. See also rule 22e-4(a)(2)
(defining ``business day'' to exclude customary business holidays).
\81\ See Liquidity Rule Adopting Release, supra note 8, at
paragraphs accompanying nn.109 and 110 (stating that staff had
observed that some funds with more thorough liquidity risk
management practices appeared to be able to better meet periods of
higher than typical redemptions without significantly altering their
risk profile or materially affecting their performance, while some
funds with substantially less rigorous liquidity risk management
practices experienced particularly poor performance compared with
their benchmark when faced with higher than normal redemptions).
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Based on an analysis of weekly flows of equity and fixed-income
funds over a period of more than ten years, outflows greater than 6.6%
occurred 1% of the time in a pooled sample across weeks and funds.\82\
Based on this analysis, we estimate that a random fund in a random week
has approximately a 0.5% chance of experiencing redemptions in excess
of the 10% stressed trade size, and there were 3.4% of weeks where more
than 1% of funds experienced net redemptions exceeding the proposed
stressed trade size. We believe that weekly outflows at the 99th
percentile is a useful approximation of the level of outflows funds may
experience in future stressed conditions.\83\ However, because it is
difficult to predict future stress events, including the effect and
length of such events--particularly without official sector
interventions--we believe it is appropriate to require funds to use a
stressed trade size amount of 10%, which is moderately higher than the
6.6% weekly outflow figure discussed above. We also considered, during
this same historical period, equity and fixed-income funds had weekly
inflows of greater than 8% for 1% of the time in a pooled sample across
weeks and funds. In addition, large, concentrated inflows have the
possibility of translating to similarly large outflows. For example, if
the large inflows are the result of investment by an institutional
investor or a fund's inclusion in a model portfolio, the fund may
experience similarly large outflows if the investor mandate changes or
if the fund is removed from the model portfolio.
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\82\ Based on an analysis of historical Morningstar weekly fund
flow data for equity and fixed income funds from 2009 through 2021.
See infra sections III.B.4.a and III.C.1.a.i (providing additional
equity and fixed income flow data and discussing this analysis in
more detail). While some Morningstar data is available for 2008, we
have not included that data in our historical flow analyses in this
release because of gaps in the 2008 data (e.g., the 2008 dataset
covers a more limited set of funds). Other available flow
information for 2008, such as from the ICI Fact Book, is not
granular enough for purposes of our analyses.
\83\ We believe weekly outflows is a better proxy for the
stressed trade size than daily outflows because stressed conditions
may take some time to fully present in flows and often result in
outflows that continue over several days or more.
---------------------------------------------------------------------------
Under the proposed approach, a fund would apply its stressed trade
size to each investment to determine its liquidity classifications. We
have observed that funds generally determine and apply a reasonably
anticipated trade size to each investment or asset class currently
(commonly referred to as pro rata or vertical slice methods). We have
also observed, however, that some funds have applied the reasonably
anticipated trade size in such a manner that the trading would be
satisfied largely by selling the fund's most liquid investments,
resulting in smaller assumed trade sizes for purposes of classifying
the fund's less liquid investments.\84\ As recognized above, small
assumed sale sizes can result in more liquid classifications generally,
as sales of small amounts are less likely to affect the market value of
the investment significantly and typically can be converted to U.S.
dollars more quickly. We are particularly concerned that use of small
assumed sale sizes for non-highly liquid investments can overstate the
liquidity of these investments and reduce the effectiveness of a fund's
liquidity risk management program when a fund needs to sell a larger-
than-assumed portion to meet redemptions under stressed conditions or
for any other portfolio management reason. Requiring funds to apply the
10% stressed trade size to each investment would better prepare funds
to manage their liquidity in stressed conditions, when a fund may be
required to sell positions that are larger than the assumed sale sizes
some funds are using currently. The amendments to replace the
determination of a reasonably anticipated trade size with a stressed
trade size are designed to enhance a fund's preparation for stressed
conditions, including the potential for sizeable outflows.
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\84\ See Liquidity Rule Adopting Release, supra note 8, at
paragraph accompanying n.1084. We do not suggest that a fund should
only, or primarily, use its most liquid investments to meet
shareholder redemptions. See id., at n.661 and accompanying
paragraph.
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We request comment on the proposed requirement for funds to apply a
stressed trade size to each investment in their liquidity
classification determinations:
1. Should we require funds to use a stressed trade size, as
proposed? Would the change from reasonably anticipated trade size to
stressed trade size materially change the proportion of investments
classified in a given liquidity category? If yes, how? Would the
proposed stressed trade size affect certain types of funds more than
others? Would the proposed stressed trade size be likely to overstate
or understate liquidity?
2. Is the proposed stressed trade size of 10% appropriate? If not,
what minimum trade size would be appropriate and why? For example,
should we increase or decrease the stressed trade size to, for example,
15% or 5% or some other threshold? Is there
[[Page 77188]]
other data that should factor into setting the stressed trade size?
3. Should the stressed trade size vary for different types of funds
and, if so, how? For instance, should the stressed trade size be a
function of the fund's flow history, such as the 99th percentile
highest week of the fund's absolute or net flows over a given period
(e.g., 3 years, 5 years, 10 years, or the life of the fund)? Should the
stressed trade size be the higher of a specified value applied to each
investment or the 99th percentile highest week of absolute flows?
4. Should the method of applying the stressed trade size to each
investment vary for different types of funds and, if so, how? Are there
types of investments that should be excluded or use a different
stressed trade size? Are there other, more appropriate methods of
applying a stressed trade size across different type of investments and
portfolios?
5. Instead of establishing a set stressed trade size, should we set
a minimum stressed trade size and provide factors for determining if a
fund should have a higher stressed trade size? If so, what factors
should funds consider in setting their stressed trade size?
ii. Determining a Significant Change to Market Value
Currently, when a fund makes liquidity classifications under rule
22e-4, it must analyze whether a sale or disposition would
significantly change the market value of the investment. In the
adopting release for rule 22e-4, the Commission explained that this
value impact analysis captures the risk of a fund only being able to
meet redemption requests in a manner that significantly dilutes the
non-redeeming shareholders.\85\ The Commission established the value
impact standard to capture the risk of dilution in cases of inadequate
liquidity, while not requiring funds to account for every possible
value movement.\86\ We propose to establish a minimum value impact
standard that defines more specifically what constitutes a significant
change in market value.\87\ We believe the proposed change would
improve the quality of funds' liquidity classifications by preventing
funds from over-estimating the liquidity of their investments and would
improve comparability of funds' liquidity classifications. In addition,
the proposed approach is consistent with more effective practices we
have observed from some funds and liquidity classification vendors, as
discussed below.
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\85\ See Liquidity Rule Adopting Release, supra note 8, at
paragraph accompanying n.334.
\86\ See id., at paragraph accompanying n.339.
\87\ See proposed rule 22e-4(a) (definition of ``Significantly
changing the market value of an investment'').
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Under the current rule, a fund may determine value impact in a
variety of ways, depending on the type of asset, or vendor, model, or
system used. There also is variation in the depth and sophistication of
funds' analyses. We believe the variation in how a fund may determine
value impact leads to differences in the quality of funds'
classifications, limits comparability of funds' classifications across
the same or similar investments, and may cause funds to over-estimate
the liquidity of their investments.
The proposed definition of a significant change in market value
would require a fund to consider the size of the sale relative to the
depth of the market for the instrument.\88\ This would vary depending
on the type of investment. For shares listed on a national securities
exchange or a foreign exchange, we believe selling or disposing of more
than 20% of the security's average daily trading volume would indicate
a level of market participation that is significant.\89\ We understand
that if a fund sold more than 20% of the average daily trading volume
of a listed equity security, such a large sale is likely to result in a
significant change in the security's market value, which would dilute
remaining investors in the fund. We have observed that a standard based
on average daily trading volume is consistent with practices many funds
and vendors apply for assessing value impact for listed equity
investments today.\90\ To determine average daily trading volume, we
propose to require funds to measure the average daily trading volume
over the preceding 20 business days. We believe using a period of 20
business days provides an appropriate measure of daily trading volume,
which would reflect current market conditions as well as consider a
period of recent market history. The 20 business day period is intended
to strike a balance between longer periods that are less reflective of
current conditions and shorter periods that can be skewed easily by an
abnormally high or low volume day. For purposes of measuring average
daily trading volume, the preceding 20 business days include those days
where U.S. markets are open but where one or more international markets
are closed, such as ``Golden Week,'' a week in Japan including multiple
Japanese public holidays. A fund would count these and any other
trading days where shares were not traded as zero volume days for the
relevant investment.
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\88\ The proposed rule would continue to provide that an
investment's classification is based on a fund's reasonable
expectations in current market conditions. See Liquidity Rule
Adopting Release, supra note 8, at section III.C.1.d (discussing
comments and suggestions on the consideration of market conditions).
Thus, a fund would be able to rely on its reasonable expectations at
the time it makes the value impact assessment. Although we are
proposing to require funds to assume an element of stressed
conditions in their liquidity classifications through the stressed
trade size, a broader requirement to predict how an investment may
trade in stressed market conditions would introduce additional
variables into the classification process that could increase the
risk of misclassifications and decrease the data quality of funds'
liquidity-related reporting and disclosure.
\89\ Under this proposal, the sale or disposition must be below
20% of the security's average daily trading volume. A fund may
choose to impose a stricter limitation of any percentage under 20%,
for example, 15% of average daily trading volume.
\90\ Through staff outreach, we observed many funds using some
percent of average daily trading volume (e.g., 15%, 20%, or 25%)
that the fund's investment can represent if it wants to be able to
sell into daily volume without affecting market prices. In practice,
this meant funds would estimate the number of days it would take to
sell or dispose of the reasonably anticipated trade size without
approaching the set percentage of average daily trading volume to
avoid impacting the value significantly. We observed funds
calculating the average daily trading volume taking into account
different sources, and for different time periods, ranging from 10
days to 6 months.
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For any investments other than shares listed on a national
securities exchange or a foreign exchange, such as fixed-income
securities and derivatives, we propose to define a significant change
in market value as any sale or disposition that a fund reasonably
expects would result in a decrease in sale price of more than 1%. Funds
currently use a variety of methods to determine significant changes in
market value in fixed-income securities, taking into account different
groups of comparable securities, asset class characteristics and
volatility, number and depth of market makers, bid-offer spread size,
volume of the security or similar securities, and elasticity of prices
in the security or similar securities. For purposes of the proposed
rule, a decrease of more than 1% would indicate a level of value impact
that is significant because the fund is selling or disposing of a
relatively large position or because the market for the investment has
constricted, and bid-ask spreads have widened. We also understand that
several commonly employed liquidity models currently use this price
decrease measure. We acknowledge that not all liquidity models specify
a price decrease explicitly as the determination for a significant
change in market value and some funds would have to make changes to
convert to this more
[[Page 77189]]
objective threshold. The proposed value impact standard would improve
funds' abilities to perform quality checks and back testing and would
allow the Commission to better analyze classification data across
funds.
In considering whether a sale is reasonably expected to result in a
price decrease of more than 1%, the fund would be required to consider
the size of the sale relative to the depth of the market for the
instrument. As part of that analysis, we believe a fund generally
should consider, among other things, the width of bid-offer spreads.
This is because the width of bid-offer spreads is an important
consideration in analyzing the costs of selling a security and thus
whether a sale would result in a price decrease exceeding 1%. For
example, a sale would be more likely to result in a price decline of
more than 1% if the trade size is large in relation to the market for
that instrument or if bid-ask spreads are wide, or if both are the
case. Wide, or widening, bid-ask spreads may indicate a lower level of
demand for the instrument, which makes it more likely that a sale of
the instrument would result in a price decline of more than 1%.
We request comment on our proposed definition of significant change
in market value:
6. Would funds have to make significant changes to their liquidity
classification methodologies to reflect the proposed amendments to the
value impact standard? If so, what effect would those changes have on a
fund's liquidity risk management program?
7. Should we define value impact through average daily trading
volume or price decline, as proposed? Should we use a different
definition of value impact instead, and if so, should it depend on the
type of investment? Should different types of funds have different
value impact standards? If yes, what standards, and for what types of
funds?
8. For shares listed on a national securities exchange or a foreign
exchange, should we define a significant change in market value as
selling or disposing of more than 20% of the average daily trading
volume, as proposed? Are there other types of investments for which an
average daily trading volume test would be appropriate? For example, is
there data available for fixed-income securities that funds could use
objectively to analyze market participation under a value impact
standard?
9. Should the percent of average daily trading volume be higher or
lower (e.g., 15% or 25%)? Should the measurement period for the average
daily trading volume be longer or shorter than the proposed 20 business
days (e.g., 10, 30, or 40 business days)? Should days where shares were
not traded be counted as zero volume days as proposed or in some other
manner? Are there circumstances in which the average daily trading
volume test should vary by instrument, type of instrument, or trading
venue?
10. For investments that are not listed on a national securities
exchange or foreign exchange, should we define a significant change in
market value as any sale or disposition that the fund reasonably
expects would result in a price decline of more than 1%, as proposed?
Should the identified percentage be higher or lower (e.g., 0.5% or 2%)?
Should this standard for determining a significant change in market
value apply to all investments? Would funds need additional guidance or
parameters to measure this standard consistently, including what inputs
or comparable investments may be used in determining the price decline?
11. Should the 1% price decline definition of value impact be
applied against the fund's last valuation of an investment, which would
include both the effect of the fund's sale and market moves?
iii. Removing Asset Class Classification
Under current rule 22e-4, a fund may generally classify and review
its portfolio investments (including the fund's derivatives
transactions) according to their asset class. However, a fund must
separately classify and review any investment within an asset class if
the fund or its adviser has information about any market, trading, or
investment-specific considerations that are reasonably expected to
significantly affect the liquidity characteristics of that investment
as compared to the fund's other portfolio holdings within that asset
class.\91\ The current provision was intended to strike a balance
between reducing operational burdens associated with classification and
providing reasonably precise liquidity classifications that
appropriately reflect investments' liquidity characteristics.\92\ The
burden to determine individual investment classifications may have
decreased since the adoption of the rule for many funds as these funds
became more familiar with and developed their liquidity risk management
programs and, in some cases, developed automated processes for
classifying investments or employed sophisticated liquidity
classification vendors that provide economies of scale. In addition, in
practice there may be weaknesses in asset class level classifications
that may result in a lack of reasonably precise classifications.
Therefore, we propose to remove the asset class method of
classification from the rule.
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\91\ See rule 22e-4(b)(1)(ii)(A).
\92\ See Liquidity Rule Adopting Release, supra note 8, at
section III.C.3.a. The current approach was also intended to
leverage fund managers' current practices and to recognize that many
investments within an asset class may be considered interchangeable
from a liquidity perspective.
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Through outreach, we understand that asset class level
classifications are not widely used by many funds. But, where these
asset class level classifications are used, this method runs the risk
of over-estimating the liquidity of a fund's investments and not
adjusting quickly in times of stress. After a fund has begun to use
asset class level classifications, and particularly if classifications
are reviewed only on a monthly basis, it might be difficult for a fund
to identify instances where a given investment's liquidity
characteristics do not align with the characteristics of other
investments in the asset class because individual investment liquidity
data is not being collected and analyzed. Through outreach, we observed
that funds generally established a process and timing for liquidity
assessments and did not change those processes or timing as market
conditions changed, and particularly were unlikely to do so under
stressed conditions. For example, during a stress event like March
2020, a fund using asset class level classifications may not be
equipped to re-classify a subset of investments in an asset class
adeptly in response to changing conditions that affect those
investments directly. Also, because funds classify a significant
portion of their holdings as highly liquid, we believe this potential
gap in identifying investments that a fund should classify differently
from other investments in the asset class is more likely to over-
estimate, rather than under-estimate, the liquidity of a fund's
investments. These tendencies run counter to the premise of the current
rule's classification system, which presumed that a fund would use
efficiencies such as asset class level classifications and monthly
review of classifications only when market conditions or other factors
did not indicate that a shift to a more granular or frequent
classification is appropriate.\93\ Therefore, we are
[[Page 77190]]
proposing to remove asset class level classifications to provide more
precise liquidity classifications that appropriately reflect
investments' liquidity characteristics.
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\93\ See rule 22e-4(b)(1)(ii) (identifying the circumstances in
which a fund must review its portfolio investments' classifications
more frequently than monthly); rule 22e-4(b)(1)(ii)(A) (identifying
the circumstances in which a fund must separately classify and
review an investment within an asset class instead of classifying
according to the investment's asset class).
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Moreover, asset class level classifications are not compatible with
the other changes we are proposing to the classification framework,
including the proposed definitions of the value impact standard. It
would also be difficult for a fund to meaningfully apply at the asset
class level a standard based on average daily trading volume or a price
decline in a given investment because the average trading volume, or
market depth generally, can vary from investment to investment even
within the same asset class. Classifying each investment separately
therefore allows a more precise assessment of that investment's
liquidity. In addition, because the proposed rule would include
specific minimum standards for classifying investments, it may reduce
burdens of classifying investments while improving the quality of
classifications relative to the current rule, consistent with the
Commission's objectives in originally allowing asset class level
classifications. Finally, staff has observed through outreach that
liquidity risk management programs have developed so that specific and
individual portfolio investment liquidity classifications are widely
used and the removal of asset class level classifications is consistent
with that approach.
We request comment on the proposed removal of the provision
permitting funds to classify the liquidity of their investments by
asset class.
12. Should we preserve the ability of funds to use asset classes
for liquidity determinations, as currently permitted? To what extent do
funds currently rely on the provision allowing liquidity
classifications by asset class? Would it be more or less burdensome for
funds to classify investments individually under the proposal's
specific minimum standards (such as the stressed trade size and the
defining the value impact standard) than to separately classify any
investment within an asset class whenever the fund or its adviser has
market, trading, or investment-specific information indicating that the
investment should be classified separately rather than as part of the
relevant asset class?
13. Would the operational burden of individually classifying be
balanced by the improved quality of data for each individual investment
as compared to classifying by asset class? To what extent would
investment-by-investment classifications differ compared to asset class
level classification? Are there other benefits to removing asset class
level classification, such as timely, useful, improved, or increased
data?
14. Is reliance on this provision more common for certain types of
funds or certain asset classes? Should asset class level
classifications be limited to specific types of funds or asset classes?
15. If we permitted asset class level classifications, how should
the stressed trade size and value impact standard in the proposal apply
to asset class level classifications?
b. Amendments to Liquidity Classification Categories
We are proposing changes to the liquidity classification categories
to improve funds' abilities to make timely payment on shareholder
redemptions, without the sale of portfolio investments resulting in the
dilution of outstanding fund shares. Section 22(e) of the Act
establishes a right of prompt redemption in open-end funds by requiring
such funds to make payments on shareholder redemption requests within
seven days of receiving the request. In March 2020, in connection with
the economic shock from the onset of the COVID-19 pandemic, open-end
funds faced a significant amount of investor redemptions, and we
believe additional changes to rule 22e-4 would assist funds in managing
investor redemptions in future stressed conditions.
Rule 22e-4 currently allows funds to classify as less liquid
investments those that the fund reasonably expects to be able to sell
or dispose of in seven calendar days or less without significantly
changing the market value of the investment, but that are reasonably
expected to settle in more than seven calendar days.\94\ Under the
current rule, an investment is classified as illiquid if it cannot be
sold or disposed of in seven calendar days or less without
significantly changing the market value of the investment.\95\ We
propose to eliminate the less liquid classification category and amend
the definition of illiquid investment to include those investments that
a fund reasonably expects not to be convertible to U.S. dollars in
current market conditions in seven calendar days or less without
significantly changing the market value of the investment, as well as
those investments whose fair value is measured using an unobservable
input that is significant to the overall measurement.\96\ Under the
proposal to eliminate the less liquid classification category, the rule
would therefore have only three liquidity classifications: highly
liquid investments, moderately liquid investments, and illiquid
investments. We also propose to amend the term ``convertible to cash''
to ``convertible to U.S. dollars,'' codifying prior Commission
statements.\97\ Finally, we propose to specify how to count the
identified number of days an investment is convertible to U.S. dollars
for purposes of the liquidity categories.
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\94\ See rule 22e-4(a)(10) (defining ``less liquid
investment'').
\95\ See rule 22e-4(a)(8) (defining ``illiquid investment'').
\96\ See proposed rule 22e-4(a).
\97\ See Liquidity Rule Adopting Release, supra note 8, at n.848
(``Cash means cash held in U.S. dollars, and would not include, for
example, cash equivalents or foreign currency.'').
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i. Removing the Less Liquid Investment Category and Classifying These
Investments as Illiquid
We propose to eliminate the less liquid classification category and
amend the definition of illiquid investment to include investments, in
part, that a fund reasonably expects not to be convertible to U.S.
dollars in seven calendar days or less without significantly changing
the market value of the investment. Investments that funds currently
classify as less liquid would become illiquid investments under the
proposed amendments, absent changes to shorten the settlement time of
many of those investments. Section 22(e) of the Act requires open-end
funds to make payment on shareholder redemption requests within seven
days of receiving the request. The proposed amendment to define an
investment as illiquid if it does not settle to U.S. dollars in seven
calendar days is designed to reduce the mismatch between the receipt of
cash upon the sale of assets with longer settlement periods and the
payment of shareholder redemptions. This would help prepare funds for
future stressed conditions by reducing the risk of a fund not being
able to meet shareholder redemptions. Unlike the current rule, the
proposed rule would directly limit to 15% the amount of fund assets
that are not reasonably expected to be convertible to U.S. dollars in
seven days.
While funds may classify different types of investments as less
liquid investments today, the most common type of investment in this
category is bank loans.\98\ Fund investments make
[[Page 77191]]
up approximately 15% of the bank loan market.\99\ Filings on Form N-
PORT show that over 90% of bank loan investments reported by open-end
funds are classified as less liquid.\100\ In 2015, commenters
addressing concerns about liquidity in the bank loan market stated that
significant efforts were then underway to materially improve settlement
times in the bank loan market, which are typically longer than other
asset classes.\101\ Bank loans are not standardized and have
individualized legal documentation. This provides flexibility of terms
for bank loans, but also increases the time for a fund to settle a bank
loan trade and receive proceeds from the sale, thus increasing the risk
of the fund not being able to meet shareholder redemptions.\102\
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\98\ Based on Form N-PORT data, bank loans made up 77% and 60%
of investments reported as less liquid in Feb. and Mar. 2020,
respectively. In addition to bank loans, a smaller number of fixed-
income securities, mortgage-backed securities, and equities are
categorized as less liquid investments.
\99\ See Leveraged Loan Primer (last visited Oct. 4, 2022),
available at https://pitchbook.com/leveraged-commentary-data/leveraged-loan-primer#market-size (stating that the Morningstar LSTA
U.S. Leveraged Loan Index, which is used as a proxy for market size
in the U.S., totaled approximately $1.375 trillion as of Feb. 2022).
As of Dec. 2021, there are 746 open-end funds that classified
approximately $204 billion in bank loan interests as reported on
Form N-PORT. Using this data, we estimate that funds held
approximately 15% of the bank loan market.
\100\ Based on Form N-PORT data, in 2021, more than 90% of the
gross value of loans reported by open-end funds were classified as
less liquid. This was also the case in Feb. and Mar. 2020.
\101\ See, e.g., Comment Letter of the Loan Syndications and
Trading Association on 2015 Proposing Release, supra note 31, File
No. S7-16-15, available at https://www.sec.gov/comments/s7-16-15/s71615-57.pdf (``LSTA Comment Letter'') (stating the goal of
transforming syndicated loan settlement to a similar settlement
period as most other asset classes).
\102\ See id.
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Around the time that the Commission adopted the liquidity rule, the
median settlement time for a loan sale was about 12 days.\103\ In the
Liquidity Rule Adopting Release, the Commission stated that a fund may
need to consider re-classifying an investment as illiquid in the event
of an extended settlement period.\104\ By July 2021, the average time
to settle a bank loan par trade in the secondary market increased to a
then seven-year high of T+23, and the median was at T+15.\105\ While
median settlement time for bank loans in which funds invest has
generally increased, Form N-PORT data has not shown funds reclassifying
these investments to take into account extended settlement times.
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\103\ See LSTA Comment Letter.
\104\ See Liquidity Rule Adopting Release, supra note 8, at
n.380 and accompanying text.
\105\ See LSTA, Secondary Trading & Settlement: Monthly July
Executive Summary (Aug. 19, 2021), available at https://www.lsta.org/news-resources/secondary-trading-settlement-monthly-july-executive-summary/?utm_source=rss&utm_medium=rss&utm_campaign=secondary-trading-settlement-monthly-july-executive-summary. In addition, fewer trades
settled within T+7, (just 20% of trades settled within the LSTA
guideline during July, a nine-percentage point reduction from the
previous year's monthly average) and settlements wider than T+20
increased 10-percentage points as of July 2021, to a 39% market
share, nearly double that of the T+7 distribution.
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We are proposing changes to remove the less liquid investment
classification to reduce the risk that funds that invest significantly
in less liquid investments may not be able to meet shareholder
redemptions. While bank loan funds were able to meet redemption
requests during March 2020, a period of significant outflows, we are
concerned that they may not be able to meet shareholder redemptions in
future stressed conditions, especially as investments in this asset
class increase. During the month of March 2020, bank loan funds
experienced outflows of approximately 13% of assets, more than any
other type of fund. In addition, since March 2020, total registered
investment company investments in bank loans have increased 50% to
approximately $200 billion.\106\ We understand that in past times of
large outflows, the median buy-side settlement time for bank loans
generally decreased and funds had a degree of success in effecting
shorter settlement periods for these investments to help meet
redemptions.\107\ We are concerned, however, that in future stress
events these attempts to shorten settlement times may fail since loans
are not standardized, have individualized legal documentation, and rely
on manual processes for settlement. We also understand that funds with
significant extended settlement investments have used borrowing through
lines of credit to meet redemptions, but lines of credit may not be
available to all funds and borrowing imposes costs that can dilute the
value of the fund for remaining investors. Based on Form N-CEN filings,
several bank loan funds have accessed their lines of credit in their
most recent reporting period.\108\ We understand that the costs of
borrowing have risen and credit has become more difficult to obtain
over time.
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\106\ This is based on Form N-PORT information as of Jan. 31,
2022.
\107\ See LSTA Comment Letter (stating that settlement times
have decreased in periods of large outflows, for example, in Aug.
2011, when bank loan funds experienced $8 billion of outflows
(approximately 13% of assets). Similarly, in Mar. 2020, when bank
loan funds experienced $12 billion of outflows (approximately 13% of
assets), we understand that settlement times also generally
decreased.
\108\ See infra note 459 and accompanying text (providing
information about bank loan funds' use of lines of credit as of Dec.
2021).
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We believe that investments that funds currently classify as less
liquid should be classified as illiquid investments and be subject to
the 15% limit on illiquid investments, so that funds may be better
prepared to satisfy redemptions in future stressed conditions without
delay and without significant dilution. Using Form N-PORT data, we
estimate that approximately 200 funds during March 2020 would have had
illiquid investments over the 15% limit if this proposed change had
been in effect, with bank loan funds being the largest type of affected
fund.\109\ As a result of the proposed amendments, more bank loan funds
may contract for expedited settlement, which would involve costs.
Alternatively, advisers with strategies that have 15% or more of assets
in investments classified as less liquid and illiquid may change those
strategies, close funds, or consider using a closed-end fund or other
investment vehicle structure that is not subject to rule 22e-4.
Further, potential additional demand for these investments could
provide incentives to shorten the settlement cycle for bank loans more
generally, which may reduce trading costs.\110\ We believe that these
amendments would reduce the risk of a fund not being able to satisfy
redemptions without diluting the interests of remaining shareholders
while waiting for the proceeds from the sale of an investment with
extended settlement.
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\109\ The number of funds is estimated by dividing the aggregate
gross value in the relevant categories by the aggregate gross value
reported.
\110\ See infra section III.C.1.b.
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ii. Additional Amendments to the Definition of Illiquid Investment
We also propose to amend the definition of illiquid investment to
include investments whose fair value is measured using an unobservable
input that is significant to the overall measurement. U.S. GAAP
establishes a fair value hierarchy that categorizes into three levels
the inputs to valuation techniques used to measure fair value.\111\ The
fair value measurements of investments are categorized in accordance
with this three-level
[[Page 77192]]
hierarchy. The highest-level measurements are those developed using
quoted, observable inputs in active markets for identical assets and
liabilities (Level 1), such as prices for identical investments on a
securities exchange; the lowest are those developed using unobservable
inputs (Level 3).\112\ We acknowledge that observability is a valuation
concept and may not always correspond to liquidity. The proposed
amendment would require those funds not already classifying investments
valued using unobservable inputs that are significant to the overall
measurement as illiquid to change their classification practices and
may change the liquidity profile for those funds under the rule to be
less liquid. To the extent there is a liquid market for affected
investments, this proposed amendment would cause funds to over-estimate
the illiquidity of their portfolios. As of December 2021, 2,006 open-
end funds held investments that were valued using unobservable inputs
that are significant to the overall measurement (Level 3 investments),
comprising $76.3 billion, or 0.27% of all open-end fund assets.\113\
Among these, $16.9 billion were classified as highly liquid investments
and $2.1 billion as moderately liquid investments.\114\ Accordingly, we
estimate that approximately 0.07% of all open-end fund assets would be
affected by this amendment.
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\111\ See FASB ASC 820-10-35-37, which sets out a fair value
hierarchy for accounting purposes, as compared to rule 2a-5, which
provides a framework for fund valuation practices and determining
fair value (including applying an appropriate methodology consistent
with the principles of FASB Accounting Standard Codification Topic
820: Fair Value Measurement (``ASC Topic 820'')) for purposes of the
Act. See Good Faith Determinations of Fair Value, Investment Company
Act Release No. 34128 (Dec. 3, 2020) [86 FR 748 (Jan. 6, 2021)
(``Valuation Adopting Release'')].
\112\ See ASC Topic 820. U.S. GAAP requires funds to maximize
the use of relevant observable inputs and minimize the use of
unobservable inputs in valuing any asset or liability. In some
cases, the inputs used to measure fair value might be categorized
within different levels of the fair value hierarchy. In those cases,
the fair value measurement is categorized in its entirety in the
same level of the fair value hierarchy as the lowest level input
that is significant to the overall measurement. See ASC 820-10-35-
16AA and 820-10-35-37A. Examples of particular assets and
liabilities that may be measured using Level 3 inputs include long-
dated currency swaps, three-year options on exchange-traded shares,
interest rate swaps, asset retirement obligations at initial
recognition, and reporting units. See FASB ASC 820-10-55-22.
\113\ See infra note 424 and accompanying paragraph. We observed
that the investments classified as highly liquid that were Level 3
investments primarily were mortgage-backed securities.
\114\ We recognize that, in light of the proposed removal of the
less liquid category, only those investments valued using
unobservable inputs that are significant to the overall measurement
that are classified as highly liquid or moderately liquid would be
affected by this proposed amendment.
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Where an investment is valued using unobservable inputs that are
significant to the overall measurement, this may indicate that an
active, liquid, and visible market for the investment does not exist.
Where there is no active, liquid, and visible market for an investment,
there may be a corresponding risk that the fund cannot sell the
investment in time to meet redemptions without dilution. The proposal
defines investments whose fair value is measured using unobservable
inputs that are significant to the overall measurement as illiquid for
purposes of this rule, which is intended to reduce this risk. By
classifying these investments as illiquid, the proposal would establish
a minimum standard for classifying the liquidity of an investment,
which is designed to provide more consistent guideposts for liquidity
classifications.
iii. Other Amendments Related to Liquidity Classification Categories
Amendments to the Definition of Moderately Liquid Investment
We propose to simplify the definition of moderately liquid
investment to mean any investment that is neither a highly liquid
investment nor an illiquid investment.\115\ The moderately liquid
investment category would continue to provide information about the
portion of a fund's portfolio that is not on the most liquid end of the
spectrum, but that still is sufficiently liquid to meet redemption
requests within the statutory seven day period.
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\115\ We also are proposing to remove a provision that addresses
how to classify an investment that could be viewed as either a
highly liquid investment or a moderately liquid investment because
the ambiguity in classification that provision addresses is no
longer present under the proposed amendments to those
classifications. See note to paragraph (b)(1)(ii) introductory text
in current rule 22e-4.
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Amendments to the Definition of Convertible to Cash and References to
Cash
We propose to amend the term ``convertible to cash'' to
``convertible to U.S. dollars'' and to make conforming amendments to
the definition of this term to refer to the ability for a fund to sell
or dispose of an investment, and for it to settle in U.S. dollars.\116\
These amendments codify prior Commission statements. In the adopting
release for rule 22e-4, the Commission stated that cash means ``cash
held in U.S. dollars, and would not include, for example, cash
equivalents or foreign currency.'' \117\ The Commission also provided
an example in that release in which the period of time it took to
repatriate or convert a foreign currency to dollars factored into the
analysis of how quickly a foreign security could convert to cash.\118\
Some funds are classifying foreign investments as highly liquid taking
into account solely the time it would take to convert the proceeds of a
sale to the foreign currency. Similarly, some funds classify foreign
currency as highly liquid without further analysis about the time that
would be needed to convert that currency to U.S. dollars. We believe it
is important to view the liquidity of fund investments in terms of
convertibility to U.S. dollars within a specified period so that a fund
is able to satisfy redemption requests in U.S. dollars.\119\ This
amendment is intended to promote the ability of funds to meet
redemptions without diluting the interests of the remaining
shareholders and increase consistency in how funds classify the
liquidity of investments, including in foreign investments and foreign
currencies. In addition to the definition of convertible to cash, we
also propose to amend other references in rule 22e-4 to refer to U.S.
dollars instead of cash for consistency and clarity.\120\
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\116\ See proposed rule 22e-4(a) (defining ``convertible to U.S.
dollars'' as the ability to be sold or disposed of, with the sale or
disposition settled in U.S. dollars) (emphasis added). We also
propose to amend the definition of convertible to U.S. dollars to
refer to disposition of an investment, and not only sales. This is a
conforming amendment, as current rule 22e-4 classifications
otherwise refer to the ability to sell or dispose of an investment.
\117\ See Liquidity Rule Adopting Release, supra note 8, at
n.848.
\118\ See id., at paragraph accompanying n.379 (providing an
example where certain foreign securities may be able to be sold in
seven calendar days or less, but may be subject to capital controls
that would limit the extent to which the foreign currency could be
repatriated or converted to dollars within this time frame and
explaining that these securities would be considered to be less
liquid investments because they would be reasonably expected to
settle in more than seven calendar days).
\119\ See id., at n.105 and accompanying text (noting concerns
about the potential mismatch between the timing of receipt of cash
for sales of fund assets and the payment of cash for shareholder
redemptions).
\120\ See proposed rule 22e-4(a) (defining ``highly liquid
investment'' and ``in-kind exchange traded fund''); and proposed
rule 22e-4(b)(1)(i)(C) (listing liquidity risk factors).
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Method for Counting the Number of Days
We propose to specify when a fund must start to measure the
identified number of days in which it reasonably expects a stressed
trade size of an investment would be convertible to U.S. dollars
without significantly changing its market value. Currently, the rule
does not directly specify when to begin counting the number of days an
investment would be convertible to U.S. dollars, and funds have
inconsistent practices as to when they begin this measurement. This
inconsistency may lead certain funds to overestimate their liquidity
classifications, and reduce
[[Page 77193]]
their ability to meet redemptions. This also detracts from
comparability when analyzing trends across funds. For example, some
funds may consider an investment highly liquid if it could be converted
to U.S. dollars three business days after the date of the
classification analysis, while others include the date of
classification when counting the number of days. Those funds that begin
counting after the date of the classification would have the advantage
of counting an additional day as compared to those funds that include
the date of classification, and their liquidity classifications may
appear to be more liquid than a similar fund that begins counting on
the date of classification. Therefore, we propose to specify that funds
must count the day of classification when determining the period in
which an investment is reasonably expected to be convertible to U.S.
dollars.\121\ For example, in order for a fund to classify an
investment as highly liquid on Monday, it would need to reasonably
expect that the investment could be sold and settled to U.S. dollars by
Wednesday at the latest.
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\121\ See proposed rule 22e-4(b)(1)(ii)(A).
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We request comment on the proposed amendments to the liquidity
classification categories:
16. As proposed, should we eliminate the less liquid investment
category and amend the illiquid investment definition to include an
investment that a fund reasonably expects can be sold within seven
calendar days without significantly changing the market value but is
not convertible to U.S. dollars within that period (i.e., investments
that are currently classified as less liquid under the rule)? What
effect would these proposed amendments have and how would those funds
that significantly invest in such less liquid investments likely
change?
17. Would the proposed amendment cause funds that currently hold
less liquid investments to contract for expedited settlement for such
investments? What are the advantages or limitations of contracting for
expedited settlement? Would the proposed amendments provide an
incentive to reduce settlement times in bank loan and other relevant
markets more generally? If so, how long might it take to reduce
settlement times in response to the rule and what would be the burdens
associated with this change? Are there certain categories of bank loans
or other investments for which market participants may be unable to
reduce the settlement time to seven calendar days or less? Which
investments and why? What other effects may occur, for example, would
some funds change their strategies, liquidate, or choose to be
structured as a different investment vehicle, such as a closed-end
fund? If some funds would convert to closed-end funds, what type of
closed-end fund would they likely choose (e.g., interval fund, or a
closed-end fund listed on an exchange)? Should we amend other rules, or
provide relief from any specific rules or provisions of the Federal
securities laws, to expedite changes to strategies or conversions to
closed-end funds or other investment vehicles?
18. Some funds classify certain bank loans as highly liquid or
moderately liquid today. What characteristics of these bank loans lead
to a reasonable expectation that they will be convertible to cash in
seven days or less without significantly changing the market value? Are
funds considering contracts for expedited settlement? Would funds need
additional guidance on how to assess the period in which a bank loan or
other investment is reasonably expected to be convertible to U.S.
dollars? For example, should we revise the proposed rule to require
that funds consider, or provide guidance suggesting that funds may wish
to consider: settlement time history for the individual or similar
investments, average settlement times for the market, and guarantees
for settlement or expedited settlement, as well as the contractual
settlement period?
19. Have the costs of borrowing risen and has credit become more
difficult to obtain over time for bank loan funds, particularly during
stressed periods?
20. As proposed, should we remove the less liquid category and
require funds to use a three category classification framework? Would
the proposed changes simplify classifications and reduce burdens over
time, after funds updated systems to reflect the change? Would the
proposed changes appropriately reflect the liquidity of a fund, or
would the current framework be more appropriate? Should funds be
permitted to invest above 15% in less liquid investments if there are
other methods or mechanisms to reduce the mismatch between the receipt
of cash upon the sale of assets with longer settlement periods and the
payment of shareholder redemptions or to address potential dilution
associated with this mismatch? If so, what other methods or mechanisms
should these funds be required or permitted to use (for example, swing
pricing, gates to suspend redemptions, redemption fees, redemptions in
kind, additional limits on less liquid investments, notice periods, or
lengthening the settlement period for paying redemptions)? \122\ If we
permit (to the extent not already permitted) or require use of one or
more of these tools, how should they be used (individually, in some
combination with each other, or with other protections, such as
disclosure, board approval, and Commission reporting)? Should we amend
other rules, or provide relief from any specific rules or provisions of
the Federal securities laws, to expedite or permit use of these methods
and mechanisms? \123\
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\122\ With a notice period, an investor's redemption request
would not be processed until the end of a notice period (e.g., after
2 to 5 days). The investor would receive the next calculated price
after the notice period ends, with payment occurring at the end of a
settlement period. With a lengthened settlement period, a redeeming
investor would receive the price next calculated after submitting
the redemption order but would not receive payment until the end of
a lengthened settlement period (e.g., 5 to 7 days after trade date).
\123\ See, e.g., section 22(e) of the Act (providing the
conditions under which a registered investment company may suspend
the right, or postpone the date, of redemption for more than seven
days).
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21. Should we provide that an investment is illiquid if it is not
reasonably expected to be convertible to U.S. dollars in a shorter or
longer period than seven calendar days? How would a shorter or longer
period align with the requirement in section 22(e) of the Act for a
fund to satisfy redemptions within seven days? If we provided a longer
period of time to convert to U.S. dollars before an investment is
classified as illiquid, how would funds prepare for the potential
mismatch during stressed situations between the amount of available
cash and the size of shareholder redemptions? Should we provide
additional exemptions to allow funds to delay redemptions to
shareholders under certain limited circumstances and conditions, such
as independent director approval?
22. Are there circumstances in which an investment is fair valued
using an unobservable input that is significant to the overall
measurement, but the investment should not be treated as illiquid for
purposes of the rule? Please explain and provide supporting data.
Should we permit a fund to classify certain types of investments that
are fair valued using unobservable inputs that are significant to the
overall measurement as highly liquid or moderately liquid and, if so,
which types? Should we instead treat investments that are fair valued
using unobservable inputs that are significant to the overall
measurement as presumptively illiquid, but permit funds to rebut this
presumption? If so, what process should we require for rebutting the
presumption? For example, should
[[Page 77194]]
we require funds to maintain records describing why they did not
classify such an investment as illiquid? Should we require funds to
disclose on Form N-PORT any circumstances in which they did not
classify such an investment as illiquid?
23. Are there other types or characteristics of investments that we
should include in the definition of illiquid investment? If so, which
ones?
24. Should we amend the definition of moderately liquid investment,
as proposed? Alternatively, should we retain the details in the current
definition that specify the number of days in which a fund must
reasonably expect an investment to be convertible to U.S. dollars in
order to classify it as moderately liquid?
25. Would the proposed changes to the liquidity classifications
affect investment options available to investors? For example, would
bank loan funds only be available in non-open-end investment vehicles?
What effect would these proposed changes have on those asset classes
that are less available for investment by open-end funds for liquidity
reasons, the availability of credit to borrowers, and more generally,
on capital formation?
26. Should we amend the definition of convertible to cash and other
references to cash in rule 22e-4 to refer to U.S. dollars, as proposed?
Would these amendments raise issues for specific types of funds? If so,
which ones and how? Would these amendments affect funds' investment
strategies, including their allocation to foreign investments and U.S.
dollars, or their performance?
27. Are there circumstances in which a fund would pay redemptions
in a different currency than U.S. dollars? If so, would it be
appropriate for that fund to be able to assess the time in which an
investment could convert to that other currency for purposes of the
rule?
28. In addition to sale and disposition, are there other ways an
investment may be converted to U.S. dollars that should be included in
the definition of convertible to U.S. dollars? If so, what are they?
29. Would the amendment to refer to U.S. dollars instead of cash in
the definitions of highly liquid investment and convertible to cash
materially change how funds classify highly liquid investments
currently? If so, how?
30. Should we require funds to include the day of classification
when counting the number of days to convert to U.S. dollars as
proposed, or should we require funds to begin to count the number of
days to convert to U.S. dollars on the following day? What are the
advantages and disadvantages of this alternative? Would this
alternative result in less conservative liquidity classifications for
some funds or investments (i.e., by causing some investments that
otherwise would have been classified as moderately liquid to be
classified as highly liquid) or impair a fund's ability to meet
redemptions?
31. Instead of using the days an investment would be convertible to
U.S. dollars in the liquidity classifications as proposed, should we
separately set the number of days to: (1) make the trade; and (2)
settle the trade or otherwise dispose of an investment, in determining
liquidity classifications? Why or why not? Is there a different way the
rule should measure the period that an investment is convertible to
U.S. dollars?
c. Frequency of Classifications
Rule 22e-4 currently requires that funds review their liquidity
classifications at least monthly in connection with reporting on Form
N-PORT, and more frequently if changes in relevant market, trading, and
investment-specific considerations are reasonably expected to
materially affect one or more of their investments'
classifications.\124\ The current rule also requires a fund to monitor
and take timely actions related to the liquidity of its investments,
including changes to its liquidity profile. Specifically, the rule
prohibits a fund from acquiring any illiquid investment if, immediately
after the acquisition, the fund would have invested more than 15% of
its net assets in illiquid investments that are assets.\125\ In
addition, the rule requires a fund to provide timely notice to its
board, and to the Commission on Form N-RN, if the fund exceeds the 15%
limit on illiquid investments, or if there is a shortfall of the fund's
highly liquid investments below its highly liquid investment minimum
for seven consecutive calendar days.\126\
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\124\ See rule 22e-4(b)(1)(ii).
\125\ See rule 22e-4(b)(1)(iv).
\126\ See rule 22e-4(b)(1)(iv)(A) and rule 22e-
4(b)(1)(iii)(A)(3); Form N-RN Parts B through D.
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We propose amendments to require a fund to classify all of its
portfolio investments each business day instead of at least
monthly.\127\ Daily classification would reflect current market
conditions more accurately and would provide funds with more data for
analysis to prepare for future stressed conditions. We believe that
daily classifications would assist liquidity risk program
administrators in better monitoring of a fund's liquidity and enhance a
fund's ability to more rapidly respond to changes that affect the
liquidity of the fund's portfolio, reflecting more effective practices
we have observed. In addition, daily classifications would help ensure
that funds timely report shortfalls below the highly liquid investment
minimum or breaches of the 15% limit on illiquid investments to the
fund's board and to the Commission, which would better achieve the
goals of the current provisions to provide board and Commission
oversight of the fund's liquidity risk management program and its
effectiveness.
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\127\ See proposed rule 22e-4(b)(1)(ii). Although rule 22e-4
currently requires funds to classify each of the fund's portfolio
investments (including each of the fund's derivatives transactions),
we have observed that some funds are not classifying all investments
in their portfolios, such as positions in to-be-announced (TBA)
contracts to trade mortgage-backed securities or the reinvestment of
cash collateral received in securities lending arrangements.
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Most funds did not report reclassifications of their portfolio
investments despite extraordinary liquidity constraints in March
2020.\128\ Based on the liquidity classification practices we observed
in March 2020 and on filings covering this period, we are concerned
that some funds effectively are equipped to classify their investments
primarily on a monthly basis to meet reporting requirements and are not
prepared to review classifications intra-month. Because intra-month
analyses for these funds would be out of the ordinary and only occur
when a fund determines that changes in relevant market, trading, and
investment-specific considerations are reasonably expected to
materially affect one or more of their investments' classifications, it
may be especially challenging during stressed conditions for these
funds to reclassify their investments intra-month. Requiring daily
classification, while involving costs, may ultimately lead to a more
efficient classification process for funds than monitoring trading
conditions to determine if and when intra-month classifications are
required. For
[[Page 77195]]
example, a daily classification requirement, in combination with the
minimum standards we propose for trade size and value impact, may lead
funds to modify their liquidity classification processes, which would
make the process more standardized, timely, and efficient.
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\128\ Despite the liquidity constraints in Mar. 2020, we
observed through Form N-PORT filings that roughly 75% of funds did
not reclassify any investment held in both Feb. and Mar. 2020.
Specifically, roughly 80% of U.S. equity funds did not reclassify
any holding that was held in both Feb. and Mar. 2020, while roughly
10% reclassified at least one investment into a more liquid category
and roughly 13% reclassified at least one investment into a less
liquid category. Roughly 55% of taxable bond funds reclassified on
average 4% of their portfolios, with the median fund reclassifying
1% of its portfolio. Of the funds that reclassified, roughly 30%
reclassified at least one investment into a more liquid category and
roughly 44% reclassified at least one investment into a less liquid
category. More funds did, however, reclassify in Mar. 2020 period
than for either Feb. or Apr. 2020.
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We request comment on the proposed amendments to require funds to
classify the liquidity of their investments on a daily basis.
32. Should we require funds to classify all portfolio investments
on a daily basis, as proposed? Would this proposed amendment result in
a material change to how funds are currently classifying? To what
extent do funds already classify the liquidity of their investments on
a daily basis or collect the information they would need to classify
daily? Would this proposed amendment better integrate liquidity risk
management and portfolio management systems?
33. We also are proposing that funds use a stressed trade size and
a defined value impact standard in determining liquidity
classifications. Would those changes affect the burdens of classifying
on a daily basis? Would those effects be different for different types
of funds? For example, would it be easier to determine on a daily basis
whether the sale of a stressed trade size of shares listed on an
exchange would exceed 20% of the average daily trading volume for those
shares than to determine whether the sale of a stressed trade size of
other investments would result in a price decline of more than 1%?
34. Instead of classifying on a daily basis, should we require
funds to classify the liquidity of their investments at some other
frequency (e.g., weekly, biweekly, or monthly)? If so, should we
maintain the requirement for a fund to classify more frequently if
changes in relevant market, trading, and investment-specific
considerations are reasonably expected to materially affect one or more
of its investments' classifications? Is there a different approach we
should use effectively to require a fund to classify its investments in
response to changing conditions? Are there certain types of funds that
should be excluded from daily classifications? If so, which funds?
35. If we require funds to classify on a non-daily frequency, how
would they monitor for compliance with the 15% limit on illiquid
investments and the highly liquid investment minimum? How are those
limits monitored for compliance now?
2. Highly Liquid Investment Minimums
a. Proposed Scope of the Requirement and Determination of the Minimum
Rule 22e-4 currently requires a fund to determine a highly liquid
investment minimum if it does not primarily hold assets that are highly
liquid investments. Funds that are subject to the highly liquid
investment minimum requirements must determine a highly liquid
investment minimum considering several factors, review the minimum at
least annually, and adopt policies and procedures to respond to a
shortfall of the fund's highly liquid investments below the minimum
required.\129\ We propose to require all funds to determine and
maintain a highly liquid investment minimum of at least 10% of the
fund's net assets, which is equivalent to the stressed trade size. In
connection with this proposed requirement, we would remove the
exclusion for funds that primarily invest in highly liquid investments
(the ``primarily exclusion''). The proposed amendments are designed to
ensure that funds have sufficient liquid investments for managing
stressed conditions and heightened levels of redemptions.
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\129\ See rule 22e-4(b)(1)(iii).
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We assessed liquidity-related data reported on Forms N-PORT, as
well as the development of liquidity risk management programs, through
staff outreach to funds and advisers. Based on Form N-PORT filings,
most funds do not determine a highly liquid investment minimum and
instead rely on the primarily exclusion.\130\ For those funds that have
highly liquid investment minimums, the rule currently requires that
they consider various liquidity factors, such as their investment
strategy and cash-flow projections, in both normal and reasonably
foreseeable stressed conditions.\131\ We understand that those funds
additionally consider factors such as asset class, market volatility,
and shareholder concentration in their determinations.
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\130\ Approximately 83% of funds holding 85% of net assets do
not report setting a highly liquid investment minimum on Form N-
PORT.
\131\ For these purposes, funds are required to consider certain
factors during stressed conditions only to the extent they are
reasonably foreseeable during the period until the next review of
the highly liquid investment minimum. See rule 22e-
4(b)(1)(iii)(A)(1).
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As discussed above, by requiring fund liquidity classifications to
assume the sale or disposition of a set stressed trade size, the
proposal is intended to better prepare all funds for future stressed
conditions.\132\ To help further prepare a fund for heightened levels
of redemptions in stressed conditions, we are proposing to require the
highly liquid investment minimum to be equal to or higher than the
assumed stressed trade size. In setting the highly liquid investment
minimum to be at least the stressed trade size, we considered data on
fund flows for setting the stressed trade size as well as data reported
on Form N-PORT on funds' current highly liquid investment minimums. As
of March 2020, for funds that had determined a highly liquid investment
minimum, the majority of those funds reported setting a highly liquid
investment minimum of less than 10% of the fund's net assets. In
contrast, approximately 8% of those funds reported setting a highly
liquid investment minimum of more than 50% of the fund's net assets.
Thus, while there is a wide divergence in highly liquid investment
minimums, most of these funds have a minimum that is lower than the
proposed 10% level. Given the level of weekly outflows some funds have
experienced and the difficulty in predicting future stress events, we
believe that a regulatory minimum of 10% for the highly liquid
investment minimum would benefit investors by improving the ability of
funds to meet shareholder redemptions in stressed scenarios.
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\132\ See supra section II.A.1.a.i for discussion of the
stressed trade size and of fund flow data.
---------------------------------------------------------------------------
In addition, the proposal's requirement for funds to both assume a
stressed trade size to determine liquidity classifications and also
maintain an equal or higher minimum of highly liquid investments is
intended to work together to better prepare them for future stressed
conditions and to reduce the risk of dilution. Not only would funds
have highly liquid investments in an amount needed to meet the stressed
trade size, they would also have more highly liquid assets to meet
redemptions without having to sell less liquid investments at
discounted prices. Funds would continue to be required to periodically
review the highly liquid investment minimum and have policies and
procedures to address any shortfall in highly liquid investments below
the minimum.
While the proposed minimum of 10% of a fund's net assets may be a
suitable highly liquid investment minimum for most funds, certain funds
may find a higher amount appropriate depending on a fund's liquidity
risk factors and investment objectives. Consistent with the current
rule, a fund would be required to consider a specified set of liquidity
risk factors to determine whether its highly liquid investment
[[Page 77196]]
minimum should be above 10%.\133\ We continue to believe that the
liquidity risk factors funds must consider in determining a highly
liquid investment minimum under the current rule and the associated
guidance the Commission provided in the Liquidity Rule Adopting Release
regarding these factors are appropriate for a fund to take into account
for these purposes.\134\
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\133\ See Liquidity Rule Adopting Release, supra note 8, at
paragraph following n.669.
\134\ See id., at section III.B.2.
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A broad variety of investments, as well as cash, may qualify
towards the highly liquid investment minimum.\135\ Since approximately
83% of funds currently rely on the primarily exclusion, we would not
expect this proposal to affect their strategies. We recognize, however,
that imposing a highly liquid investment minimum of at least 10% would
require some other funds to hold a larger amount of highly liquid
assets than they currently do, and thus may affect these funds'
performance or strategies.\136\ For funds with strategies focused on
investments that would not be considered highly liquid, they would have
to determine how to constitute a portfolio of investments that would
allow the fund to meet its strategy and investing parameters while
maintaining a highly liquid investment minimum of at least 10%. All
funds would be subject to the same highly liquid investment minimum of
at least 10%, which would minimize any competitive advantage for
similar funds associated with the proposed highly liquid investment
minimum requirements. We believe it is important that all funds be
prepared to meet redemptions in future stressed scenarios, and that
funds would be better able to do so with the proposed highly liquid
investment minimum requirements.
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\135\ See id., at n.663 and accompanying text.
\136\ As recognized above, being unprepared for higher than
normal redemptions also can affect a fund's performance when such
redemptions occur. See supra note 81. For instance, although less
liquid assets generally offer a higher return, the trading costs
associated with selling these assets during periods of increased
redemptions may offset this risk premium, potentially resulting in a
lower overall return for fund investors. See infra note 351 and
accompanying text.
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In establishing a uniform floor for the highly liquid investment
minimum, we are also proposing to remove the exclusion for funds that
invest primarily in highly liquid investments. The Commission adopted
the primarily exclusion because it believed the benefits associated
with requiring such funds to determine and review a highly liquid
investment minimum, or to adopt shortfall procedures, would not justify
the associated burdens.\137\ Since that time, however, we have observed
that a fund relying on the primarily exclusion may experience
significant declines in its liquidity that result in the fund holding
less than 50% of its portfolio in highly liquid investments for a
period of time. For example, a fund that invests significantly in a
given foreign market and that generally classifies those investments as
highly liquid can experience substantial declines in the amount of its
highly liquid investments if, for example, there is political or
economic turmoil in or an extended holiday closure of that foreign
market. Funds that currently use the primarily exclusion instead of
determining and maintaining a highly liquid investment minimum do not
have the benefit of shortfall procedures, including board oversight, to
respond to events or market conditions that may cause the fund to fall
under its previously determined level of primarily held highly liquid
investments. By requiring a highly liquid investment minimum for all
funds, investors would enjoy the benefit of policies and procedures
that are designed to ensure not only oversight by the liquidity risk
program administrator but also the fund's board.
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\137\ Liquidity Rule Adopting Release, supra note 8, at
paragraph accompanying n.724.
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Moreover, the burdens of complying with highly liquid investment
minimum requirements for funds that currently use the primarily
exclusion may be reduced because many fund complexes already have
experience developing highly liquid investment minimum shortfall
policies and procedures. It may be possible for funds in the same
complex to leverage this experience to reduce the burdens of developing
these policies and procedures for funds that previously qualified for
the primarily exclusion. As liquidity risk management programs have
matured, and continue to mature, many fund complexes continue to gain
experience with highly liquid investment minimum shortfall policies and
procedures, which may also reduce burdens. By requiring all funds to
adopt a highly liquid investment minimum, we are seeking to help ensure
that funds would be better prepared to handle future stressed
conditions, which may occur suddenly and unexpectedly, as they would
have sufficient liquid investments for managing heightened levels of
redemptions.
We request comment on the proposed amendments to highly liquid
investment minimum requirements.
36. Should we require all funds to determine and maintain a highly
liquid investment minimum, as proposed? What effect would this proposal
have on funds? For example, would some funds have to change their
strategies or expect effects on performance?
37. Should some types of funds be excluded from the requirement to
have a highly liquid investment minimum? If yes, which ones and why?
For example, should we preserve the exclusion for funds that primarily
hold highly liquid assets? Alternatively, should funds currently using
the primarily exclusion have a higher highly liquid investment minimum
requirement? Would funds using the primarily exclusion be as prepared
to meet redemptions in stressed scenarios without a highly liquid
investment minimum and its corresponding policies and procedures?
38. If the primarily exclusion is kept, should we define the amount
of highly liquid assets a fund must maintain under this standard (e.g.,
investing at least 51% of the fund's net assets in highly liquid
assets, or a higher or lower amount)?
39. Should we establish a regulatory minimum for the amount of
highly liquid investments of 10%, as proposed, or should it be set at
15% or 5% (or some other higher or lower amount)? Would establishing a
regulatory minimum reduce the burdens associated with determining and
periodically reviewing the fund's highly liquid investment minimum?
40. Rather than propose a regulatory minimum with factors that a
fund must consider to determine whether its own highly liquid
investment minimum should be higher, should we require all funds to use
the same highly liquid investment minimum? Would this set a level
playing field for all funds and diminish any competitive advantage for
a fund with a lower highly liquid investment minimum? If so, what
amount would be appropriate for a uniform highly liquid investment
minimum for all funds (e.g., 5%, 10%, 15%, or a higher or lower
amount)?
41. Would providing more detail or guidance on the liquidity risk
factors be helpful? If so, which factors?
42. Would funds that do not currently have a highly liquid
investment minimum be able to leverage policies and procedures already
developed for highly liquid investment minimums, for example by other
funds in the same complex, to reduce the burdens of developing these
policies and procedures? If not, what costs would funds incur to adopt
and implement highly liquid investment minimum policies and procedures?
[[Page 77197]]
b. Calculation of the Highly Liquid Investment Minimum
We are proposing amendments to rule 22e-4 that are designed to help
ensure that the highly liquid investments a fund holds to meet its
highly liquid investment minimum are available to support the fund's
ability to meet redemptions. A key aim of the highly liquid investment
minimum requirement is to decrease the likelihood that funds would be
unable to meet their redemption obligations.\138\ Building on existing
aspects of rule 22e-4, the proposed amendments would require that, when
determining the amount of assets a fund has classified as highly liquid
that count toward the highly liquid investment minimum, the fund
account for limitations in its ability to use some of those assets to
meet redemptions.\139\ Specifically, in assessing compliance with the
fund's highly liquid investment minimum, the fund would be required to:
(1) subtract the value of any highly liquid assets that are posted as
margin or collateral in connection with any derivatives transaction
that is classified as moderately liquid or illiquid; and (2) subtract
any fund liabilities.\140\
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\138\ See Liquidity Rule Adopting Release, supra note 8, at text
following n.117.
\139\ As the Commission explained at the time it adopted rule
22e-4, this is not meant to suggest that a fund should only, or
primarily, use highly liquid investments to meet shareholder
redemptions. Instead, we believe that a fund holding sufficient
highly liquid assets will support the fund in meeting redemption
requests in a non-dilutive manner, and assist it in readjusting its
portfolio in times of market stress, heightened volatility, and
managing its obligations to derivatives counterparties. See
Liquidity Rule Adopting Release, supra note 8, at n.680 and
accompanying text.
\140\ Proposed rule 22e-4(b)(1)(iii)(B)(1); 22e-
4(b)(1)(iii)(B)(2). Rule 22e-4 currently refers to a ``pledge'' of
margin or collateral, rather than ``posting.'' We are proposing to
use the term ``post'' because we believe this term is more commonly
used within the industry and by other regulators to refer to
instances where a party provides margin or collateral to its
counterparty to meet the performance of its obligation under one or
more derivatives transactions as a result of a change in the value
of such obligations since the trade was executed or the last time
such collateral was provided (commonly referred to as variation
margin) or is provided to secure potential future exposure following
default of a counterparty (commonly referred to as initial margin).
See, e.g., Margin Requirements for Uncleared Swaps for Swap Dealers
and Major Swap Participants, 86 FR 6850 (Jan. 25, 2021).
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i. Margin or Collateral of Moderately Liquid and Illiquid Derivatives
The requirement for a fund to reduce the value of its highly liquid
assets by the amount posted as margin or collateral in connection with
a non-highly liquid derivatives transaction reflects that this amount
of highly liquid assets is not available for the fund to use to meet
redemptions.\141\ This is because, where a fund enters into a
moderately liquid or illiquid derivative and posts highly liquid assets
as margin or collateral, the posted collateral is highly liquid, but
the fund cannot access the value of posted assets unless the fund exits
the derivatives transaction. Since the fund has classified the
derivative as moderately liquid or illiquid, it does not reasonably
expect to be able to exit the derivatives transaction within three
business days. We recognize that the fund may be able to access the
specific assets posted as margin or collateral by replacing them with
other assets acceptable to the fund's counterparty. But regardless of
the specific assets posted, the value of collateral posted in
connection with a moderately liquid or illiquid derivative would not be
convertible to U.S. dollars within three business days or less.
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\141\ See Liquidity Rule Adopting Release, supra note 8, at
nn.727-730 and accompanying text. This aspect of the proposed rule
would only require an adjustment to the amount of a fund's highly
liquid investments that are assets, since investments that are in a
liability position are unable to be used to meet redemption
requests. See proposed rule 22e-4(b)(1)(iii)(B)(1).
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Under the current rule, a fund is required to identify the
percentage of the fund's highly liquid investments that it has posted
as margin or collateral in connection with derivatives transactions
that the fund has classified as less than highly liquid.\142\ The
Commission believed that this approach struck an appropriate balance
between providing transparency and reducing burdens on funds.\143\ The
Commission observed that a fund generally would not need to
specifically identify particular assets that are posted as margin or
collateral to cover particular derivatives transactions, but instead
would calculate the percentage of highly liquid investments posted as
margin or collateral for derivatives transactions classified in each of
the other classification categories.\144\ Under the rule, a fund that
has posted both highly liquid investments and non-highly liquid
investments as margin or collateral in connection with a non-highly
liquid derivatives transaction should reduce its highly liquid
investments, rather than assume that posted non-highly liquid
investments would first cover the derivatives transaction, unless the
fund specifically identifies non-highly liquid investments as margin or
collateral in connection with a derivatives transaction.\145\ Finally,
the Commission observed that the current approach responds to
commenters' concerns that linking the liquidity of specific assets
posted as margin or collateral to the liquidity of a fund's derivatives
transactions could understate the liquidity of those assets, since a
fund may be able to readily substitute another liquid asset for the
asset posted as margin or collateral.\146\
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\142\ Rule 22e-4(b)(1)(ii)(C). In addition, funds currently also
are required to exclude highly liquid assets that are posted as
margin or collateral in connection with non-highly liquid
derivatives transactions when determining whether the fund primarily
holds highly liquid assets. Rule 22e-4(b)(1)(iii)(B).
\143\ See Liquidity Rule Adopting Release, supra note 8, at
n.476 and accompanying text.
\144\ Id. at n.489 and accompanying text.
\145\ Note 1 to proposed rule 22e-4(b)(1)(iii)(B)(1). Cf. Note 1
to rule 22e-4(b)(1)(ii)(C). See also Liquidity Rule Adopting
Release, supra note 8, at nn.489-490 and accompanying text
(explaining that in the absence of such an instruction, some funds
might instead take the opposite approach, and assume that posted
non-highly liquid investments first cover these less liquid
derivatives transactions, creating inconsistencies between funds).
\146\ We recognize that margin or collateral may be determined
and paid by funds on the basis of a group of derivatives
transactions, with the fund posting or receiving a net amount of
margin or collateral. When a fund pays margin or collateral in
connection with a group that includes derivatives transactions that
are highly liquid and non-highly liquid, funds already must
determine the amount of margin or collateral attributable to the
non-highly liquid derivatives under the current rule. For example, a
fund must perform this attribution in order to identify the
percentage of the fund's highly liquid investments that it has
posted as margin or collateral in connection with derivatives
transactions that are not themselves highly liquid.
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The proposed approach is intended to enhance investor protection
while continuing to strike an appropriate balance with the potential
increased burdens on funds. The proposed approach would not require
funds to identify and reclassify specific assets posted as margin or
collateral, but rather to reduce the value of the fund's highly liquid
assets available to meet the fund's highly liquid investment minimum by
the value of the assets posted as margin or collateral. We also propose
to maintain, with conforming changes, the explanatory note discussed
above guiding the allocation of amounts posted as margin or
collateral.\147\ By reducing the fund's highly liquid investments by
the value of amounts posted as margin or collateral, the proposed
approach would avoid burdens associated with tracking specific
securities posted as margin or collateral and reclassifying investments
as they are posted as margin or collateral and recalled. It also would
not
[[Page 77198]]
understate the liquidity of specific securities that are posted as
margin or collateral because each security would continue to be
classified based on its own characteristics, and instead the
adjustments would only be made at the aggregate level.\148\ Moreover,
many of the operational concerns commenters raised when rule 22e-4 was
proposed, which led the Commission to adopt the current approach,
related to the treatment of assets segregated under the Commission's
Investment Company Act Release 10666, which the Commission has since
rescinded, effective August 19, 2022.\149\ We therefore believe the
proposed amendments would enhance investor protections by helping to
ensure a fund's highly liquid assets are in fact available to meet
redemptions, while continuing to balance the value of the provision
against the operational burdens to implement it.
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\147\ See supra note 145. In connection with the proposed
amendments to the rule's highly liquid investment minimum
provisions, we propose to re-number certain existing paragraphs and
to add paragraphs to the rule. As a result, we propose to update
cross-references to the highly liquid investment minimum provisions
within the rule. See proposed rule 22e-4(b)(1)(iii)(C) through (E)
and proposed rule 22e-4(b)(3)(iii).
\148\ See Liquidity Rule Adopting Release, supra note 8, at
n.491 and accompanying text.
\149\ See Liquidity Rule Adopting Release, supra note 8, at
nn.468-472 and accompanying text (operational concerns); Derivatives
Adopting Release, supra note 21, at section II.L (withdrawal of
Investment Company Act Release 10666).
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ii. Fund Liabilities
Under the proposal, a fund would also be required to reduce the
amount of highly liquid assets that count toward the fund's highly
liquid investment minimum by the amount of the fund's liabilities. This
proposed change is intended to result in a more accurate calculation of
the highly liquid investment minimum.\150\ The proposed approach would
include any liabilities, as defined in 17 CFR 210.6-04 (rule 6.04 of
Regulation S-X). For example, this would include investment liabilities
and amounts payable for investment advisory, management, and service
fees. Reducing the amount of highly liquid assets by fund liabilities
reflects that fund liabilities are generally paid in cash, meaning that
highly liquid assets may need to be liquidated in order to satisfy
those liabilities rather than to meet redemptions.
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\150\ The highly liquid investment minimum is the percentage of
a fund's net assets that it invests in highly liquid assets that are
eligible to count toward the minimum under the rule. See rule 22e-
4(a)(7) (defining highly liquid investment minimum). Because this
calculation uses net assets as the denominator (which reflects the
amount of assets less any liabilities), we believe the numerator of
eligible highly liquid assets similarly should be net of
liabilities.
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Based on staff outreach, it is our understanding that the proposal
reflects many funds' existing practices. For example, when a fund has
significant liabilities, they generally will be incurred in connection
with derivatives transactions or other investments that give rise to a
fund liability. Because funds are required to classify all investments,
including liabilities, investments such as highly liquid derivatives in
a liability position will reduce the value of the fund's highly liquid
investments that are assets. To enhance investor protection by
preventing assets that a fund may in the future use to pay liabilities
from also being counted toward the fund's highly liquid investment
minimum, and to promote consistency in how funds calculate their highly
liquid investment minimum, we are proposing to require that all funds
reduce their highly liquid assets used to satisfy their highly liquid
investment minimum by the amount of the fund's liabilities.\151\
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\151\ Depending on the rules of any applicable exchange and
local law, a variation margin payment with respect to a derivatives
transaction may be deemed to settle the fund's liability for the
daily mark-to-market loss on the transaction. In that case or any
other case where a fund does not have a liability in connection with
a given transaction, the fund would not be required to reduce its
highly liquid investments in connection with that transaction under
the proposal.
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We request comment on these aspects of the proposal, including:
43. Should we, as proposed, require a fund to reduce the amount of
its highly liquid investments computed for the purposes of determining
compliance with its highly liquid investment minimum by the value of
any highly liquid assets that are posted as margin or collateral in
connection with any derivatives transaction that is classified as
moderately liquid or illiquid? Why or why not? Should we also require
that amounts posted as margin or collateral in connection with
derivatives transactions that are classified as highly liquid be
treated in this way? Alternatively, should we exempt amounts posted as
margin or collateral in connection with certain types or categories of
derivatives transactions from this requirement?
44. How frequently do funds calculate the percentage of their
highly liquid assets posted as margin or collateral in connection with
non-highly liquid derivatives transactions today? Would the proposed
requirement to calculate this value on a daily basis present new
challenges?
45. Should we, as proposed, require a fund to reduce the amount of
its highly liquid assets computed for the purpose of determining
compliance with its highly liquid investment minimum by the value of
any liabilities? Do funds already make this reduction when determining
compliance with highly liquid investment minimums? Should we instead
require a fund to reduce the amount of its highly liquid assets by a
different amount, such as the percentage of the fund's total assets
that its liabilities represent? Are there certain classes or types of
fund liabilities that should not be counted? For example, should we
provide an exception for liabilities associated with fund borrowings
that are used to meet redemptions in order to avoid a disincentive for
funds to borrow for this purpose under appropriate circumstances?
46. We propose that, for these purposes, the amount of a fund's
liabilities would be computed in the same manner as a fund computes its
liabilities for purposes of rule 6-04 of Regulation S-X. If we use this
standard, as proposed, would the amount by which funds should reduce
their highly liquid assets be clear? Are there any issues that may
arise from using the standard funds use to prepare their balance
sheets? Would a different definition of ``liabilities'' be more
appropriate?
3. Limit on Illiquid Investments
Rule 22e-4 currently limits a fund's ability to acquire illiquid
investments. Specifically, the rule prohibits a fund from acquiring any
illiquid investment if, immediately after the acquisition, the fund
would have invested more than 15% of its net assets in illiquid
investments that are assets.\152\ We are proposing to amend the rule's
limitation on illiquid investments to provide that the value of margin
or collateral that a fund could only receive upon exiting an illiquid
derivatives transaction would itself be treated as illiquid for these
purposes.\153\ As the Commission stated in 2016, the potential effects
of a fund's use of derivatives are relevant to assessing, managing, and
periodically reviewing a fund's liquidity risk.\154\ The potential
effects may be heightened when the derivatives transaction is itself
illiquid, and thus may be difficult for a fund to exit quickly enough
to use the associated margin or collateral to meet redemption requests,
or at all. Funds' use of illiquid derivatives is subject to several
limitations but, for open-end funds, the risks associated with illiquid
derivatives may be heightened as a result of the funds'
redeemability.\155\
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\152\ See rule 22e-4(b)(1)(iv). A fund also must notify its
board, and report confidentially to the Commission on Form N-RN, if
its illiquid investments that are assets exceed 15% of net assets.
\153\ See proposed rule 22e-4(b)(1)(iv).
\154\ See Liquidity Rule Adopting Release, supra note 8, at text
accompanying nn.218-223.
\155\ The limitations on funds' issuance of senior securities,
which include derivatives creating certain payment or delivery
obligations, in section 18 of the Act and 17 CFR 270.18f-4 (rule
18f-4) provide certain protections to investors, and the proposed
amendments are designed to complement those protections. See
Derivatives Adopting Release, supra note 21 (stating that a fund's
derivatives risk management program would be part of an adviser's
overall management of portfolio risk and would complement--but would
not replace--a fund's other risk management activities, such as a
fund's liquidity risk management program adopted under rule 22e-4).
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[[Page 77199]]
Under the proposal, for purposes of determining whether the fund is
in compliance with the limitation on illiquid investments, the fund
would treat as illiquid the amount of margin or collateral it has
posted in connection with a derivatives transaction that is classified
as an illiquid investment and that the fund would receive if it exited
the derivatives transaction (``excess collateral'').\156\ This proposed
requirement recognizes that, because a fund does not reasonably expect
to be able to convert an illiquid derivatives investment to U.S.
dollars within seven days, the fund likewise would not be able to
convert to U.S. dollars the value of excess collateral posted as margin
or collateral in connection with the derivatives transaction within
seven days. Therefore, the proposal would require a fund to include the
value of the excess collateral or margin when it determines the amount
of illiquid assets it holds for purposes of the 15% limit on illiquid
investments.
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\156\ This does not mean that the investment acting as margin or
collateral would need to be classified as an illiquid investment
under the rule. A fund would classify the relevant investment
according to the rule's classification framework. In order to aid
understanding of the reported data, we propose to require a fund to
report the value of investments treated as illiquid as a result of
this provision. See section II.E.1.d, infra and Item B.8.b of
proposed Form N-PORT.
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As with the proposed amendments related to the amounts posted as
margin or collateral for non-highly liquid derivatives, a fund would
not be required to specifically identify particular assets that it
posted as margin or collateral to cover specific derivatives
transactions. Instead, a fund would calculate the value of its assets
posted as margin or collateral in connection with illiquid derivatives
transactions and treat that value of assets as illiquid.\157\
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\157\ See Item B.8.b of proposed Form N-PORT.
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We request comment on this aspect of the proposal, including:
47. Should we, as proposed, require funds to treat as illiquid
investments the value of excess collateral the fund has posted in
connection with a derivatives transaction that is classified as an
illiquid investment? Are there circumstances where a fund would have
ready access to the value of such collateral even though the associated
derivatives transaction is illiquid?
48. Are there challenges to identifying and monitoring the amount
of excess collateral a fund has posted in connection with a derivatives
transaction that is classified as an illiquid investment? If so, are
there ways to address those challenges?
49. Are there other instances where we should treat an investment
as illiquid for purposes of the rule's limit on illiquid investments
that the current rule and the proposal do not contemplate?
50. Should we amend any other aspects of the illiquid investment
limitations in the rule? For example, should we change the amount of
the limit on illiquid investments from 15% to a lower amount, such as
10% or 5%, or a higher amount, such as 20% or 25%?
B. Swing Pricing
We are proposing amendments to rule 22c-1 that would require all
registered open-end management investment companies to engage in swing
pricing under certain conditions, except for money market funds and
ETFs (the latter, ``excluded funds'').\158\ Swing pricing is a process
of adjusting a fund's current NAV when certain conditions are met, such
that the transaction price effectively passes on costs stemming from
shareholder inflows or outflows to the shareholders engaged in that
activity. Trading activity and other changes in portfolio holdings
associated with purchases and redemptions may impose costs, including
trading costs and costs of depleting a fund's liquidity. These costs,
which currently are borne by the non-transacting shareholders in the
fund, can dilute the interests of these shareholders. In addition, this
can create incentives for shareholders to redeem quickly to avoid
losses, particularly in times of market stress. If shareholder
redemptions are motivated by this first-mover advantage, they can lead
to increasing outflows, and as the level of outflows from a fund
increases, the incentive for remaining shareholders to redeem may also
increase.\159\ By imposing the costs associated with net purchases or
net redemptions on the shareholders who are purchasing or redeeming
from the fund at that time, swing pricing can more fairly allocate
costs, reduce the potential for dilution of investors who are not
currently transacting in the fund's shares, and reduce any potential
first-mover advantages.
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\158\ See proposed rule 22c-1(b). We refer to registered open-
end management investment companies other than excluded funds as
``funds'' or ``open-end funds'' when discussing the swing pricing
requirement. We continue to believe it is appropriate to limit swing
pricing to these funds and to not include other fund types, such as
unit investment trusts or closed-end funds. See Swing Pricing
Adopting Release, supra note 8, at nn.62-72 and accompanying text.
With respect to excluded funds, the Commission recently proposed to
require certain money market funds to engage in swing pricing under
rule 2a-7, but those money market funds would not be subject to the
proposed swing pricing requirement under rule 22c-1(b). See Money
Market Fund Reforms, Investment Company Act Release No. 34441 (Dec.
15, 2021) [87 FR 7248 (Feb. 8, 2022)] (``Money Market Fund Proposing
Release''). ETFs, including an ETF share class of any fund that
issues multiple classes of shares representing interests in the same
portfolio, would not be subject to the swing pricing requirement, as
discussed below. See definition of ``Exchange-traded fund'' in
proposed rule 22c-1(d).
\159\ Some research suggests that a first-mover advantage in
open-end funds may lead to cascading anticipatory redemptions akin
to traditional bank runs. This research generally models an
exogenous response to negative fund returns and not trading costs.
However, these results may extend to trading costs to the degree
that cost based dilution may reduce subsequent fund returns, which
would trigger runs in these models. See, e.g., Chen, Qi, Itay
Goldstein, and Wei Jiang. 2010. ``Payoff Complementarities and
Financial Fragility: Evidence from Mutual Fund Outflows.'' Journal
of Financial Economics 97(2): 239-262. See also Goldstein, Itay, Hao
Jiang, and David Ng. 2017. ``Investor Flows and Fragility in
Corporate Bond Funds.'' Journal of Financial Economics 126(3):592-
613. See also Morris, Stephen, Ilhyock Shim, and Hyun Song Shin.
2017. ``Redemption Risk and Cash Hoarding by Asset Managers.''
Journal of Monetary Economics 89: 71-87. See also Zeng, Yao. 2017.
``A Dynamic Theory of Mutual Fund Runs and Liquidity Management.''
Working Paper. See also Ma, Yiming, Kairong Xiao, and Yao Zeng.
2021. ``Mutual Fund Liquidity Transformation and Reverse Flight to
Liquidity.'' Working Paper. See also Ma, Yiming, Kairong Xiao, and
Yao Zeng. 2021. ``Bank Debt versus Mutual Fund Equity in Liquidity
Provision.'' Working Paper. See also Christof W. Stahel. 2022.
``Strategic Complementarity Among Investors with Overlapping
Portfolios'', available at https://ssrn.com/abstract=3952125
(positing that investors behave similarly regardless of whether they
hold assets indirectly through a fund or directly through a
separately managed account and the general explanation for investor
decisions to sell assets is that all market participants compete for
finite market liquidity).
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1. Proposed Swing Pricing Requirement
Under the proposal, every open-end fund other than an excluded fund
would be required to establish and implement swing pricing policies and
procedures that adjust the fund's current NAV per share by a swing
factor either if the fund has net redemptions or if it has net
purchases that exceed an identified threshold.\160\ We are proposing to
require these funds to use swing pricing as an anti-dilution tool, in
contrast to the optional framework that currently exists in rule 22c-1.
Based on our observations from the events in March 2020, including in
other jurisdictions where swing pricing is a common tool, requiring
funds to use
[[Page 77200]]
swing pricing could result in benefits for investors, as discussed
below.\161\ However, at present no U.S. funds have implemented swing
pricing. One reason funds have not implemented swing pricing is that
they lack timely flow information to operationalize this anti-dilution
tool. However, even if all funds had access to sufficient flow
information in order to implement swing pricing, some may nonetheless
choose not to implement it due to implementation costs or because
investors in U.S. funds are unfamiliar with swing pricing. Therefore,
funds may not be incentivized to be the first to adopt swing pricing.
We believe that a regulatory requirement, rather than a permissive
framework, would accrue benefits to investors that justify the
implementation costs and would overcome these collective action
problems that may have prevented swing pricing implementation. In
addition, we continue to believe the information a fund that uses swing
pricing must disclose in its prospectus will improve public
understanding regarding a fund's use of swing pricing.\162\
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\160\ See proposed rule 22c-1(b)(1) and definition of ``Inflow
swing threshold'' in proposed rule 22c-1(d).
\161\ See supra notes 59 to 63 and accompanying text (stating
that some fund managers with both U.S. and European operations
indicated to the staff that swing pricing would have been a useful
tool for U.S. funds to have had to combat dilution in Mar. 2020).
\162\ See Swing Pricing Adopting Release, supra note 11, at
n.360 and accompanying text. In 2016, when the Commission adopted
the optional swing pricing rule for open-end funds that are not
excluded funds, it also adopted certain amendments to Form N-1A to
enhance disclosure related to a fund's use of swing pricing, if
applicable. Among other things, these amendments required that a
fund that uses swing pricing explain the fund's use of swing
pricing, including its meaning, the circumstances under which the
fund will use it, the effects of swing pricing on the fund and
investors, and the upper limit it has set on the swing factor. See
Item 6(d) of Form N-1A. Although no funds currently use swing
pricing, and therefore do not provide swing pricing disclosures to
their investors, under the proposed rule all funds other than
excluded funds would be required to provide these disclosures, other
than the swing factor upper limit disclosure, to their investors.
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Some academics and market participants have suggested that swing
pricing has provided significant benefits to long-term investors in
funds in other jurisdictions, reducing dilution attributable to the
transaction costs associated with shareholder activity.\163\ As an
example, one foreign fund industry group has suggested that funds using
swing pricing exhibit superior performance returns over time compared
to funds with identical investment strategies and trading patterns that
do not employ anti-dilution measures.\164\ In terms of performance
benefits, one study found that, for a 10% rise in monthly outflows, the
associated decline in monthly returns relative to a fund's benchmark
was double the amount for a fund that does not use swing pricing in
comparison to a fund that uses swing pricing (a 6 basis point decline
versus a 3 basis point decline, respectively).\165\ And one investment
manager reviewed the effects of swing pricing for twenty of its
European funds in 2019 and found that the anti-dilution effect of swing
pricing improved annual performance for these funds by around 10 to
more than 60 basis points.\166\
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\163\ See, e.g., Dunhong Jin, Marcin Kacperczyk, Bige Kahraman,
and Felix Suntheim, Swing Pricing and Fragility in Open-end Mutual
Funds, The Review of Financial Studies, 35(1) (2022), available at
https://academic.oup.com/rfs/article/35/1/1/6162183 (``Jin, et
al.''); BlackRock, Swing Pricing--Raising the Bar (Sept. 2021),
available at https://www.blackrock.com/corporate/literature/whitepaper/spotlight-swing-pricing-raising-the-bar-september-2021.pdf (``BlackRock Swing Pricing Paper'').
\164\ See Association of the Luxembourg Fund Industry, Swing
Pricing Brochure (July 2022), available at https://www.alfi.lu/getattachment/3154f4f7-f150-4594-a9e3-fd7baaa31361/app_data-import-alfi-alfi-swing-pricing-brochure-2022.pdf.
\165\ See CSSF Paper, supra note 61.
\166\ See BlackRock Swing Pricing Paper, supra note 163.
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In addition, in March 2020, many European funds that used swing
pricing lowered their swing thresholds and increased the size of their
swing factors, suggesting there was a need to make more frequent and
significant adjustments to the funds' NAVs at that time to avoid
substantial dilution that otherwise would have occurred.\167\ One study
found that surveyed funds using swing pricing during a three week
period of elevated redemptions in March 2020 recouped roughly 6 basis
points of total net assets on average from redeeming investors.\168\
The swing pricing policies that the proposed rule would require, which
are similar to those used by some foreign funds, are designed to
mitigate dilution arising from shareholders' purchase and redemption
activity, particularly during times of stress when those dilution costs
may increase. In addition to reducing dilution, some studies also
suggest that swing pricing dampens redemption pressure, although some
have found this effect to be minimal or nonexistent during certain
periods of market stress.\169\
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\167\ See notes 59 to 63 and accompanying text.
\168\ See Claessens and Lewrick, supra note 61.
\169\ See CSSF Paper, supra note 61 (stating that funds applying
swing pricing are less exposed to redemption pressure during
episodes of elevated market volatility, but this dampening effect
appears to vanish during episodes of severe market volatility, such
as in Mar. 2020); see also infra notes 354 to 355 and accompanying
text.
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Consistent with our current optional swing pricing framework, the
proposed swing pricing requirement for open-end funds would apply to
both net purchases and net redemptions. Although liquidity and
transaction costs associated with meeting net redemptions can present
heightened risks of dilution, particularly in stress periods, we
continue to believe that net purchases also may cause shareholder
dilution.\170\ However, when a fund has net purchases, we propose to
require swing pricing only if the amount of net purchases exceeds a
specified threshold.
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\170\ See Swing Pricing Adopting Release, supra note 13, at
paragraph accompanying n.166.
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While the proposed swing pricing requirement generally would apply
to all registered open-end funds other than excluded funds, we propose
to retain the current provision that does not permit feeder funds in a
master-feeder fund structure to use swing pricing.\171\ The use of
swing pricing would generally be inappropriate for feeder funds,
because that level of a fund structure does not actually transact in
underlying portfolio assets as a result of net purchase or net
redemption activity. A master fund, however, generally would be subject
to the swing pricing requirement. The master fund may purchase
portfolio assets to invest purchasing shareholders' cash (as
transferred through the feeder fund) or sell portfolio assets to pay
redemption proceeds (reducing the feeder fund's interest in the master
fund). Thus, to the extent that net purchases into or redemptions from
the master fund by one or more feeder funds, or any other investors in
the master fund, would trigger the application of swing pricing under
the proposed rule, the swing factor would be applied at the level of
the master fund.
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\171\ See proposed rule 22c-1(b)(5) and current rule 22c-
1(a)(3)(iv).
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Consistent with current rule 22c-1, we propose to exclude ETFs from
the swing pricing requirement because ETFs often impose fees in
connection with the purchase or redemption of creation units that are
intended to defray operational processing and brokerage costs to
prevent possible shareholder dilution.\172\ We also are not including
ETFs within the scope of the proposed requirement because we believe
that swing pricing could impede the effective functioning of an ETF's
arbitrage mechanism. Additionally, notwithstanding section 18(f)(1) of
the Act, a fund with a share class that is an exchange-traded fund is
subject to the swing pricing requirement only with respect to any share
classes that are not
[[Page 77201]]
exchange-traded funds.\173\ The proposed rule provides this exemption
to allow funds with both mutual fund and ETF share classes to apply
swing pricing to only their mutual fund share classes. Absent an
exemption, differences between the ETF and mutual fund share classes
created by swing pricing could result in a fund being deemed to issue a
senior security, which would otherwise be prohibited under the
Act.\174\ Thus, a fund with an ETF share class would exclude the ETF
share class's flow information when determining whether and how to
apply swing pricing, and would not adjust the NAV of the ETF share
class by the swing factor in computing the share price of that class.
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\172\ See Swing Pricing Adopting Release, supra note 13, at
paragraph accompanying n.68.
\173\ See proposed rule 22c-1(b)(6).
\174\ Section 18(f)(1) of the Act generally makes it unlawful
for any registered open-end company to issue any class of senior
security. Section 18(g) defines senior security to include any stock
of a class having a priority over any other class as to distribution
of assets or payment of dividends.
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We request comment on our proposal to require any fund that is not
an excluded fund to implement swing pricing.
51. As proposed, should we require any fund that is not an excluded
fund to implement swing pricing? Should we provide any additional
exclusions from the swing pricing requirement? For example, should
funds that invest solely or primarily in highly liquid investments be
permitted, but not required, to use swing pricing? If we provide an
exclusion for funds that primarily invest in highly liquid investments,
how should we define primarily for these purposes (e.g., more than 50%,
66%, or 75%)? Should we use the same definition of highly liquid
investment as the liquidity rule for these purposes? If not, how should
we define highly liquid investments for purposes of an exclusion from
the swing pricing requirement? If a fund primarily invested in highly
liquid investments were to no longer qualify for this exclusion, when
should it be required to adopt swing pricing (e.g., immediately or
within a certain grace period)? Alternatively, should we limit the
exclusion from swing pricing to funds that do not invest more than a
certain percentage of assets in illiquid investments? What maximum
level of illiquid investments would be appropriate to qualify for the
exclusion (e.g., 1%, 2%, 5%, or 10%)? When should a fund be required to
adopt swing pricing if it no longer complies with this exclusion (e.g.,
immediately or within a certain grace period)? Should we use the same
definition of illiquid investments as the liquidity rule for these
purposes?
52. Should we limit the swing pricing requirement to only certain
types of mutual funds and retain an optional framework for other mutual
funds? If so, how should we identify by rule the types of mutual funds
that would most benefit from a swing pricing requirement? As an
example, would it be appropriate to require swing pricing for fixed-
income mutual funds only, and to retain an optional approach for other
funds? If so, how would a fixed-income fund be defined for this purpose
(e.g., a mutual fund that invests at least a certain percentage in
fixed-income investments, such as 50%, 75%, or 80%)? How would fixed-
income investments, or any other type of portfolio investment, be
defined for this purpose?
53. Should we adopt swing pricing as a default tool, with a
requirement that an open-end fund, other than an excluded fund,
implement swing pricing unless certain conditions are met? For example,
should a fund be required to implement swing pricing unless its board
of directors makes certain determinations (e.g., that the fund and its
shareholders are unlikely to experience significant dilution in
connection with investor purchases and redemptions) and the fund
maintains records of such determinations? Should a fund be required to
report information about the reasons for such a determination publicly?
54. Should swing pricing remain an optional tool for all mutual
funds, other than excluded funds? If so, how likely are funds to use
the tool if we adopt the proposed hard close requirement or take other
steps to facilitate a fund's ability to determine its daily flows
before the NAV is finalized? Are certain types of funds more likely to
use swing pricing if it remained an optional tool? If so, why are these
funds more likely to use swing pricing than others? Are the funds that
would use swing pricing if it remained optional the same funds that
would benefit most from addressing dilution associated with shareholder
transactions?
55. As proposed, should we retain the current provision in the rule
that does not allow feeder funds in a master-feeder structure to engage
in swing pricing?
56. Under the proposal, ETFs, the shares of which are listed and
traded on a national securities exchange, and that are formed and
operate under an exemptive order under the Investment Company Act or in
reliance on rule 6c-11, would not be subject to swing pricing. Is the
proposed definition of ETF appropriate? If we adopt the swing pricing
requirement, would mutual funds seek to convert to an ETF structure?
Are there any actions or exemptive relief that the Commission should
take or grant to facilitate the conversion of mutual funds to ETFs? If
ETFs were to become the predominant form of open-end fund under the
Investment Company Act, would that affect the need to impose swing
pricing? And likewise, if ETFs were to become the predominant form of
open-end fund, would that benefit or harm investors, and if so, how and
to what extent?
57. Should we provide that funds with an ETF share class must
exclude the ETF share class from the application of swing pricing, as
proposed? What, if any, operational challenges would exist for such
funds under this approach? Should we instead require that ETF share
classes be subject to the swing pricing requirement, which would result
in authorized participant purchases and redemptions being effected at
an adjusted NAV?
58. Should we require swing pricing for both net redemptions and
net purchases, as proposed, or only for net redemptions? Do dilution
and liquidity concerns exist for open-end funds in both scenarios?
59. What would be the operational challenges and costs for funds to
adopt and implement swing pricing, as proposed? If funds
operationalized swing pricing in March 2020, would it have been an
effective tool to address dilution during that period? To what extent
were funds selling portfolio assets and incurring transaction costs to
meet redemptions, or in anticipation of future redemptions, during that
period?
60. Will the existing swing pricing disclosures required in Form N-
1A be sufficient to help investors understand swing pricing? How
familiar are U.S. investors with swing pricing? Are there any
amendments we should make to the swing pricing disclosure requirements
in Form N-1A that would help investors better understand the concept of
swing pricing? For example, should funds be required to disclose in
their registration statements the frequency they have applied, or would
have applied, a swing factor over a specified period of time (e.g., 1,
3, or 5 years) based on historical flow information? Should we require
a fund to provide additional disclosure about swing pricing to
investors outside of the registration statement? For example, should we
require funds to disclose the effects of swing pricing in shareholder
reports (e.g., in management's discussion of fund performance)?
[[Page 77202]]
61. Is the experience with swing pricing in certain foreign
jurisdictions relevant to an analysis of whether swing pricing would be
an effective tool for U.S. funds? Beyond the operational differences
identified in this release, are there differences in regulatory
frameworks, markets, fund investors, or other factors between the U.S.
and these other jurisdictions that might cause U.S. funds' experiences
with swing pricing to differ? \175\
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\175\ See infra note 225 (discussing that European jurisdictions
in which funds use swing pricing generally already have a hard
close, which results in European funds receiving order flow much
earlier than U.S. funds).
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62. Rule 2a-4 under the Act requires a fund, when determining its
current NAV, to reflect changes in holdings of portfolio securities and
changes in the number of outstanding shares resulting from
distributions, redemptions, and repurchases no later than the first
business day following the trade date. Are there any changes we should
make to rule 2a-4 to address dilution? For example, should we amend
that rule to require that funds reflect these changes on trade date?
2. Amendments to Swing Threshold Framework
The current rule permits a fund to determine its own swing
threshold for net purchases and net redemptions, based on a
consideration of certain factors the rule identifies.\176\ We are
proposing to specify when a fund must use swing pricing to adjust its
current NAV, which would differ depending on whether the fund has any
net redemptions or has net purchases above a specified threshold on a
given day.
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\176\ The factors a fund currently must consider in determining
the size of its swing threshold are: (1) the size, frequency, and
volatility of historical net purchases or net redemptions of fund
shares during normal and stressed periods; (2) the fund's investment
strategy and the liquidity of the fund's portfolio investments; (3)
the fund's holdings of cash and cash equivalents, and borrowing
arrangements and other funding sources; and (4) the costs associated
with transactions in the markets in which the fund invests. See rule
22c-1(a)(3)(i)(B).
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When the Commission adopted the swing pricing provisions in 2016,
it determined to require a swing threshold and not to prescribe a swing
threshold floor applicable to all funds because it believed that
different levels of net purchases and net redemptions would create
different risks of dilution for funds with different strategies,
shareholder bases, and other liquidity-related characteristics.\177\ At
that time, the Commission believed consideration of the swing threshold
factors--which took into account these different liquidity-related
characteristics--would lead a fund to set a threshold at a level that
would trigger the fund's investment adviser to trade portfolio assets
in the near term to a degree or of a type that may generate material
liquidity or transaction costs for the fund. We further believed that
after considering these factors, a fund would be unable to set the
swing threshold at zero. Thus the current rule does not contemplate
full swing pricing, but assessment of the swing threshold factors could
lead certain funds to set low swing thresholds approximating full swing
pricing.
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\177\ For considerations relating to the swing threshold in the
current rule, see generally Swing Pricing Adopting Release, supra
note 11, at nn.150-155 and accompanying text.
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In the intervening period, however, we have observed that the size
of funds' swing thresholds in certain other jurisdictions has depended
more on uniform decisions by the manager of a fund complex than on an
individual fund's liquidity-related circumstances.\178\ In addition, we
considered our experience with the liquidity rule discussed above,
where currently allowed discretion has led to favorable liquidity
assessments that tend to over-estimate funds' liquidity during stressed
market conditions and that fail to change dynamically during stressed
market conditions. A similar experience translated to swing pricing
could cause high swing thresholds set during calm market conditions
that do not adjust downward as may be appropriate in some cases during
stressed market conditions. As a result of these experiences, we are
concerned that retaining the principles-based framework for setting
swing thresholds under the current rule would not result in the level
of fund-specific tailoring the Commission contemplated and, instead,
would simply result in undue variation among similarly situated funds
and, in some cases, swing thresholds high enough that swing pricing
does not adequately address dilution.
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\178\ See Bank of England Survey, supra note 60 (``In most cases
we observed that funds with different primary strategies and assets,
but managed by the same fund manager, used both the same thresholds
for applying swing pricing, and the same calculation of the
standardised swing factor. This appears to indicate that managers
may not be fully considering specific factors such as in the
investor base or asset-specific factors for individual funds.'').
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In the case of net redemptions, the proposed rule would require a
fund to apply swing pricing always (i.e., without a swing
threshold).\179\ Because every net redemption can potentially involve
trading or borrowing costs that dilute the value of the fund, as well
as depletion of a fund's liquidity for remaining shareholders that
increases the likelihood of future dilution, the proposal, in setting a
uniform approach to triggering swing pricing in all circumstances,
would require a fund to apply a swing factor regardless of the size of
its net redemptions, which is intended to fairly allocate costs and
reduce dilution. Applying swing pricing regardless of the size of net
redemptions may help reduce any potential first-mover advantage
associating with redeeming before other investors. However, the types
of costs the swing factor must take into account would depend on the
size of net redemptions. Specifically, the proposed rule would require
a fund to include market impacts in its swing factor only if net
redemptions exceed 1% of the fund's net assets (the ``market impact
threshold'').\180\ Market impact costs are the costs incurred when the
price of a security changes as a result of the effort to purchase or
sell the security.\181\
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\179\ See proposed rule 22c-1(b)(1)(i).
\180\ See proposed rule 22c-1(b)(2)(i)(C) and definition of
``Market impact threshold'' in proposed rule 22c-1(d).
\181\ Market impact costs reflect price concessions (amounts
added to the purchase price or subtracted from the selling price)
that are required to find the opposite side of the trade and
complete the transaction.
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We understand that there may be operational challenges and
complexities to estimating market impact costs. Recognizing these
difficulties, and that market impacts are likely to be minimal or even
negligible when redemptions are not significant, the proposal sets a
market impact threshold below which estimates of market impact would
not be necessary. Based on our analysis of historical daily flow data
over a period of more than 10 years for equity and fixed-income mutual
funds, a given fund had daily outflows of more than 1% on slightly more
than 1% of trading days.\182\ We propose a 1% market impact threshold
to balance the operational challenges of frequently estimating market
impacts with the goal of reducing dilution, particularly in times of
stress (i.e., when a fund is more likely to experience redemptions of
more than 1% of net assets and market impacts are likely to be larger).
We recognize that smaller funds may be less likely than larger ones to
have market impacts at a 1% threshold, because they generally would be
selling smaller investment sizes than larger funds would at that
threshold. However, there are circumstances in which smaller funds may
also experience market impact costs at the 1% threshold; for example,
if the fund holds substantial
[[Page 77203]]
illiquid investments or during periods of market stress. Therefore, the
proposal requires all funds to assess whether market impact costs would
occur when net redemptions exceed a 1% threshold and, if they do occur,
to include such costs in the swing factor. A uniform market impact
threshold for all funds would provide a consistent and objective
threshold for all funds to consider market impacts.
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\182\ Based on Morningstar data for the period of Jan. 2009
through Dec. 2021.
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When a fund has net purchases, we propose to only require swing
pricing--including market impact--if the amount of net purchases
exceeds 2% of the fund's net assets (the ``inflow swing
threshold'').\183\ We recognize that smaller levels of net purchases
are less likely to result in dilution than net redemptions. This is
because funds, while required to pay redemptions within seven days, are
not required to invest cash inflows within a specified period.
Therefore, if bid-ask spreads have widened on a day that the fund
receives the cash inflows, the fund manager generally can wait to
invest the cash to reduce transaction costs.\184\ In addition, while
investing the cash inflows could decrease the liquidity of the fund,
particularly if the cash is used to purchase illiquid investments, the
liquidity rule curbs this possibility by limiting the amount of
illiquid investments a fund can acquire.
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\183\ See definition of ``Inflow swing threshold'' in proposed
rule 22c-1(d).
\184\ Regardless of bid-ask spreads, a fund manager also may
choose to use cash inflows to invest in derivatives to obtain market
exposure quickly while strategizing where to invest that cash on a
longer-term basis. Funds may be incentivized to invest promptly in
an effort to avoid reduced returns and tracking error.
---------------------------------------------------------------------------
For these reasons, the proposal sets a swing threshold for net
purchases but not one for net redemptions. We also recognize that low
levels of net purchases are less likely to result in dilution, but that
higher levels of net purchases are more likely to result in dilution
absent appropriate tools for mitigating it. Based on our analysis of
historical daily flow data over a period of more than 10 years for
equity and fixed-income mutual funds, a given fund had daily inflows of
approximately 2% on about 1% of trading days.\185\ Therefore, similar
to the proposed market impact threshold, we propose an inflow swing
threshold of 2% to balance the operational challenges of frequently
implementing swing factors for net purchases with the goal of reducing
dilution, particularly when a fund has significant inflows.
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\185\ Based on Morningstar data for the period of Jan. 2009
through Dec. 2021.
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Although the proposed rule would identify a market impact threshold
that would apply to net redemptions and an inflow swing threshold for
net purchases, the rule would permit the fund's swing pricing
administrator to use smaller thresholds than the rule identifies in
either of these instances as the administrator determines is
appropriate to mitigate dilution.\186\ Flexibility to use a smaller
threshold is designed to recognize that there may be circumstances in
which a smaller threshold than the rule requires would help reduce
dilution, such as when the fund holds a larger amount of investments
that are less liquid, in times of market stress, or in the case of a
large fund (i.e., because a large fund is selling or purchasing a
larger amount of instruments than a small fund at a 1% market impact
threshold for net redemptions or a 2% inflow swing threshold for net
purchases). For example, a fund might elect to implement swing pricing
if the fund experiences net purchases of any amount.
---------------------------------------------------------------------------
\186\ See definitions of ``Inflow swing threshold'' and ``Market
impact threshold'' in proposed rule 22c-1(d). Under the proposed
rule, the term ``swing pricing administrator'' has the same meaning
as the term ``person(s) responsible for administering swing
pricing'' under the current rule. See proposed rule 22c-1(d);
current rule 22c-1(a)(3)(ii)(C). The swing pricing administrator is
the fund's investment adviser, officer, or officers responsible for
administering the fund's swing pricing policies and procedures. The
proposed rule specifies that the swing pricing administrator may
consist of a group of persons. As with the current rule, the fund's
board of directors must designate this person or group of persons.
---------------------------------------------------------------------------
We understand that in having the option to set a lower market
impact threshold for net redemptions and inflow swing threshold for net
purchases, the swing pricing administrator would have discretion that
it potentially could use to enhance fund performance in a misleading
manner by adjusting the fund's NAV more frequently or more
substantially than is needed to address dilution. To help address this
risk, under the proposal the administrator would be required to include
in its written reports to the board the information and data supporting
its determination to use lower thresholds.\187\ Additionally,
consistent with the current rule, a fund's portfolio manager could not
be designated as the swing pricing administrator.\188\
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\187\ See proposed rule 22c-1(b)(3)(iii)(C). Consistent with the
current rule, a fund would be required to maintain a written copy of
the report provided to the board for six years, the first two years
in an easily accessible place. See rule 22c-1(a)(3)(iii); proposed
rule 22c-1(b)(4).
\188\ See rule 22c-1(a)(3)(ii)(C) and proposed rule 22c-
1(b)(3)(ii). See also Swing Pricing Adopting Release, supra note 11,
at n.269 and accompanying text.
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We request comment on our proposed amendments to the swing pricing
threshold.
63. Should we adopt a framework that, in the case of net
redemptions, requires a fund to adjust its NAV by a swing factor only
when those net redemptions exceed an identified threshold (i.e., as we
propose for net purchases)? If so, should that threshold be the same
size as the 1% market impact threshold, or a lower or higher amount
(e.g., 0.5%, 1.5%, or 2%)?
64. Should we require the application of the swing factor
regardless of the size of net purchases or net redemptions, or only
when they exceed a certain percentage of a fund's net assets? Should
funds have discretion to set their own thresholds? If so, should that
discretion be based on the swing threshold factors currently in the
rule or should we adjust those factors?
65. Should we include a market impact threshold for net
redemptions, as proposed? Is 1% an appropriate level for the market
impact threshold? Should it be a lower or higher amount (e.g., 0.5%,
1.5%, or 2%)? Is there different data or analysis that we should take
into account to determine the market impact threshold?
66. Should we include an inflow swing threshold for net purchases,
as proposed? Is 2% an appropriate level for the inflow swing threshold?
Should it be a lower or higher amount (e.g., 0.5%, 1%, 1.5%, or 3%)? Is
there different data or analysis that we should take into account to
determine the inflow swing threshold?
67. Would the proposed inflow swing threshold, or a requirement to
use swing pricing in the case of net purchases more generally, cause a
fund to limit the total amount an investor can invest in the fund? If
so, what effects would this have on investors?
68. Should we permit the swing pricing administrator to use
discretion to establish a smaller market impact threshold for net
redemptions or a smaller inflow swing threshold for net purchases if
the administrator determines a smaller threshold is appropriate to
mitigate dilution, as proposed? Should we prescribe the circumstances
in which a smaller threshold would be permitted, the timing of such a
determination by the swing pricing administrator (e.g., if a swing
pricing administrator must formally establish a smaller threshold that
will remain in place for a period of time), disclosure of such a
determination to the fund's investors, and recordkeeping requirements
in support of the determination? Should we require the fund's board,
instead of
[[Page 77204]]
the swing pricing administrator, to approve use of a smaller threshold?
Should we permit the swing pricing administrator to exclude certain
types of costs from the swing factor if it uses a lower-than-required
threshold? For example, should a swing pricing administrator be
permitted to exclude market impact estimates from the swing factor if
it uses an inflow swing threshold that is lower than 2%, and instead
only include market impact estimates when inflows also exceed 2%?
69. Should the swing pricing administrator or the board have
flexibility to establish larger thresholds than proposed (i.e., to
apply a swing factor only when net redemptions exceed a specified
percentage, to include market impacts in the swing factor when net
redemptions are an identified amount that is greater than 1%, or to
apply a swing factor only when net purchases exceed an identified
amount that is greater than 2%)? If so, what are the circumstances in
which a fund board or the swing pricing administrator should have
flexibility to use larger thresholds that the proposed rule identifies?
70. Should we allow certain types of funds to use different
thresholds than those the proposed rule identifies? For example, should
we permit or require smaller funds to use larger thresholds? If so, how
should we identify smaller funds for these purposes? Should the rule
identify larger thresholds for smaller funds, or should smaller funds
have flexibility to determine their own thresholds? As another example,
should we permit or require funds that hold significant amounts of
highly liquid investments to use larger thresholds? If so, how should
we identify funds that hold significant amounts of highly liquid
investments for these purposes? Should the rule identify larger
thresholds for these funds, or should they have flexibility to
determine their own thresholds?
3. Determining Flows
Consistent with the current rule, the swing pricing administrator
must review investor flow information to determine if the fund has net
purchases or net redemptions and the amount of net purchases or net
redemptions.\189\ For these purposes, investor flow information means
information about the fund investors' daily purchase and redemption
activity. Investor flow information may consist of individual,
aggregated, or netted eligible orders, and excludes any purchases or
redemptions that are made in kind and not in cash.\190\ Currently it
would be difficult to determine investor flow information on a given
day because some intermediaries do not provide order flow until after
the fund has finalized its NAV. In recognition of these challenges, the
current rule permits a swing pricing administrator to make swing
pricing determinations based on receipt of sufficient investor flow
information to allow the fund to estimate reasonably whether it has
crossed a swing threshold with high confidence.\191\ While the hard
close provision in the proposed rule is intended to result in funds
generally having flow information in a timely manner, and therefore
greatly reduce the need for estimation, we recognize some estimation
may still be required. The proposed rule would, therefore, continue to
permit the swing pricing administrator to make swing pricing
determinations based on reasonable, high confidence estimates of
investor flows.\192\
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\189\ See rule 22c-1(a)(3)(i)(A) and proposed rule 22c-
1(b)(1)(i).
\190\ See definition of ``Investor flow information'' in
proposed rule 22c-1(d). See also infra section II.C.2 (discussing
the proposed definition of ``eligible order'' for purposes of the
hard close requirement).
\191\ See rule 22c-1(a)(3)(i)(A).
\192\ Under the current rule, the swing pricing administrator is
permitted to make swing threshold determinations based on receipt of
sufficient flow information ``to allow the fund to reasonably
estimate whether it has crossed the swing threshold(s) with high
confidence.'' See rule 22c-1(a)(3)(i)(A).
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Under our proposal, the swing pricing administrator would be
required to review investor flow information on a daily basis to
determine: (1) if the fund experiences net purchases or net
redemptions; and (2) the amount of net purchases or net redemptions. We
propose to permit the swing pricing administrator to make these
determinations based on ``reasonable, high confidence estimates.''
While there would be less of a need to estimate flows under the
proposed hard close requirement, we understand that a swing pricing
administrator still would need to use estimates in some cases. For
instance, if an investor submits an exchange order to redeem its shares
from Fund A and simultaneously invest the proceeds in Fund B, the swing
pricing administrator for Fund B may need to estimate the incoming cash
by multiplying the number of shares redeemed from Fund A by an estimate
of Fund A's NAV, which may be the prior day's transaction price. In
this situation, we recognize it will not be possible for the swing
pricing administrator to determine the exact size of the related flow
information until a later time. Therefore, we propose to permit the use
of reasonable, high confidence estimates to make swing pricing
determinations. Furthermore, some funds groups with both U.S. and
European operations may already have experience with this type of
estimation, because European funds that have adopted swing pricing
generally use the prior day's price to estimate today's flows.
We request comment on our proposal requirements related to
shareholder flow information.
71. Should we permit a swing pricing administrator to make
reasonable, high confidence estimates of investor flows, as proposed?
Are there operational complexities to this approach? Is the rule's
reference to reasonable, high confidence estimates of investor flows
sufficiently clear? If not, how should we revise the rule to provide
greater clarity about permitted estimates?
72. As proposed, should we remove references to receipt of
sufficient investor flow information in the rule in light of the
proposed hard close requirement?
73. Is the proposed definition of ``investor flow information''
clear and understandable? Should the rule continue to exclude any
purchases or redemptions that are made in kind and not in cash, as
proposed?
74. Should we provide additional guidance about circumstances in
which a swing pricing administrator may need to use estimates in
connection with arriving at a reasonable, high confidence estimate of
the fund's investor flow information and how the administrator should
arrive at those estimates? Are there other types of investor orders,
beyond orders that identify the number of shares to be purchased or
sold and exchanges, that would still require estimation under a hard
close approach? Should funds be able to use the prior day's transaction
price for purposes of estimating flows where the amount of such flows
are dependent on having a transaction price? Should funds be permitted
to make adjustments to the prior day's price for these purposes (e.g.,
to reflect market movements relative to fund benchmarks that occurred
after the prior day's NAV was struck)? If so, under what circumstances
should we permit such adjustments?
75. If we adopt the proposed hard close requirement, would there be
scenarios in which a swing pricing administrator would be unable to
arrive at a reasonable, high confidence estimate of investor flows? If
so, when would this occur? How should a fund comply with the swing
pricing requirement if the administrator is unable to arrive at a
reasonable, high
[[Page 77205]]
confidence estimate of investor flows on a given day?
76. Would the use of reasonable, high confidence estimates of
investor flows subject swing pricing determinations to abuse? Should
the use of estimates be limited to specific circumstances? Are there
other ways for the swing pricing administrator to make swing pricing
determinations without the use of reasonable, high confidence estimates
of investor flows?
77. Do fund groups with both U.S. and European operations already
have experience with investor flow estimation? If so, would experience
with European operations help these fund groups use estimates in their
U.S. funds? What changes to the proposed rule, if any, would help fund
groups without prior experience with investor flow estimation?
4. Swing Factors
In determining the swing factor, the proposed rule would require a
fund's swing pricing administrator to make good faith estimates,
supported by data, of the costs the fund would incur if it purchased or
sold a pro rata amount of each investment in its portfolio to satisfy
the amount of net purchases or net redemptions (i.e., a vertical
slice).\193\ The current swing pricing framework requires that the
swing factor take into account only the near-term costs expected to be
incurred by the fund as a result of net purchases or net redemptions
that occur on the day the swing factor is used, as well as borrowing-
related costs associated with satisfying redemptions.\194\ Under our
proposal, a fund would be required to assume it would purchase or sell
a pro rata amount of each investment in its portfolio, rather than
consider the specific investments it would purchase to invest the
proceeds from subscriptions or sell to meet redemptions.\195\ Because a
fund would need to calculate its costs based on the purchase or sale of
a vertical slice of its portfolio, rather than selecting specific
investments or borrowing to meet redemptions, we have proposed to
remove borrowing costs from the swing factor calculation. We recognize
that there are many ways a fund could pay redemptions or invest
proceeds from investor purchases, and a fund may not necessarily sell
or purchase a vertical slice of its portfolio holdings to do so.
However, we believe analyzing costs based on an assumed purchase or
sale of a vertical slice of the fund's portfolio would more fairly
reflect the costs imposed by redeeming or purchasing investors than an
approach that focuses solely on the costs associated with the
instruments that the fund expects to buy or sell (or expected borrowing
costs, in the case of redemptions). For example, under the current
rule, if a fund sells only highly liquid investments to meet
redemptions, the swing factor would typically reflect relatively low
transaction costs of selling those investments and any near-term
rebalancing, and generally would not account for the effect of leaving
remaining investors with a less liquid portfolio or potential longer-
term rebalancing costs. In contrast, the proposed requirement that a
fund calculate costs to purchase or sell a vertical slice of the
portfolio is designed to recognize the potential longer-term costs of
reducing the fund's liquidity under these circumstances.
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\193\ See proposed rule 22c-1(b)(2).
\194\ These near-term costs include spread costs, transaction
fees and charges arising from asset purchases or asset sales
resulting from those purchases or redemptions. See rule 22c-
1(a)(3)(i)(C).
\195\ See proposed rule 22c-1(b)(2).
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In addition, using a vertical slice is more objective than the
current approach, because the swing factor administrator does not need
to anticipate what actions the fund will take to pay redemptions or
invest proceeds from investor purchases, which may vary from day to
day. This should make the swing factor easier to administer. Further,
under the proposed swing pricing framework and consistent with the
current rule, a swing factor could generally be determined on a
periodic basis, as long as developments that should affect the swing
pricing administrator's good faith estimates of spreads, market impact,
and other transaction costs, such as significant market developments,
prompt a quicker reevaluation.\196\ A quicker reevaluation would be
required to comply with the proposed amendments where developments
would otherwise prevent the prior swing factor from reflecting the cost
the fund would incur if it purchased or sold a pro rata amount of each
portfolio investment under current market conditions. Accordingly, we
believe a fund would have the incentive to reevaluate promptly its
swing factor in these circumstances because having an accurate and fair
transaction price is crucially important to investors. We believe that
funds would address the frequency of swing factor determinations when
designing their policies and procedures relating to swing pricing.
---------------------------------------------------------------------------
\196\ See Swing Pricing Adopting Release, supra note 11, at
paragraph accompanying n.268.
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Calculating the swing factor would differ depending on whether the
fund is experiencing net purchases or net redemptions. In the case of
net redemptions, the good faith estimates must include, for selling a
pro rata amount of each investment in the fund's portfolio to satisfy
the amount of net redemptions: (1) spread costs; (2) brokerage
commissions, custody fees, and any other charges, fees, and taxes
associated with portfolio investment sales; and (3) if the amount of
the fund's net redemptions exceeds the market impact threshold, the
market impact.\197\ In the case of net purchases, swing pricing would
only be applied if the amount of the fund's net purchases exceeds
2%.\198\ In such cases the good faith estimates must include, for
purchasing a pro rata amount of each investment in the fund's portfolio
to invest the proceeds from the net purchases: (1) spread costs; (2)
brokerage commissions, custody fees, and any other charges, fees, and
taxes associated with portfolio investment purchases; and (3) the
market impact.\199\ We believe these components of the swing factor for
both net redemptions and net purchases, taken together, approximate the
aggregate costs associated with dilution. We also believe that
providing a standard for calculating swing factors, including the
vertical slice approach and the identification of the categories of
costs funds must include, would help avoid the variability in how funds
calculate swing factors, as observed in some other jurisdictions where
funds use swing pricing.\200\
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\197\ See proposed rule 22c-1(b)(2)(i).
\198\ See proposed rule 22c-1(b)(2)(ii).
\199\ Id.
\200\ See Bank of England Survey, supra note 60. This report
states that in calculating swing factors, some surveyed UK funds
only considered bid-ask spreads, some other funds also considered
explicit transaction costs such as commissions, and a few funds
considered market impact as well. Moreover, in reviewing the size of
swing factors applied in Mar. 2020, the report found that corporate
bond funds with net outflows applied swing factors ranging between -
5% and +0.5% from Mar. 10 to 23. The report states that the scale of
variation suggests that fund-specific experiences are not the sole
explanation for differences in swing factors and that different
approaches fund managers took in applying swing pricing also
contributed to these variations.
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We understand that in calculating the swing factor, fund managers
may have incentives to over-estimate costs in order to improve fund
performance. However, doing so would be misleading. To help address
this risk, under the proposal funds would be required to report their
swing factor adjustments publicly on Form N-PORT. We believe this
public transparency
[[Page 77206]]
should reduce a fund's incentive to over-estimate costs. Additionally,
a fund's portfolio manager, who arguably might have the strongest
incentives to over-estimate costs, could not be designated as the swing
pricing administrator.\201\
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\201\ See proposed rule 22c-1(b)(3)(ii).
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The method for calculating a fund's spread costs would differ
depending on how the fund values its portfolio holdings. We understand
that funds may value portfolio holdings at the bid price or the mid-
market price when striking their NAVs.\202\ If a fund values its
portfolio holdings at the bid price, it would not need to include
spread costs in its swing factor when the fund has net redemptions. In
contrast, if the fund has net purchases exceeding 2%, the fund would
need to include spread costs, which would reflect the full bid-ask
spread. For a fund that uses mid-market pricing, it would need to
include spread costs in its swing factor any time it applies swing
pricing. When a fund using mid-market pricing has net redemptions, or
net purchases exceeding 2%, the spread cost component of its swing
factor would reflect half of the bid-ask spread.
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\202\ See FASB ASC 820-10-35-36C (providing that if an asset
measured at fair value has a bid price and an ask price, the price
within the bid-ask spread that is most representative of fair value
in the circumstance shall be used to measure fair value, and that
the use of bid prices for asset positions is permitted but not
required for these purposes); FASB ASC 820-10-35-36D (stating that
use of mid-market pricing as a practical expedient for fair value
measurements within a bid-ask spread is not precluded). Since a
seller generally asks for a higher price for a security than a buyer
bids for that security, the mid-market price is incrementally higher
than the bid price for a security, but lower than its ask price.
---------------------------------------------------------------------------
The proposal would require a fund to include market impact in its
swing factor only if the amount of net redemptions exceeds the market
impact threshold, and in all cases where the amount of net purchases
exceeds the inflow swing threshold. The market impact component of the
swing factor would reflect good faith estimates of the market impact of
selling (in the case of net redemptions) or purchasing (in the case of
net purchases) a vertical slice of a fund's portfolio to satisfy the
amount of net redemptions or net purchases. The fund would estimate
market impacts for each investment in its portfolio by first estimating
the market impact factor. This factor is the percentage change in the
value of the investment if it were purchased or sold, per dollar of the
amount of the investment that would be purchased or sold. Then, the
fund would multiply the market impact factor by the dollar amount of
the investment that would be purchased or sold if the fund purchased or
sold a pro rata amount of each investment in its portfolio to meet the
net redemptions or net purchases.\203\
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\203\ See proposed rule 22c-1(b)(2)(iii).
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We understand that it may be difficult to produce timely, good
faith estimates of the market impact of purchasing or selling a pro
rata portion of each instrument the fund holds. Recognizing these
difficulties, and because some securities held by mutual funds may have
similar characteristics and would likely incur similar costs if
purchased or sold, the proposed rule would permit the swing pricing
administrator to estimate costs and market impact factors for each type
of investment with the same or substantially similar characteristics
and apply those estimates to all investments of that type rather than
analyze each investment separately.\204\
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\204\ See proposed rule 22(c)-1(b)(iv).
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The existing swing pricing framework currently in rule 22c-1 does
not permit a fund to include market impact costs relating to
transacting in the fund's investments in the swing factor calculation.
At the time of the rule's adoption, the Commission stated that it may
be difficult for many funds to estimate readily market impact costs,
and that subjective estimates of market impact costs could grant
excessive discretion in a fund's determination of a swing factor.\205\
We understand that it may continue to be difficult to determine market
impact costs with precision, while a fund would be able to determine
other relevant factors more precisely.\206\ However, we believe the
experiences of European funds that employed swing pricing through March
2020 have highlighted the importance of considering market impact
costs, given the stressed nature of markets at that time, the level of
those funds' redemptions, and the size of those funds' swing factors.
We understand that only some European funds consider market impact
costs when determining their swing factors.\207\ A recent survey
conducted by the Association of the Luxembourg Fund Industry
(``ALFI''), however, observed an increase in asset managers including
market impact in their swing factors, with 35% of surveyed asset
managers including this component in the factor calculation.\208\
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\205\ See Swing Pricing Adopting Release, supra note 11, at
paragraph accompanying n.240.
\206\ Methodologies used to estimate market impact are often
created by liquidity measurement vendors. These vendors typically
create a model to gauge what size of trade will have a market impact
on a security (using various factors such as bid-offer spreads,
issue sizes, recent daily average volumes, and recent trade sizes),
back-test the model to check its accuracy, and then adjust the
weights of the various factors used in the model accordingly.
\207\ See Bank of England Survey, supra note 60 (stating that
most surveyed fund managers did not factor market impact explicitly
into their swing factors, and few had models in place to estimate
spreads when needed).
\208\ See ALFI Swing Pricing Survey 2022 (July 2022), available
at https://www.alfi.lu/getattachment/8417bf51-4871-41da-a892-f4670ed63265/app_data-import-alfi-alfi-swing-pricing-survey-2022.pdf.
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To address the concern that market impact estimation may be
difficult, and that subjective estimates of market impact costs could
grant excessive discretion in the determination of a swing factor, we
are providing additional parameters for estimating market impact to
make the calculation more objective as discussed above. These
prescriptive requirements should help to limit subjectivity, and
recordkeeping requirements would require funds to document their market
impact factors, facilitating our staff's review and oversight of mutual
fund swing pricing.\209\
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\209\ See rule 31a-2(a)(2) (requiring funds to preserve for a
period of not less than six years all schedules evidencing and
supporting each computation of an adjustment to the fund's NAV based
on swing pricing policies and procedures). A fund's records under
the proposed amendments should generally include the fund's unswung
NAV, the level of net purchases or net redemptions that the fund
encountered (and estimated) that triggered the application of swing
pricing, the swing factor that was used to adjust the fund's NAV,
and relevant data supporting the calculation of the swing factor,
including the components of the swing factor such as market impact.
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The current swing pricing framework requires the establishment of
an upper limit on the swing factor used.\210\ The Commission included a
2% upper limit in the current rule to make sure that swing pricing
would not operate as a ``de facto gate.'' \211\ We are not including an
upper limit on the swing factor under our proposed framework. We
propose to remove the requirement for the board to review and approve
the fund's swing threshold and the upper limit on the swing factor(s)
used, as well as any charges on these items, to conform to our proposed
swing pricing framework.\212\ The more specific parameters in this
proposal for determining a fund's swing factor are intended to
sufficiently mitigate the
[[Page 77207]]
concerns that led to an upper limit in the existing swing pricing
regime. In addition, although the current rule does not prescribe which
investments a fund would purchase or sell, the current upper limit may
provide an incentive for funds to sell their most liquid assets first,
which may increase the risk of dilution when the fund later rebalances
its portfolio. Furthermore, we understand that in certain other
jurisdictions, several funds experienced costs and dilution that led to
swing factors above 2% in March 2020.\213\ Those cases suggest that the
swing factors helped mitigate dilution and did not constitute a de
facto gate, given that they reflected market conditions at that time.
We recognize that liquidity costs could vary widely across funds and
under different market conditions, and we do not wish to limit the
extent to which swing pricing could mitigate dilution. Finally, the
policies and procedures for determining the swing factor would be
required to be approved by the fund's board, which has an obligation to
act in the best interests of the fund.
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\210\ See rule 22c-1(a)(3)(i)(C). Additionally, a fund's board
of directors, including a majority of directors who are not
interested persons of the fund must approve the fund's swing
threshold(s) and the upper limit on the swing factor(s) used, and
any changes to the swing threshold(s) or the upper limit on the
swing factor(s) used. See rule 22c-1(a)(3)(ii).
\211\ See Swing Pricing Adopting Release, supra note 13, at text
accompanying nn.253-254.
\212\ See proposed rule 22c-1(b)(3). We also propose to modify
the board's review of a fund's swing pricing policies and procedures
to include ``their effectiveness at mitigating dilution'' rather
than ``the impact on mitigating dilution.'' See proposed rule 22c-
1(b)(3)(iii)(A).
\213\ See, e.g., Commission de Surveillance du Secteur
Financier, Swing Pricing Mechanism--FAQ, available at https://www.cssf.lu/en/Document/cssf-faq-swing-pricing-mechanism/(providing
guidance for increasing the swing factor above the maximum level
identified in a fund's prospectus under certain circumstances, and
noting that typical maximum swing factors observed in fund
prospectuses are between 1% and 3%).
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Additionally, Form N-1A currently requires funds that use swing
pricing to disclose a fund's swing factor upper limit.\214\ Because we
propose to remove the swing factor upper limit in the rule, we also
propose to remove the requirement to provide an upper limit on the
swing factor from Item 6(d) of Form N-1A.\215\
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\214\ Item 6(d) of Form N-1A.
\215\ See Item 6(d) of proposed Form N-1A.
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We request comment on our proposed calculation of a fund's swing
factor.
78. Does our proposed requirement that a fund calculate the swing
factor by assuming it would sell or purchase a pro rata amount of each
investment in its portfolio properly account for liquidity costs? Are
there other considerations related to liquidity costs that the swing
pricing framework should take into account, such as shifts in the
fund's liquidity management or other repositioning of the fund's
portfolio?
79. Should funds calculate the swing factor by estimating the costs
of purchasing or selling only the investments the fund plans to buy or
sell to satisfy shareholder purchases or redemptions (consistent with
the current rule), rather than calculating the swing factor based on
the costs the fund would incur if it sold a pro rata amount of each
investment in its portfolio (as proposed)? Which approach would more
fairly reflect the costs imposed by redeeming or purchasing investors?
80. Should we permit a fund not to use the vertical slice
assumption when doing so would require the fund to assume that it is
purchasing or selling an amount of a given instrument that would not be
permissible under other rules (e.g., if it would result in an
assumption that a fund would purchase an amount of illiquid investments
that exceeds 15%)? If so, how should we modify the assumption for these
purposes? Should we require a vertical slice assumption in all cases
for administrative ease and consistency in calculations?
81. As proposed, should the swing factor calculation take into
account spread costs; brokerage commissions, custody fees, and any
other charges, fees, and taxes associated with portfolio investment
sales; and the market impact under certain circumstances? Should we
remove any of these types of costs from the calculation? Are there
other types of costs we should include?
82. Should the swing factor calculation take into account borrowing
costs like under the current rule? Should the proposed rule only
include borrowing costs for certain assets, such as illiquid assets?
Should illiquid investments be defined for this purpose using the same
definition as in rule 22e-4?
83. Should the way in which a fund calculates spread costs depend
on whether it uses midpoint or bid pricing when valuing its holdings?
Should we allow a fund that uses bid pricing not to apply a swing
factor when it has net redemptions unless the amount of net redemptions
exceeds a threshold (e.g., the market impact threshold)? Should we
require all funds to use bid pricing, either instead of or in
combination with a swing pricing requirement? Would use of bid pricing
effectively address dilution, particularly when net redemptions are
small? Instead of requiring swing pricing as proposed, should we
require a fund to use bid pricing to compute its share price or
otherwise adjust its price to reflect spread costs on days the fund
estimates that it has net redemptions? If so, should the fund also use
ask pricing on days the fund estimates that it has net purchases?
Should we require a fund to use bid pricing to compute its share price
on all days, regardless of whether the fund has net redemptions or
purchases?
84. Should we require the swing factor to include market impact
under certain circumstances, as proposed? Do some or all funds already
estimate market impact factors, or perform similar analyses, to inform
trading decisions or liquidity rule classifications? If so, would these
funds' prior experience smooth the transition to making a good faith
estimate of the market impact factor under the proposal? Would the
proposed amendments to the liquidity rule further enhance funds'
ability to estimate market impacts? What difficulties might funds
experience in developing a framework to analyze market impact factors
and in producing good faith estimates of market impact factors for
purposes of the proposed swing pricing requirement? What are the
specific operational challenges in estimating market impact? Are there
ways we could reduce those difficulties, while still requiring
redeeming investors to bear costs that reasonably represent the costs
they would otherwise impose on the fund and its remaining shareholders?
85. Should we permit funds to calculate swing factors on a periodic
basis, as long as developments such as significant market developments
prompt a quicker re-evaluation, as proposed? Does this approach have
any effect on the goals of reducing dilution, improving fairness, and
addressing potential first-mover advantages? Are there other
circumstances in which a fund should be required to re-evaluate its
swing factors or certain swing factor components, such as changes in
the fund's investment strategy or liquidity? Should we instead require
funds to calculate swing factors (or certain components of swing
factors) on a daily basis or at some other defined minimum frequency
(e.g., weekly or monthly) unless developments prompt a quicker re-
evaluation?
86. Should the rule permit, rather than require, funds to follow
the identified inflow swing threshold, market impact threshold, and
swing factor calculations set forth in the rule? If so, what
considerations or factors should the rule require a fund to consider
when determining thresholds and swing factors if the fund determines
not to follow the threshold or calculations set forth in the rule? For
example, instead of removing the factors a fund must consider when
setting swing threshold(s) under the current rule, should we maintain
those or similar factors for purposes of determining a fund's market
impact
[[Page 77208]]
threshold or the inflow swing threshold? \216\
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\216\ See rule 22c-1(a)(3)(i)(B).
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87. Should funds be subject to a numerical limit on the size of
swing factors? If so, should we retain the current rule's 2% swing
factor upper limit and the disclosure of the limit in Form N-1A?
Alternatively, should the limit be higher or lower (e.g., 1% or 3%)?
88. Should we allow a fund to use a set swing factor, such as 2% or
3%, in times of market stress when estimating a swing factor with high
confidence may not be possible? How would we define market stress for
this purpose? Should a fund's swing pricing administrator, adviser, or
a majority of the fund's independent directors, be permitted to
determine market conditions were sufficiently stressed such that the
fund would apply the set swing factor? Are there other circumstances in
which we should permit or require a fund to use a default swing factor?
For example, should the rule establish a default swing factor that
would apply when a fund has illiquid investments that exceed 15% or
when a fund drops below its highly liquid investment minimum under rule
22e-4?
89. Should the rule permit a fund to apply a market impact factor
of zero for certain investments or under certain circumstances? For
example, should a fund be able to use a market impact of zero for
certain categories of investments, such as Treasuries or other
investments that the fund classifies as highly liquid investments under
rule 22e-4? Are there particular circumstances in which it would not be
reasonable for the rule to permit a fund to use a market impact factor
of zero, such as in stressed market conditions?
90. Instead of specifying swing factor calculations and thresholds
in the rule, should we require a fund to adopt policies and procedures
that specify how the fund would determine swing pricing thresholds and
swing factors based on principles set forth in the rule? If so, should
the policies and procedures include the methodologies from the market
impact factor calculation we proposed? Should the policies and
procedures be required to include the swing factor calculation? Should
the policies and procedures be required to define the market impact
threshold with reference to a metric other than net purchases or net
redemptions? If we require policies and procedures, should we specify
the market impacts and dilution costs that a fund's swing pricing
program must address, rather than specifying specific principles and
calculation methodologies?
91. Are there circumstances in which it would not be possible to
estimate the market impact factor with a high degree of accuracy? If
so, what modifications should we make to the proposal?
92. Would our proposed swing pricing requirement cause or
incentivize investors to move their assets out of the funds that must
implement swing pricing into other investment vehicles that do not use
swing pricing, such as ETFs, collective investment trusts (``CITs''),
or separately managed accounts? What are the potential effects
associated with these decisions? For example, when would such movements
occur (e.g., before the end of the compliance period for a swing
pricing requirement, if adopted, or over a longer time horizon)? Would
retirement plan sponsors or others remove mutual funds as investment
options if swing pricing is required? In the case of separately managed
accounts, should the Commission take any action with respect to how the
Investment Company Act may apply to investment advisory programs
seeking to provide the same or similar professional management services
on a discretionary basis to a large number of advisory clients having
relatively small amounts to invest? \217\
---------------------------------------------------------------------------
\217\ See, e.g., 17 CFR 270.3a-4.
---------------------------------------------------------------------------
93. Would a swing pricing requirement change the behavior of funds?
For example, would it cause any changes to fund strategies or
practices?
94. How might swing pricing affect investor behavior in a period of
liquidity stress? Would swing pricing increase fund resilience by
reducing the first-mover advantage that some investors may seek during
periods of market stress? Would swing pricing encourage investors to
redeem smaller amounts over a longer period of time because investors
will not know whether the fund's flows during any given pricing period
will trigger swing pricing and, if so, the size of the swing factor for
that period?
95. Based on historical data, how would our swing pricing framework
affect funds' transaction prices under normal market conditions?
96. Rather than requiring funds to adopt a swing pricing
requirement, should we provide more than one approach to mitigate
dilution and require each fund to implement an anti-dilution tool, but
permit each fund to determine its own preferred approach? If so, which
anti-dilution tool options should the rule provide? Should we, for
example, allow a fund to adopt swing pricing, a liquidity fee (i.e.,
purchase and/or redemption fees), or dual pricing? \218\ Are there
other options that would be appropriate under this approach? Would
funds' use of different approaches benefit investors by increasing
investor choice or, conversely, would these differences confuse
investors or make it more difficult for them to compare funds with each
other?
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\218\ See infra section II.D for a discussion of potential
liquidity fee or dual pricing frameworks.
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97. The current rule requires a fund's board of directors to
approve the fund's swing pricing policies and procedures and to
designate the persons responsible for swing pricing. Should we require
board involvement in the day-to-day administration of a fund's swing
pricing program in addition to its compliance oversight role? How might
funds maintain segregation between portfolio management and swing
pricing administration? Should a fund's chief compliance officer have a
designated role in overseeing how the fund applies the proposed swing
pricing requirement?
98. The current rule requires a fund's board to review, no less
frequently than annually, a report prepared by the swing pricing
administrator on the fund's use of swing pricing, including the
effectiveness of the fund's policies and procedures and any material
changes to them since the last report. Should we require board review
of a swing pricing report more or less frequently than annually? Should
we require less frequent board review over time (e.g., every quarter
for the first year after implementation and then less frequently in
following years as the fund gains experience implementing the swing
pricing program under various market conditions)? Should we require the
fund to disclose any material inaccuracies in the swing pricing
calculation to the board (e.g., as they arise, no less frequently than
quarterly, or at some other frequency)? Would this disclosure
requirement be additive, or would fund boards already receive
information about material inaccuracies in the swing pricing
calculation in the course of existing board oversight? \219\
---------------------------------------------------------------------------
\219\ See, e.g., 17 CFR 270.38a-1 (requiring the fund's chief
compliance officer to provide a written report to the board
addressing each material compliance matter occurring since the date
of the chief compliance officer's last report to the board);
Compliance Programs of Investment Companies and Investment Advisers,
Investment Company Act Release No. 26299 (Dec. 17, 2003) [68 FR
74713 (Dec. 24, 2003)] (``Rule 38a-1 Adopting Release''), at n.84
(``Serious compliance issues must, of course, always be brought to
the board's attention promptly, and cannot be delayed until an
annual report.'').
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99. In addition to the proposed requirement that funds would
publicly
[[Page 77209]]
report their swing factor adjustments on Form N-PORT, should funds also
be required to post that same information on their websites? If so, how
promptly should website reporting be required (e.g., weekly, monthly,
quarterly, annually)? Are there other ways to provide this information
to investors?
C. Hard Close
Currently if an investor submits an order to an intermediary to
purchase or redeem fund shares, that order will be executed at the
current day's price as long as the intermediary receives the order
before the time the fund has established for determining the value of
its holdings and calculating its NAV (typically 4 p.m. ET).\220\ The
fund, however, might not receive information about that order until
much later, sometimes as late as the next morning. We are proposing
amendments to rule 22c-1 under the Act to require a hard close for
those funds that are required to implement swing pricing.\221\ The
proposed hard close requirement would provide that a direction to
purchase or redeem a fund's shares is eligible to receive the price
established at the current day's price solely if the fund, its
designated transfer agent, or a registered securities clearing agency
(collectively, ``designated parties'') receives an eligible order
before the pricing time as of which the fund calculates its NAV.\222\
Orders received after the fund's established pricing time would receive
the next day's price.\223\ In 2003, the Commission proposed a similar
hard close requirement but did not adopt the proposed amendments.\224\
The proposed hard close amendments would serve multiple goals, such as
facilitating mutual funds' ability to operationalize swing pricing by
ensuring that funds receive timely flow information, modernizing and
improving order processing, as well as helping to prevent late trading.
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\220\ Although not all funds calculate their NAVs as of 4 p.m.
ET, throughout this release we use 4 p.m. ET as the time as of which
a fund calculates its NAV unless otherwise noted.
\221\ As discussed above in section II.B, swing pricing would be
required for all registered open-end management investment companies
other than money market funds and ETFs. The proposal would not
affect the operation of current rule 22c-1 for money market funds or
ETFs, as well as unit investment trusts (which are also subject to
rule 22c-1).
\222\ See proposed rule 22c-1(a)(3).
\223\ Funds generally compute their NAVs once per day, although
some funds compute their NAVs multiple times per day. For
simplicity, this discussion assumes that a fund computes its NAV
once per day.
\224\ See Amendments to Rules Governing Pricing of Mutual Fund
Shares, Investment Company Act Release No. 26288 (Dec. 11, 2003) [68
FR 70388 (Dec. 17, 2003)] (``2003 Hard Close Proposing Release'').
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1. Purpose and Background
We are proposing to require all registered open-end funds (other
than money market funds and ETFs) to implement swing pricing in order
to combat dilution. Our hard close proposal is designed to support the
proposed swing pricing amendments by facilitating the more timely
receipt of fund order flow information. To implement the proposed swing
pricing requirement, mutual funds need sufficient net order flow
information to determine whether to apply a swing factor, and the size
of that swing factor, before they finalize that day's price. Based on
staff outreach with foreign regulators and asset managers that operate
in Europe, we understand that a hard close is common in other
jurisdictions in which funds currently implement swing pricing, and use
of a hard close in those jurisdictions facilitates the receipt of
timely flow information to inform swing pricing decisions.\225\ The
proposed hard close requirement would facilitate the more timely
receipt of order flow information by requiring that the fund, its
transfer agent, or a clearing agency receive all orders that are
eligible to receive that day's price before the fund computes its NAV.
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\225\ We understand that the hard close employed in these other
jurisdictions is not necessarily the same as the hard close approach
we are proposing. For example, we understand it is common in some
other jurisdictions for the required time of receipt of orders by
the fund to be several hours before the time as of which the fund
values its holdings.
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Beyond facilitating swing pricing, our proposed hard close
amendments to rule 22c-1 also would help prevent late trading of fund
shares. Because a financial intermediary currently can submit an order
that it received before 4 p.m. ET to a designated party after 4 p.m. ET
for execution at that day's NAV, there is a risk that an intermediary
could unlawfully alter orders using after-hours information to benefit
the intermediary or its clients. The Commission and others uncovered
several instances of late trading in the early 2000s.\226\ While the
Commission adopted rules to address concerns about late trading, we
believe that the hard close proposal, when coupled with our current
rules, would more effectively prevent late trading.\227\ For example,
some fund intermediaries are not subject to examination by the
Commission and staff, and we are unable to examine whether those
intermediaries permit or engage in unlawful late trading. By proposing
to require that all purchase and redemption orders be received by the
fund, its transfer agent, or a registered clearing agency by 4 p.m. ET,
the proposal would prevent intermediaries from altering orders after 4
p.m. ET or unlawfully misrepresenting that an order was received before
4 p.m. ET and entitled to that day's price. We believe that the
proposed amendments would aid in the elimination of late trading
through intermediaries by requiring certain SEC-regulated parties to
receive orders before the NAV is computed to receive that day's price.
The proposed hard close requirement would also modernize and improve
order processing and reduce operational risks, as discussed below.
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\226\ See, e.g., 2003 Hard Close Proposing Release, supra note
224 (discussing investigations by Commission staff of suspected late
trading, which suggested that, at the time, late trading of fund
shares was not an isolated event). See, also, e.g., In the Matter of
Steven B. Markovitz, Investment Company Act Release No. 26201 (Oct.
2, 2003); In the Matter of Theodore Charles Sihpol, III, Investment
Company Act Release No. 27113 (Oct. 12, 2005); In the Matter of Legg
Mason Wood Walker, Inc., Investment Company Act Release No. 27071
(Sept. 21, 2005); In the Matter of Canadian Imperial Holdings, Inc.
and CIBC World Markets Corp., Investment Company Act Release No.
26994 (July 20, 2005); In the Matter of Brean Murray & Co., Inc.,
Investment Company Act Release No. 26761 (Feb. 17, 2005).
\227\ See, e.g., Rule 38a-1 Adopting Release, supra note 219
(adopting rule 38a-1 under the Act, which requires written policies
and procedures reasonably designed to prevent violation of the
securities laws, oversight of compliance by the fund's service
providers, and designation of a chief compliance officer).
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2. Pricing Requirements
Under the proposed rule, an eligible order to purchase or redeem
would receive the price for the next pricing time after a designated
party receives the order.\228\ We propose to define the terms ``pricing
time'' and ``eligible order'' for purposes of the rule.\229\ Eligible
orders would receive a price based on the current NAV as of the next
pricing time, which would include an adjustment to the NAV to include
the swing factor, as applicable. Consistent with the current rule, the
fund's board of directors would be required to establish a ``pricing
time,'' which would be defined as the time or times of day as of which
the fund calculates the current NAV of its redeemable shares pursuant
to the rule (typically 4 p.m. ET). The price of a fund's shares would
typically be finalized several hours after the pricing time, giving
funds time to calculate the current NAV, apply any
[[Page 77210]]
swing factor, and finalize and publish the fund share price.
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\228\ See proposed rule 22c-1(a)(3).
\229\ See definitions of ``Eligible order'' and ``Pricing time''
in proposed rule 22c-1(d).
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For purposes of the proposed hard close requirement, an eligible
order to purchase or redeem fund shares would have to supply certain
information about the size of an investor's intended trade. This
approach is intended to facilitate swing pricing by providing mutual
funds with information they can use to calculate investor flows. In
addition, this approach requires that trading intentions are clear
before 4 p.m., which would further help prevent late trading.
Specifically, we propose to define the term ``eligible order'' to mean
a direction to purchase or redeem a specific number or value of fund
shares. For example, an eligible order would include the direction to
purchase or sell either (1) a specific number of shares of a fund
(e.g., 100 shares, or all the shares held in the account), or (2) an
indeterminate number of shares of a specific value (e.g., $10,000 of
shares of the fund).
The proposed definition of eligible order also would include
exchange orders. An exchange refers to the process in which an investor
initiates an order to purchase shares of a fund using the proceeds from
a contemporaneous order to redeem shares of another fund. When an
exchange is initiated, two transactions are created--a redemption of
securities and a purchase. We understand that exchanges are often
between funds in the same fund complex, however, exchanges can occur
between funds in different complexes. In either case, exchanges often
are processed as a single transaction so that both the redemption and
purchase components of the exchange receive same-day pricing. For
exchanges involving a fixed number of shares on the redemption leg, the
amount and number of shares of the second fund to be purchased will not
be known until the NAV of the first fund is determined, which will be
after the NAV is struck after 4 p.m. ET. For example, if an investor
submits an order to redeem 100 shares of Fund A and invest the
redemption proceeds in Fund B, the amount of the redemption proceeds
from Fund A is not known until Fund A determines its price for that day
and, likewise, the purchase amount for Fund B is not known until that
time.\230\ Under our proposed rules, this exchange transaction would
qualify as an eligible order so that these contemporaneous transactions
may continue to occur.
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\230\ See supra section II.B.3 (discussing how a fund whose
shares are purchased in an exchange transaction can estimate the
size of the inflow for purposes of the proposed swing pricing
requirement).
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To receive that day's price, a designated party must receive the
eligible order before the pricing time.\231\ The fund's designated
transfer agent is a registered transfer agent that is designated in the
fund's registration statement filed with the Commission.\232\
Currently, NSCC is the only registered clearing agency for fund shares,
which operates its Fund/SERV service for processing fund transactions.
The proposed rule would specify that eligible orders are irrevocable as
of the next pricing time after a designated party receives the order.
The proposed requirement of irrevocability of an eligible order is
designed to prevent the cancellation or modification of orders by
investors or intermediaries after the pricing time applicable to the
order.\233\ Preventing the cancellation or modifications of orders
after the pricing time would help avoid continuing adjustments to the
investor flow information that a fund uses to make swing pricing
decisions. In addition, the alteration or cancellation of fund orders
after the pricing time may be used as a means to facilitate late
trading as fund investors may become aware of new market information
after the order has been submitted and after the pricing time. We
request comment on the proposed approach to implementing the hard close
requirement, including:
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\231\ Although orders would have to be received by Fund/SERV or
the designated transfer agent by 4 p.m. ET to ensure same-day
pricing, the clearing agency and designated transfer agent each may
complete its processing after the pricing time.
\232\ See proposed rule 22c-1(d). The term ``transfer agent''
has the same meaning as in section 3(a)(25) of the Exchange Act [15
U.S.C. 78c(a)(25)] and does not include underlying or sub-transfer
agents. A fund may designate more than one transfer agent in its
registration statement.
\233\ The irrevocability of an order does not prevent a fund
from rejecting an order and does not affect the ability of a fund to
maintain policies and procedures for correcting bona fide errors.
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100. Should we make any changes to the definitions included in the
proposed rule? Is the definition of ``eligible order'' clear and
understandable? Is the definition of ``designated transfer agent''
clear and understandable? Is the definition of ``pricing time'' clear
and understandable''? Are there other terms we should define?
101. Should the proposed hard close requirement permit exchanges,
as proposed? If not, what goals of the proposed hard close requirement
would be supported by no longer permitting exchanges?
102. Should the definition of ``eligible order'' require orders to
be irrevocable as of the pricing time, as proposed? Should funds be
permitted to correct bona fide errors under a hard close, as proposed?
If not, how should errors be resolved? Are there other reasons why an
eligible order should not be considered irrevocable as of the pricing
time?
103. Should the definition of ``eligible order'' include directions
to purchase or redeem a specific percentage of fund shares in an
account or a specific percentage of an account's value?
104. To what extent do designated parties already time stamp orders
based on the time of receipt? Should we include new requirements for
each designated party to time stamp order information for purposes of
the hard close requirement?
105. Should we include funds, designated transfer agents, and
registered clearing agencies as designated parties, as proposed? Would
allowing registered clearing agencies to receive eligible orders for
purposes of the hard close delay the ability of the fund's swing
pricing administrator to assess investor flow information to make swing
pricing decisions? If so, how long would this delay be?
106. Beyond the proposed designated parties, are there other
parties involved in processing order information that should be
eligible to receive eligible orders before the pricing time so that
orders may receive that day's NAV? For example, should a fund's
principal underwriter qualify as a designated party and, if so, why? To
what extent do direct investors or intermediaries today place orders
with a fund's principal underwriter or directly with the fund's
transfer agent?
107. Should we limit the proposed hard close requirement to funds
that must implement swing pricing under the amendments to rule 22c-1,
as proposed?
108. The proposed amendments to rule 22c-1 would establish
different requirements for money market funds, transactions by
authorized participants with ETFs, and unit investment trusts than for
all other open-end funds, which would be required to implement a hard
close. Would investors, funds, or intermediaries be confused by the
different pricing requirements that would be created by the proposed
amendments to rule 22c-1? If so, what confusion would be created? What
party to a transaction would bear that confusion? Would additional
burdens be created by having different pricing requirements under
proposed rule 22c-1 for these different types of registered investment
companies?
[[Page 77211]]
3. Effects on Order Processing, Intermediaries and Investors, and
Certain Transaction Types
The proposed hard close would require changes to current order
processing practices. Although modernizing these practices is intended
to reduce operational risk and enhance resilience, in addition to the
benefits related to swing pricing and helping deter late trading, we
recognize these changes would also involve costs.\234\
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\234\ See infra section III.C.3 discussing the estimated costs
of the hard close proposal on funds, designated parties,
intermediaries, and investors.
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a. Order Processing Improvements
The system updates that would support the implementation of a hard
close may provide additional benefits by requiring modernization of how
orders are processed. Today, some intermediaries net their customers'
purchase and redemption orders in a given fund against each other,
meaning that an intermediary combines and offsets the value of purchase
and redemption activity across multiple customer accounts. Instead of
netting purchases and redemptions together, some other intermediaries
maintain separation between purchase orders and redemption orders.
After aggregating customers' orders, intermediaries then submit orders
in one or more batches, with most orders submitted to the designated
party after 4 p.m. ET. As a result of the proposed hard close
requirement, some intermediaries may opt to discontinue infrequent or
even once-a-day batch processes for submitting orders and instead adopt
more frequent batch processing approaches that result in more frequent
order submission throughout the business day. Some intermediaries may
even elect to utilize message-based communications for order flow, in
which orders are submitted on a near-real-time basis.\235\ We
understand based on industry outreach that some intermediaries
currently do not submit orders throughout the day to facilitate
customers' ability to cancel or correct orders intra-day, before the
orders are submitted to a designated party. If intermediaries continue
to provide this capability to customers under a hard close, they would
likely either: (1) need to develop a process with designated parties
for cancelling and correcting orders submitted to a designated party
before the pricing time (as eligible orders are irrevocable under the
proposal as of the pricing time, but not before); or (2) submit orders
to a designated party relatively close in time to the pricing time,
instead of throughout the day.
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\235\ Intermediaries that take advantage of netting likely would
be unable to eliminate batch processing altogether since netting
necessitates definition of a period over which trades are netted and
a process that collects eligible customer orders and nets them
together into a single order for submission to a fund. Message-based
communication is less likely to be implemented when netting is
utilized.
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If an intermediary submits orders more often or earlier in the day,
it would be less vulnerable to an intra-day disruption within its own
operational environment. Orders that have been submitted prior to a
disruption are able to be accepted and acknowledged by a fund, even if
the intermediary experiences delays in its own processing. This
improves the intermediary's operational resilience, since some
operational activities on which the intermediary is dependent will be
able to continue. Similarly, earlier order submission should also
result in earlier confirmations from the fund.\236\ As such, the
chances increase for an intermediary to submit an order and receive a
confirmation even if the fund's transfer agent has a disruption later
in the day. This reduces an intermediary's vulnerability to disruptions
in others' operational processing, further improving the intermediary's
operational resilience. Collectively, as all intermediaries, funds, and
fund transfer agents process orders more frequently, operational
resilience across all market participants improves.\237\
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\236\ The term ``confirmation,'' for the purposes of this
release, unless otherwise indicated, refers to the process by which
a fund accepts a purchase or redemption order. The confirmation
process discussed in this section is different from the
confirmations required by 17 CFR 240.10b-10 (Exchange Act rule 10b-
10). Confirmations under rule 10b-10 require broker-dealers to
provide specific disclosures in writing to customers at or before
the completion of a transaction. See rule 10b-10 under the Exchange
Act.
\237\ See infra section II.C.3.b for additional complexity and
possible points of failure in current order processing practices.
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The proposed hard close would also eliminate cancellations and
corrections that are submitted after the pricing time. As a result, an
investor or intermediary would bear the cost, if any, of the errors
leading to a cancel or correct order. We believe it would be unfair for
a fund's shareholders to bear the cost of an error in this case, as the
investor or intermediary was the cause of that error. For errors that
were the intermediary's responsibility, the intermediary should be
solely accountable for correcting the error and, if necessary,
compensating the investor. We understand that currently some
intermediaries and funds have complex processes for posting
cancellations and corrections, including processes for funds to bill
intermediaries for errors.
In addition, the proposed hard close requirement would improve the
confirmation process for funds. The confirmation process helps ensure
the accuracy of the trade that will be settled. Until the fund provides
a confirmation, an intermediary does not know whether the order will be
accepted or rejected. Under current practice, we understand that
because of the delay in intermediaries submitting orders, funds
likewise issue order confirmations on a delayed basis. When an
intermediary must submit all orders by a certain time under the hard
close proposal, funds would be able to issue confirmations to
intermediaries earlier. We believe that timelier confirmations by funds
would support the reduction of operational risks and improve market
resiliency by providing certainty to intermediaries and investors about
whether orders are accepted or rejected at an earlier point in the
process, meaning they have more time to work toward settlement of the
trade or determine how to manage a rejected order.\238\ Further,
intermediaries similarly may be able to issue trade confirmations
required by rule 10b-10 of the Exchange Act to their customers on a
timelier basis, although an intermediary will need to wait until the
price is published before it can calculate the net money or number of
shares to issue the trade confirmation to its customer. Requiring a
hard close may also facilitate settlement modernization. Many funds
settle purchases and redemptions on a T+1 basis, and the proposed hard
close could help improve the settlement process by providing complete
information about eligible orders on the trade date.
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\238\ An order may be rejected for a variety of reasons
including, among others, the intermediary is not set up to transact
with a particular fund, an order to sell is for more than the number
of shares held, or an order to purchase is less than the fund's
investment minimum.
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In addition, providing funds with more timely and accurate
information about the fund's daily flows under the proposed hard close
would allow funds to make portfolio and risk management decisions based
on more complete and accurate flow information than is available under
current practices. Currently, some funds may rely on projected flows
when making investment decisions, though these projections may be
unreliable because of orders that the fund does not receive until the
next day, including cancellations and corrections. Other funds may
instead rely on flow information posted at the custodian because of its
accuracy, but this
[[Page 77212]]
information is delayed. For example, for a fund that settles on T+1,
the custodian often will post the flow at the end of the day on T+1,
which may not be visible to the portfolio manager until the morning of
T+2. With a hard close, however, flow information should be available
from the transfer agent on the night of the trade date. In addition, by
eliminating the possibility that the fund could receive additional
orders after the pricing time, including cancellations and corrections,
the data available that night would be more reliable. Similarly, a fund
managing its risk would be able to do so more effectively by having
access to accurate flow data more quickly. Ultimately, the proposed
hard close requirement is designed to further the Commission's mission
to protect investors and reduce risk by improving the timeliness of
order flow information communicated to the fund.
b. Effects on Intermediaries
The proposed amendments would require changes in the ways funds and
intermediaries process fund purchase and redemption orders. As
discussed above, intermediaries generally submit aggregated and, in
some cases netted, orders in one or more batches, often after 4 p.m.
ET. Some intermediaries submit orders directly to the fund's transfer
agent or to Fund/SERV, while some intermediaries rely on other
intermediaries, such as clearing brokers or retirement platforms, to
submit orders to the transfer agent or Fund/SERV. In addition, some
intermediaries' systems do not initiate batch processing until a fund's
final NAV is received or until final NAVs are received for all funds
offered on their platforms.
In response to the proposed hard close requirement, funds and
intermediaries would need to make significant changes to their business
practices, including updating their computer systems, altering their
batch processes, or integrating new technologies that facilitate faster
order submission. Intermediaries would need to reengineer their systems
to ensure disseminated order information reaches the transfer agent or
Fund/SERV before 4 p.m., unless they determine to process fund orders
at the next day's price as a matter of practice.\239\ For
intermediaries with reliance on ``downstream'' intermediaries,
coordination in the timing of order communication will be essential to
ensure orders reach the fund, transfer agent, or registered clearing
agency prior to the deadline. In addition, Fund/SERV may need to run
more batch cycles in the period leading up to 4 p.m. than it does
today, as currently batch cycles run into the evening and overnight to
receive and process orders from intermediaries.
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\239\ While the proposed hard close requirement would require
intermediaries to transmit eligible orders before 4 p.m. ET,
intermediaries would still be able to process orders after 4 p.m.
for purposes of execution and settlement, as they currently do
today. For example, after receiving the NAV the intermediary would
then be able to determine the net money to be paid to the investor
or to be collected.
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We understand that retirement plan recordkeepers may face
particular challenges with adhering to the proposed hard close
requirement.\240\ Retirement plan recordkeepers may employ a method of
order processing that relies on receiving the current day's NAV before
submitting orders. Funds do not typically receive the order flow
information for transactions from retirement plan recordkeepers until
well after the day's NAV has been calculated. These order flows are
delayed, we understand, due to the calculations that the retirement
plan recordkeepers complete under plan rules as well as to legacy
systems that require the final NAV before finalizing the order. For
retirement plan recordkeepers, we understand that current recordkeeping
systems require that day's NAV before the participant's plan
instructions may be applied to the participant's order. Once the order
has been processed through the investment instructions specific to the
participant's plan, it can be placed for execution. In addition,
retirement plan recordkeepers may perform compliance and other checks
on orders before finalizing the orders for submission post-NAV strike.
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\240\ See Comment Letter of The Principal Financial Group on
2003 Hard Close Proposing Release, File No. S7-27-03 and Comment
Letter of ASPA on 2003 Hard Close Proposing Release, File No. S7-27-
03. The comment file for the 2003 Hard Close Proposing Release,
where these comment letters can be accessed, is available at https://www.sec.gov/rules/proposed/s72703.shtml.
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We understand that the time it currently takes between when some
retirement plan recordkeepers begin to process their orders and when
the order is finally submitted to the fund can take upward of six hours
due to the limitations of their current processing systems and
hardware. We believe that retirement plan recordkeepers would need to
substantially update or alter their processes and systems to
accommodate the proposed hard close requirement to submit orders more
quickly. In the event compliance and other checks are required, plans
may need to utilize the prior day's NAV to estimate the share or dollar
size of an order for those orders to receive same day pricing.
c. Intermediary Cut-Off Times
To help ensure that order flow information is provided to a
designated party before the established pricing time, the proposed rule
would likely cause some intermediaries to set their own internal cut-
off time for receiving orders to purchase or redeem fund shares that is
earlier than the pricing time established by the fund. Intermediaries
may use earlier cut-off times to provide time to transmit order flow
information to a designated party so those orders receive that day's
price. Investors, therefore, depending on the entity through which an
investor is transacting (e.g., a broker-dealer, retirement plan
recordkeeper, or the fund's transfer agent), may have different
deadlines for the same fund for submission of orders to receive that
day's price. For example, an investor submitting an order to a fund's
transfer agent might have until 3:59 p.m. ET to submit its order, while
an investor submitting an order to an introducing broker would likely
have to submit its order earlier to provide enough time for the
introducing broker to send the order to the clearing broker and for the
clearing broker to send it to the transfer agent or to Fund/SERV.
Investors transacting through intermediaries may lose some
flexibility in when they may submit orders through an intermediary to
receive that day's price as intermediaries may institute earlier cut-
off times. Because technology has advanced since the Commission last
considered a hard close in 2003, we generally do not believe, however,
that intermediaries would need to establish cut-off times significantly
earlier than the pricing time set by the fund. We recognize, however,
that layered cut-off times may occur when an intermediary uses one or
more tiers of other intermediaries to submit orders, and that cut-off
times generally would be earlier for investors submitting orders to
lower-tier intermediaries. We also recognize that intermediaries that
net order activity or rely on batch processing may require additional
time to support such netting or batch activities, while those
intermediaries that submit orders individually through message-based
communications may have a higher volume of orders submitted, but a
shorter time between order submission by an investor and order receipt
by a fund, transfer agent, or registered clearing agency. While the
proposed hard close requirement generally would cause intermediaries to
establish earlier cut-off times, the proposed rule would not prevent an
intermediary from
[[Page 77213]]
transmitting orders it received after its internal deadline but before
4 p.m. ET on an individual basis to the fund's transfer agent or to
Fund/SERV in order to receive that day's price.
d. Effects on Certain Transaction Types
We recognize that the proposed hard close requirement could extend
completion times for certain types of transactions, where the specific
number or value of fund shares to be purchased or redeemed is unknown
until that day's price is available. For example, under certain
retirement plan rules, certain transactions, such as plan loans or
withdrawals, currently remain incomplete until all fund positions in
the investor's accounts are valued using that day's prices.
Specifically, some plan provisions specify a hierarchy for drawing from
different investments to accommodate participant loan or withdrawal
requests. As an example, the plan may require the sale of shares in
Fund A to pay the loan or withdrawal before the sale of shares in Fund
B. In this case, until that day's final price for Fund A shares is
available, the retirement plan recordkeeper may not know if the value
of the participant's investment in Fund A is sufficient to pay the loan
or withdrawal amount on its own, or if satisfying the loan or
withdrawal request in full will also require redemptions from Fund B.
Under the hard close proposal, although plans would not be required
to change their rules governing these kinds of transactions,
transaction requests that are subject to hierarchy rules may take one
or more additional days to complete than they would currently. This is
because the retirement plan recordkeeper would no longer be able to
wait until final prices are available before calculating and submitting
one or more redemption orders to satisfy the requested plan
transaction. In the above example, this would mean that the
recordkeeper would likely submit an order to redeem shares of Fund A on
the first day and may submit an order to redeem shares of Fund B on a
subsequent day if the loan or withdrawal is not fully funded. We
understand that these transactions typically are a small percentage of
overall retirement plan flows and that plan participants generally do
not receive immediate execution of loan or withdrawal requests
today.\241\ Thus, we believe the aggregate effect of the proposed hard
close requirement on such transactions would not be significant.
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\241\ For example, according to one source, in 2021, 4.1% of
defined contribution plan participants took withdrawals, and at the
end of Dec. 2021, 12.5% of participants of plan participants had
loans outstanding. See ICI Research Report, Defined Contribution
Plan Participants' Activities, 2021 (Apr. 2022), available at
https://www.ici.org/system/files/2022-04/21_rpt_recsurveyq4.pdf.
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As another example, the proposed hard close requirement could
extend the period of time for executing an investor's request to
rebalance its holdings to a target asset allocation or model portfolio.
We understand that currently these requests may be facilitated by first
valuing the investor's existing positions, based on final prices for
that day, and then submitting orders that would result in the desired
allocation. The proposed rule would not permit these orders to receive
same-day pricing if they are submitted after the pricing time, and
therefore may require the intermediary to achieve the desired
rebalancing through a series of orders over more than one day or to
rebalance using prices from the prior day. In addition, the proposed
hard close might affect current order processing for funds of funds. We
understand that a lower-tier fund in a fund of funds structure may not
receive purchase or redemption orders from upper-tier funds until well
after 4 p.m. Under the proposed rule, the lower-tier fund (or another
designated party) would have to receive an upper-tier fund's orders to
purchase or redeem the lower-tier fund's shares before the lower-tier
fund's pricing time to receive that day's price for the orders.
e. Effects on Investors
The extent to which the hard close proposal would affect investors
largely depends on the value investors place on their ability to obtain
same-day pricing for orders initiated in the period immediately before
4 p.m. ET or on the complex transaction types discussed above.\242\
Most fund shareholders are long-term investors, and thus we believe
that most fund orders are not time sensitive. In addition, because of
advances in technology, it seems likely that intermediaries would set
cut-off times that are only incrementally earlier than current cut-off
times. As a result, it seems likely that many investors would
experience a significant change in when they must submit their orders
to intermediaries. For those investors who place a premium on being
able to place orders up until 3:59 p.m. ET, they generally could place
orders with the fund's transfer agent to retain this option.\243\ While
we understand that investors may experience a change in how late they
may transact through intermediaries that set earlier cut-off times as a
result of our proposed rule, overall the proposal is intended to better
protect shareholders' interests by operationalizing swing pricing to
combat shareholder dilution and enhancing fund resiliency. We request
comment on the effects of the proposed hard close on order processing,
intermediaries and investors, and on different transaction types:
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\242\ Rule 22c-1 already affects investors differently based on
the time zone in which the investor lives. Investors located in time
zones other than the eastern time zone are subject to different cut-
off times today. For example, 4 p.m. ET is 10 a.m. Hawaii time,
meaning that an investor in Hawaii has to submit its order before 10
a.m. to receive that day's NAV if the fund's pricing time is 4 p.m.
ET.
\243\ See infra section III.C.3 discussing that some investors
may be affected by the proposed hard close requirement if they
desire to transact later in the day in response to market events and
are limited in their ability to change intermediaries or place
orders with the fund's transfer agent.
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109. Should we require funds to implement the proposed hard close
requirement? Are there alternatives to the proposed hard close
requirement that we should implement? Would the proposed hard close
requirement help funds operationalize swing pricing? Would the proposed
hard close requirement help prevent late trading? Are the Commission's
efforts to modernize fund order processing supported by the proposed
hard close requirement?
110. What steps would intermediaries be required to take to
operationalize the proposed hard close requirement? Are there
operational impediments to funds implementing the proposed hard close
requirement? Are there operational impediments for intermediaries,
transfer agents, and/or registered clearing agencies in implementing
the proposed hard close requirement? Are there other operational
changes that would be helpful to operationalize swing pricing?
111. Would retirement plan providers need to make changes to plan
rules in order to accommodate compliance with a hard close? Are plan
rules able to be altered for plans that are currently owned, or would
alterations only be feasible on a going forward basis? If a change in
plan rules would be necessary, how would plan rules need to be altered?
How would plan participants be affected by changes to plan rules?
112. Would the proposed rule affect intermediaries' ability to net
order flow? Would intermediaries move to message-based communications,
where orders are transmitted to the transfer agent or registered
clearing agency as they are received, in response to the proposed hard
close requirement?
113. Would elimination of cancellations and corrections that
designated parties currently may receive
[[Page 77214]]
after the pricing time streamline processing and reduce costs for funds
and/or designated parties and, if so, by how much? Would costs for
investors be affected by the elimination of these cancellations and
corrections?
114. Should there be any exceptions from the proposed hard close
requirement for exigencies or types of parties? For example, should
there be exceptions for certain scenarios (e.g., emergencies), fund
types (e.g., funds of funds), or intermediaries (e.g., retirement plan
recordkeepers)? If so, what should be the parameters of such
exceptions? For example, should we permit investor orders to receive
same-day pricing treatment as the result of an emergency, if the
intermediary is unable to send orders or a designated transfer agent or
clearing agency is unable to receive orders? Should an emergency
exception be conditioned on the board or the chief executive officer of
the intermediary, transfer agent, or clearing agency certifying to the
nature and duration of the emergency and, in the case of an
intermediary, that the intermediary received the orders before the
applicable pricing time? Should we permit conduit funds, which invest
all their assets in another fund and must calculate their NAV on the
basis of the other fund's NAV, and which include master-feeder funds
and insurance company separate accounts, to receive same-day pricing?
Should we provide an exception to permit certain intermediaries, such
as retirement plan recordkeepers, to receive same-day pricing for the
orders they submit, even if not received by a designated party before
the pricing time, as long as the relevant intermediary received the
orders before the pricing time? Should there be other conditions
associated with such an exception, such as a requirement to provide
advance notice of certain flow information to the fund or another
designated party?
115. Should we provide an exception from the proposed hard close
requirement for certain transaction types (e.g., retirement plan loans
or withdrawals or certain rebalancing transactions)? Should we amend
the definition of eligible order to include these or other transaction
types? If so, what information should we require the intermediary to
supply to a designated party before the pricing time to qualify for
same-day pricing? Should retirement plan recordkeepers or other
intermediaries be permitted to estimate order flow information for
specific transaction types, like loans or withdrawals? Would the
estimates be prepared using the prior day's price, or through some
other method?
116. If exceptions to the hard close were permitted, how would that
affect the proposed swing pricing requirement?
117. Would the proposed hard close requirement help retirement plan
recordkeepers to reduce their batch processing cycles and, if so, how?
118. Should the rule permit a fund or other designated party to
impose a cut-off for orders received before that day's NAV computation?
For example, if the time for an order to receive that day's NAV is 4
p.m. ET, should the fund be permitted to impose an earlier time of day,
say 2 p.m. ET, as an earlier cut-off time to receive orders? Would the
ability to disconnect the cut-off time for receiving orders from the
pricing time help facilitate swing pricing by providing additional time
to calculate the swing factor?
119. If different funds adopted different cut-off times for receipt
of orders pursuant to rule 22c-1, would intermediaries and transaction
processing systems be able to accommodate such differences on a fund
specific basis? How would different cut-off times affect investors?
Would it be confusing or challenging for investors if there were
variation among funds' cut-off times?
120. If most funds continue to calculate their NAVs as of 4 p.m. ET
and, as proposed, funds are required to implement swing pricing and are
subject to a hard close, would funds have sufficient time between 4
p.m. ET and when they publish their prices to assess their flow
information and apply the proposed swing pricing requirement, including
determination of a swing factor, as applicable? If not, how might funds
adjust their practices to provide more time to make swing pricing
determinations? For example, would funds publish their prices later
than they typically do, which is currently several hours after the
pricing time? \244\ Are there any changes we could make to facilitate
later publication of prices, if needed? As another example, would funds
begin to calculate their NAVs as of an earlier time than 4 p.m. ET?
What affect, if any, would such a change have on transaction processing
and the valuation of the fund's investments?
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\244\ See infra section III.C.2.a (discussing the potential
effects on intermediaries and other market participants if funds
were to publish their prices later than they currently do).
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121. How would the proposed hard close requirement affect
investors? For example, what percentage of investors place orders
shortly before 4 p.m., and how important is it for those investors to
receive that day's price as opposed to the next day's price? When
intermediaries establish their own cut-off times by which customers
must place orders to receive that day's price, would these cut-off
times be close to 4 p.m. ET as a result of competition among
intermediaries and customer demand? Are intermediaries able to
accelerate the time between receiving an order and relaying that order
to a designated party compared to current practice? Would it be
confusing or challenging for investors if there were variation among
intermediaries' cut-off times? Are there circumstances in which
intermediaries would transmit orders received after their internal cut-
off times and before 4 p.m. ET to a fund's transfer agent or to Fund/
SERV individually to receive same-day pricing? Would this increase the
risk of errors or otherwise be burdensome on funds or intermediaries?
122. Should the rule initially require that funds receive order
flow information by a time that is after the pricing time in order to
``phase in'' the proposed hard close requirement? For example, instead
of requiring a designated party to receive all of a fund's order flow
information by 4 p.m. ET each day, should we initially require receipt
of order flow information by the designated party one to two hours
after the pricing time with the goal of eventually moving the time of
receipt to before the pricing time? Would a delayed phase in of the
proposed hard close requirement be compatible with the proposed swing
pricing requirement? If so, how would a fund determine whether to swing
its NAV if it does not have all of its order flow information until
after the pricing time?
123. We understand that intermediaries currently may adjust trade
amounts to account for commissions or other fees. Would the proposed
hard close requirement affect how these adjustments are made? If so,
should we make any changes to the proposed approach to better
accommodate such adjustments?
124. Would earlier confirmations from a fund to an intermediary
reduce an intermediary's vulnerability to disruptions? Would
intermediaries process orders more frequently under a hard close? If
so, would more frequent order processing increase the resiliency of
funds and transfer agents? If not, why not?
125. Would intermediaries need to set earlier cut-off times than is
the current practice for investors in order to get orders to a
designated party before the pricing time? If so, how early? How
[[Page 77215]]
much time do intermediaries need to process order flow information?
126. Should the rule require that funds set a uniform cut-off time
for orders to be received by intermediaries? If the rule requires a
uniform cut-off time, should we also require that a fund disclose the
cut-off time, such as in the fund's prospectus? Would funds,
collectively, establish consistent cut-off times for these purposes, or
would intermediaries need to manage different fund-specific cut-off
times?
127. Some intermediaries may establish earlier cut-off times in
order to accommodate a hard close. Would investors that want to make an
order up until 3:59 p.m. place orders with a fund's transfer agent
instead of with an intermediary to preserve this flexibility? Are there
limitations on certain investors' abilities to place orders with the
transfer agent instead of through an intermediary?
128. Would some intermediaries choose to no longer distribute open-
end funds that would be subject to the hard close requirement in order
to avoid compliance costs? In addition, would retirement plan providers
be more likely to replace mutual funds as plan investment options with
ETFs or CITs? If so, how would this affect investors?
4. Other Proposed Amendments to Rule 22c-1
The proposed amendments would retain the requirements of the
current rule concerning the frequency and time of determining the NAV,
but would reorganize and reword those provisions.\245\ The proposed
amendment would use the phrase ``based on the current net asset value
of such security established for the next pricing time,'' as opposed to
``based on the current net asset value of such security which is next
computed'' in the current rule. While its substance is already
required, this amendment would codify in the rule text that orders
received after the pricing time, but before calculation of the NAV is
complete, do not receive same-day pricing.\246\ We also propose to
reorganize certain other provisions of rule 22c-1, including the
existing exceptions to the rule's forward pricing requirement.\247\ In
addition, we propose to revise certain terminology in the rule.\248\
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\245\ See rule 22c-1(a), (b)(1), and (d); proposed rule 22c-
1(a).
\246\ See 2003 Hard Close Proposing Release, supra note 224, at
n.26.
\247\ See rule 22c-1(a)(1), (a)(2), and (c); proposed rule 22c-
1.
\248\ For example, we propose to replace references to
``orders'' in the current rule with references to ``directions'' to
purchase or redeem, which is intended to distinguish between the
concept of eligible orders that we propose to add for purposes of
the proposed hard close requirement and directions to purchase or
redeem shares of other registered open-end investment companies that
are not subject to the proposed hard close requirement. As another
example, we propose to incorporate the term ``pricing time'' into
provisions of the rule that are not specific to the hard close
requirement for cohesion of the rule.
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We are also proposing to remove the provision from rule 22c-1 that
would allow funds not to calculate their current NAV on days in which
changes in the value of the fund's securities will not materially
affect the current NAV. We believe this provision is no longer
necessary because a fund generally would need to determine its current
NAV in the first instance before it could conclude with certainty that
changes in the value of the fund's securities would not materially
affect the fund's current NAV.
We request comment on the other proposed amendments to rule 22c-1,
including:
129. Are our proposed amendments to provide that orders received
after the pricing time, but before calculation of the NAV is complete,
do not receive same-day pricing sufficiently clear?
130. Should we retain the current provision in rule 22c-1 that
allows a fund not to calculate its NAV on days when the changes in the
value of the fund's portfolio securities do not materially affect the
current NAV? If so, how would this affect the ability of a fund to
implement swing pricing? Do any funds rely on this provision today? If
so, what are the scenarios in which a fund relies on this provision?
How are changes in the value of the fund's securities determined if the
fund is not valuing the underlying securities and computing the NAV on
a daily basis?
5. Amendments to Form N-1A
Open-end funds use Form N-1A to register under the Investment
Company Act and to register offerings of their securities under the
Securities Act. Item 11 of Form N-1A requires a fund to describe how it
prices its shares. Item 11(a) specifically requires that funds state
when they calculate the NAV and that the price at which a purchase or
redemption is effected is based on the next NAV calculation after the
order is placed. We are proposing to amend this disclosure to also
require, if applicable, that funds disclose that if an investor places
an order with a financial intermediary, the financial intermediary may
require the investor to submit its order earlier than the fund's
pricing time to receive the next calculated NAV. As discussed above,
intermediaries may set different times by which investors must have
their purchase or redemption orders in place to receive that day's
price. We believe that this proposed disclosure is important so that
investors may understand the potential variability in the time by which
intermediaries may require an order to be placed to receive a
particular day's price.
We request comment on the proposed amendments to Form N-1A,
including:
131. Would the proposed requirement for funds to disclose in their
prospectuses that orders placed with intermediaries may need to be
submitted earlier to receive that day's price be helpful to investors?
132. In addition to the proposed disclosure requirements, are there
additional disclosures relating to the proposed hard close requirement
that we should require? Should funds be required to disclose the cut-
off times of their intermediaries in their distribution network? If so,
where should this disclosure be located (e.g., in the fund's
registration statement or on its website)? What potential challenges,
if any, would a fund encounter in providing an up-to-date list of
intermediary cut-off times?
D. Alternatives to Swing Pricing and a Hard Close Requirement
1. Alternatives to Swing Pricing
In lieu of the proposed swing pricing requirement, we have also
considered whether there are alternative methods by which we could
require funds to pass on costs stemming from shareholder purchase or
redemption activity to the shareholders engaged in that activity. These
alternatives could be used independently or in combination with each
other. Some of these alternatives would be dependent on investor flow
information, similar to the proposed swing pricing requirement. In
those cases, an alternative could be paired with either a hard close
requirement or one of the alternatives to the hard close that we
discuss below.
a. Liquidity Fees
One alternative we considered is a framework that would apply a
charge in the form of a liquidity fee rather than an adjustment to the
fund's price.\249\ A
[[Page 77216]]
liquidity fee would apply as a separate charge to a transacting
investor and would not change the fund's price. A liquidity fee could
be used to impose liquidity costs on purchasing or redeeming investors
and address dilution, much like a swing pricing-related price
adjustment. We recognize that a liquidity fee framework could have
certain advantages over a swing pricing requirement. For example,
liquidity fees provide greater transparency for redeeming or purchasing
investors of the liquidity costs they are incurring. Liquidity fees
also provide a mechanism for imposing liquidity costs directly on
purchasing or redeeming investors, without adjusting the transaction
price for investors who are trading in the other direction.\250\ In
addition, some funds and their intermediaries are currently equipped to
apply certain purchase and/or redemption fees.\251\
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\249\ Although certain U.S. funds may use liquidity fees for
redemptions, they are rarely used to address dilution, other than in
the case of short-term trading of fund shares. See rule 22c-2 under
the Act. The use of redemption fees and anti-dilution levies in
Europe varies to some extent by jurisdiction. For example, Irish-
domiciled funds are more likely to have adopted anti-dilution levies
than Luxembourg-domiciled funds. Overall, however, we understand
that swing pricing was more widely used by European fund complexes
in Mar. 2020 than redemption fees or anti-dilution levies. See ICI,
Experiences of European Markets, UCITS, and European ETFs During the
COVID-19 Crisis (Dec. 2020), available at https://www.ici.org/doc-server/pdf%3A20_rpt_covid4.pdf.
\250\ For instance, on a day the fund has net redemptions, swing
pricing adjusts a fund's NAV downward, and investors who purchase
the fund's shares that day buy at a discount. On a day when a fund
has net purchases, swing pricing adjusts a fund's NAV upward, and
investors who sell the fund's shares that day sell at a premium.
Swing pricing must account for these discounts or premiums that
other investors are receiving to fully address dilution.
\251\ For example, some funds impose redemption fees under rule
22c-2 under the Investment Company Act. See supra note 67 for a
discussion of how many funds we estimate apply redemption fees.
---------------------------------------------------------------------------
However, the proposed swing pricing requirement may have several
advantages over liquidity fees for relevant open-end funds. With swing
pricing, a fund can pass liquidity costs on to redeeming or purchasing
investors in a fair and equal manner, without any reliance on
intermediaries to achieve fair and equal application of costs.
Liquidity fees may require more coordination with a fund's
intermediaries than swing pricing because fees need to be imposed on a
transaction-by-transaction basis by each intermediary involved--which
may be difficult with respect to omnibus accounts that intermediaries
may create to aggregate all customer activity and holdings in a
fund.\252\ Funds and their transfer agents may contract with
intermediaries to have them impose liquidity fees under these
circumstances, which may include a review of contractual arrangements
with fund intermediaries and service providers to determine whether any
contractual modifications are necessary or advisable to ensure that
liquidity fees are appropriately applied to beneficial owners of fund
shares. While we could require intermediaries to submit purchase and
redemption orders separately to transact in a fund's shares, which
could allow funds and their transfer agents to apply fees directly,
this type of requirement would also involve some operational costs.
Requiring intermediaries to submit purchase and redemption orders
separately would require operational changes for some intermediaries
because they would no longer be able to net otherwise offsetting
customer purchases and redemptions.\253\ In addition, the volume of
transactions that transfer agents and Fund/SERV process would increase
if netting were not permitted. Further, unlike swing pricing, the
amount collected from a liquidity fee is not available to the fund for
a period of time until the intermediary remits to the fund the amount
charged.\254\ If the fund is under stress, the unavailability of the
amount collected from fees might cause the fund to incur other costs it
might not have otherwise incurred, such as costs associated with
selling investments to pay redemptions when the fee amount, if
remitted, would have helped the fund pay those redemptions.
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\252\ See infra section III.E.2 (noting certain omnibus
accounting practices that may make a liquidity fee operationally
difficult). Swing pricing, on the other hand, would require some
funds and intermediaries to create new systems and operational
procedures, but once those are in place, swing pricing would be
incorporated in the process by which a fund strikes its NAV and sets
the transaction price (including any swing of the NAV).
Intermediaries would then effect customer transactions at the
transaction price, as they do today, without further operational
changes or coordination with the fund.
\253\ See supra section II.C.3.a (discussing that some
intermediaries currently net orders, while others separately submit
purchase and redemption orders).
\254\ While money collected from the fee would not be available
to the fund until the intermediary remits payment, we understand
that a fund would reflect the fee amount it is owed as an accrual
until the fund receives the fee payment. The accrual would help
prevent declines in the fund's NAV that would otherwise result from
any delay in remittal. Proper booking of the accrual would, however,
require the intermediary to inform the fund of the fee amount on an
accurate and timely basis.
---------------------------------------------------------------------------
There are many potential variations of a liquidity fee framework.
The trigger for applying fees could be based on net flows, similar to
swing pricing, or other indicators that a fund's trading costs are
increasing (e.g., widening spreads or reduced liquidity of the fund's
portfolio investments). Alternatively, a fee could apply to all trades
of a given type (for example, all redemption orders). When a fee
applies, the determination of the size of the liquidity fee could be
either dynamic to reflect changing costs or simplified to remain
relatively static. As for how the fee is processed, it could be applied
to the purchase or sale or could be processed separately from the
trade.
As an example, similar to the proposed swing pricing requirement, a
dynamic liquidity fee could be calculated to reflect certain costs
(e.g., spread, other transaction costs, and market impact) a fund is
likely to incur to meet redemptions or invest the proceeds from
subscriptions based on the direction and magnitude of that day's flows.
Dynamic liquidity fees that may change in size from one day to the next
may involve greater operational complexity and cost than swing pricing,
as intermediaries would have to identify and apply different fee
amounts for each fund in which their clients transact each day. This
approach also generally would necessitate timely flow information if
the fee were processed as part of a transaction, similar to the
proposed swing pricing requirement. If the fee were processed
separately from the transaction and applied to an investor's account on
a delayed basis, a fund would likely have more time to receive flow
information than under the proposed swing pricing requirement, which
could avoid the need for a hard close or related alternatives. Delayed
application of the fee, however, may raise complications related to
collecting fee amounts from investors, particularly when an investor
has otherwise redeemed the full amount of its holdings. Follow-on fees
also significantly increase the number of transactions to process, and
may complicate reporting for custodians and advisers in situations
where a transaction may occur in one reporting period but the fee
related to the transaction is not applied until the next reporting
period. In addition, an intermediary may face difficulties projecting
upcoming cash balances in its client accounts if there are upcoming
fees to be charged, but the amounts of those fees are unknown. The fund
itself may also have challenges with projecting its own cash balance if
it cannot predict when accrued fees will be received from each
intermediary.
Instead of a dynamic liquidity fee, we could require a simplified
liquidity fee. A simplified liquidity fee, for example, could be a set
percentage of the transaction amount, such as 1%. Or it could be a
default fee, such as 1%, that a fund could adjust up (possibly up to a
cap) or down as it determines is in the best interest of the fund. A
simplified liquidity fee could apply to both purchases and redemptions,
given that both purchases and redemptions can contribute to dilution.
Under this type
[[Page 77217]]
of approach, fees could be equivalent for both transactions, or fees
could be higher on one side and lower on the other (for example, a
purchase fee of 0.25% and a redemption fee of 1%). Alternatively, we
could require a one-sided simplified fee that applies to redemptions
only or to purchases only, with the premise that a fee charged on
redemptions could also help to offset dilution that may result from
purchases (or vice versa). Because all shareholders purchase and redeem
the fund's shares during the life of an investment, a one-sided fee
would apply to all shareholders at some point and could help mitigate
dilution that fund investors collectively contribute to through their
purchase and redemption activity. A simplified liquidity fee would not
necessarily require flow information. For instance, if a simplified fee
applied only to redemptions, a set fee could apply to all redemptions
or only to redemptions when the fund's trading costs are significantly
increasing, such as in times of stress.\255\ If the dependency on flow
information is removed, a simplified liquidity fee likely could be
processed as part of a transaction, avoiding the need to process a fee
as a separate follow-on transaction.
---------------------------------------------------------------------------
\255\ We discuss an alternative in which a liquidity fee would
apply when a fund's trading costs are significantly increasing in
more detail in section II.D.3.b.
---------------------------------------------------------------------------
The size of a simplified liquidity fee likely would be more
predictable for investors and intermediaries than a dynamic fee or
swing pricing. This would enhance transparency and would likely be
easier to implement. While the size of the fee generally would be known
in advance, it may or may not be easy to predict when a fee would
apply. For example, if a fee applied to all redemptions, then investors
and intermediaries would have certainty on when fees would apply.
However, if fees applied only in certain circumstances, such as when
trading costs are materially increasing or the fund has experienced net
redemptions over multiple consecutive days, then application of a fee
may be more difficult to predict, particularly if a fund's threshold
for applying a fee is non-public or based on factors that are difficult
for other market participants to observe or predict. An approach where
it is difficult to predict when a fee would apply could help avoid
preemptive redemptions in anticipation of fees applying in the near
future, but it would also be less transparent. In addition, if
liquidity fees are applied rarely, then application of a fee might be
viewed as a sign that a fund is under stress, which could incentivize
further redemptions, particularly if the fee amount is viewed as
minimal.
Between dynamic and simplified fees, a dynamic fee would better
reflect the costs associated with fund purchases or redemptions on a
given day. A simplified fee, however, would be less costly to implement
because, among other things, it would not necessarily require a hard
close or any alternatives to the hard close to provide actual or
estimated flow information. While a simplified fee would be less
sensitive to the fluctuating costs associated with fund purchases or
redemptions, this fee would aid in the offset of costs stemming from
purchase and redemption activity and could assist with the mitigation
of investor dilution.
On balance, we are proposing a swing pricing requirement because it
may have operational advantages or be better tailored to mitigate
dilution relative to liquidity fee options, but we request comment on
using a liquidity fee framework to impose liquidity costs and whether a
liquidity fee alternative may have fewer operational or other burdens
than the proposed swing pricing requirement while still achieving the
same overall goals of reducing shareholder dilution.
133. How do the operational implications of swing pricing, as
proposed, differ from the operational implications of a dynamic
liquidity fee framework (e.g., one where liquidity fees vary in size
and increase during periods of stress)? What are the operational
implications of a requirement for mutual funds to impose a liquidity
fee that can change in size and that may need to be applied with some
frequency (up to daily)? Are fund intermediaries equipped to apply
dynamic fees on a regular basis? Would funds have insight into whether
and how intermediaries apply these fees to redeeming investors?
134. If we adopt a liquidity fee framework instead of a swing
pricing framework, should a fund be required to apply a liquidity fee
under the same circumstances in which a fund would be required to
adjust its net asset value under the proposed swing pricing
requirement? Should a fund be required to use the same approach to
calculating a liquidity fee as the proposed approach to calculating a
swing factor? Should the same board oversight framework apply under
this approach as the proposed swing pricing requirement (e.g., with the
board approving the fund's liquidity fee policies and procedures and
designating a liquidity fee administrator, and such administrator would
report periodically to the board)?
135. Should funds be required to apply liquidity fees to all
redemption or purchase orders, or should liquidity fees apply only upon
a trigger event? If so, under what circumstances should a fee apply?
For example, should liquidity fees apply when trading costs are
materially increasing? \256\ Should liquidity fees apply when a fund
has had net outflows over multiple consecutive days? If so, should net
outflows be of a certain size (e.g., 2%, 5%, or 10%) and over what
period of time should net outflows trigger a fee (e.g., 2, 3, or 4
consecutive days)? Would this approach help mitigate dilution, or would
it contribute to first-mover advantages and potentially result in
unfair application of fees?
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\256\ See infra section II.D.3.b. for additional discussion and
requests for comment about such an approach.
---------------------------------------------------------------------------
136. Should a liquidity fee apply to both purchasing and redeeming
investors? Alternatively, should a liquidity fee apply to redeeming
investors only or to purchasing investors only?
137. Should funds be required to maintain records related to the
application of liquidity fees? For example, should funds be required to
maintain records of the dates on which the fund applied liquidity fees
and in what amount? If application of liquidity fees is subject to fund
or board discretion, should a fund be required to maintain records
documenting why the fund did or did not apply liquidity fees under
certain circumstances?
138. Should liquidity fees apply to purchase or redemption orders
of a specific size only? If so, what size? How operationally feasible
would such an approach be? Would it create incentives for investors to
modify their order amounts in an effort to avoid a fee, such as by
holding smaller amounts of a fund's shares at multiple intermediaries
or splitting up a purchase or sale order over multiple days? How should
such an approach treat separate accounts managed by the same adviser,
such as separate accounts managed through a wrap program?
139. Should a liquidity fee framework have an exclusion for
purchase or redemption orders of a de minimis amount? How should we
identify an order for a de minimis amount? Should it be a set dollar
figure (e.g., $2,500 or less), a set percentage of the fund's net
assets, or a set amount that would be collected from application of a
fee (e.g., $50 or less)? Should the amount of a de
[[Page 77218]]
minimis exclusion be adjusted for inflation over time?
140. How should the amount of the liquidity fee be determined?
Should the liquidity fee be dynamic but based only on that day's
spreads? Should it include other transaction costs, including market
impact? Instead of a dynamic fee amount that could change daily, should
the fee amount be based on a fund's historical trading costs and
evaluated periodically, such as annually, quarterly, or monthly? Should
the fee be a flat percentage established by rule (such as 0.5%, 1%, or
2%), or should the fee increase as net redemptions or net purchases,
illiquidity, or other variables increase? Should the fee amount be
based on reasonably expected transaction costs but, if a fund cannot
reasonably estimate those costs, it can use a default fee amount set by
rule? If so, what should that default fee amount be (e.g., 0.5%, 1%,
2%, or 3%)? Should the rule include a default fee amount that funds can
always choose to use, with the option to use a higher or lower amount
if such amount is determined to be in the best interest of the fund?
Should there be a minimum or maximum fee amount, such as a 0.25%
minimum or a 2% maximum?
141. If we adopt a liquidity fee framework instead of a swing
pricing framework, are there any ways to simplify the application of
fees to investors that invest through an intermediary, such as
investors in an omnibus account, to facilitate funds or fund transfer
agents applying fees directly to investor purchases or redemptions
occurring through an omnibus account? For example, should fund
intermediaries be required to separately submit purchase and redemption
orders, rather than net them, in order to transact in a fund's shares?
What would the operational consequences of such a requirement be for
fund intermediaries and for investors? To what extent do intermediaries
already submit purchase and redemption orders separately, and does this
practice vary by type of intermediary (for example, are broker-dealers
more likely to submit separate purchase and redemption orders than
retirement plan recordkeepers)? Would there be consequences for fund
transfer agents, Fund/SERV, or others associated with increased order
volume or other changes that would result from a requirement to submit
purchase and redemption orders separately? What changes, if any, would
funds or fund transfer agents need to make to be equipped to apply
liquidity fees directly? If submission of purchase and redemption
orders separately is necessary to implement a liquidity fee framework,
is it necessary for the Commission to mandate receipt of orders in this
way to ensure compliance by all market participants? If purchase and
redemption orders may be submitted on a net basis, as some
intermediaries do currently, how would a fund accrue for liquidity fees
in a timely manner? Should the Commission require fund transfer agents
to apply liquidity fees directly and, if so, why or why not?
142. If we adopt a dynamic liquidity fee framework, would it be as
reliant on timely flow information as the proposed swing pricing
requirement? For example, could funds and intermediaries apply a
dynamic fee to a transacting investor after an order begins to be
processed at that day's NAV but before the trade settles? Could dynamic
fees be applied after settlement, or would that create challenges in
collecting a fee from investors who redeemed the full amount of their
holdings? If a fee applies on a delayed basis, how should investors be
notified of the application of a fee? Would it be preferable to apply a
simplified fee that may less accurately reflect the costs of investor
transactions and may mitigate dilution with less precision, but that
could be applied at the same time an order is processed? Are there any
other factors to consider when deciding between dynamic and simplified
liquidity fees?
143. If we adopt a liquidity fee framework, should we require that
the same liquidity fee amount apply to all share classes (for example,
if a liquidity fee is 1% on a given day, the 1% fee must apply to all
share classes)? Alternatively, should we permit the fee amount to
differ among classes (for example, a 1% fee for one class and a 0.5%
fee for another class) and, if so, why?
144. Should a liquidity fee apply differently based on the type of
fund or the type of intermediary through which an investor trades? If
so, what would be the basis for the differences in how a liquidity fee
applies?
145. What investor flow information, if any, would be required to
implement a liquidity fee alternative? To the extent that a liquidity
fee alternative requires timely investor flow information, should the
alternative be paired with the proposed hard close requirement? Are
there different considerations or effects related to the proposed hard
close requirement if we were to require funds to use a liquidity fee?
Would it be effective to implement the liquidity fee alternative with
an alternative to the hard close requirement discussed below, such as
indicative flows, estimated flows, or delayed cut-off times for
intermediaries?
146. Should a liquidity fee requirement be implemented through
amendments to rule 22c-2 or through a new rule? To what extent would
information that financial intermediaries agree to provide under a
shareholder information agreement be important for funds to receive
under a liquidity fee framework? \257\ Is there other information funds
would need to receive from financial intermediaries to determine that
liquidity fees are appropriately applied? Should we amend the
definition of shareholder information agreement to require that
information, or are there other mechanisms for funds to receive that
information (e.g., distribution agreements)? Are there other rules we
should amend if we adopt a liquidity fee requirement, such as rule 11a-
3 under the Act, which permits application of certain fees in
connection with an exchange offer notwithstanding section 11(a) of the
Investment Company Act? If we amend rule 11a-3, should the rule treat a
liquidity fee in the same way as a redemption fee, as defined in that
rule? \258\
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\257\ See rule 22c-2(c)(5) (defining a shareholder information
agreement as a written agreement under which a financial
intermediary agrees, among other things, to provide certain
information to a fund promptly upon request, including taxpayer
identification number of all shareholders who have purchased,
redeemed, transferred, or exchanged fund shares held through an
account with the financial intermediary, and the amount and dates of
such activity).
\258\ Under rule 11a-3, an offering company may cause a security
holder to be charged a redemption fee in connection with an exchange
offer, subject to certain conditions. See rule 11a-3(b)(2); rule
11a-3(a)(7) (defining a redemption fee as a fee that a fund imposes
pursuant to rule 22c-2).
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147. How should funds be required to disclose liquidity fees to
investors? Should liquidity fees be reflected in the prospectus fee
table, as mutual fund (other than money market fund) redemption fees
currently are? \259\ Or, similar to money market fund liquidity fees,
should liquidity fees be excluded from the prospectus fee table? \260\
Should funds be required to disclose the circumstances in which they
would impose liquidity fees in the prospectus? If a liquidity fee only
applies on some days, should the fund be required to disclose on its
website that it is applying a liquidity fee that day and the size of
the fee? Should funds be required to report information about
[[Page 77219]]
liquidity fees that are imposed? For example, should a fund be required
to report on Form N-PORT the dates the fund imposed liquidity fees (or
the number of days on which fees were applied) and the amount of the
fee applied on each occurrence? If a fund or its board has discretion
on when to apply liquidity fees, should a fund be required to disclose
why a liquidity fee was or was not imposed under certain circumstances?
Should funds be required to report other information about liquidity
fees or report information in other locations, such as in shareholder
reports, on fund websites, or in Forms N-CEN or N-RN? Would any
existing items on Form N-PORT, Form N-CEN, Form N-1A, Form N-RN, or
other forms need to be modified if we were to adopt a liquidity fee
framework instead of swing pricing?
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\259\ See Item 3 of Form N-1A.
\260\ See Instruction 2(b) to Item 3 of Form N-1A (excluding
money market fund liquidity fees imposed in accordance with rule 2a-
7 from the definition of ``redemption fee'').
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148. How quickly do intermediaries currently remit to funds the
amounts collected from purchase or redemption fees applied to customer
accounts? If remittal currently is delayed, what are the causes of
delay? If we adopted a liquidity fee, would funds reflect any delayed
liquidity fee payment as an accrual? Under a liquidity fee approach,
should intermediaries be required to remit payments to funds within a
certain amount of time after a purchase or redemption? If so, what is
an appropriate amount of time for remittal (e.g., on the day of
settlement or within one or two days after settlement)? For example,
should we adopt a rule that would provide that a fund must prohibit an
intermediary from purchasing the fund's shares in nominee name on
behalf of others if the intermediary does not remit payment on a timely
basis? Are there other appropriate consequences for an intermediary
that has a pattern or practice of late payments, such as a requirement
that orders from such an intermediary may not receive today's price and
will be executed on a subsequent day at that day's price in order to
otherwise limit the dilutive effects of purchase and sale orders
received through that intermediary since fees are not paid in a timely
manner? Should we require a fund to charge an additional surcharge to
an intermediary that does not remit payment on a timely basis? Should
funds be required to report the names of intermediaries who are delayed
in remitting payment and the amount due? If so, where should funds
provide this information (for example, Form N-PORT, Form N-CEN, fund
websites, or registration statements)?
149. Would a liquidity fee requirement have different effects on
investor behavior than a swing pricing requirement? For example,
because application of liquidity fees is more observable than
application of swing pricing, would liquidity fees be more likely to
affect investors' decisions of whether to purchase or redeem fund
shares?
b. Dual Pricing
We also considered the use of dual pricing as an anti-dilution
measure. A fund that uses dual pricing would quote two prices--one for
incoming shareholders (reflecting the cost of buying portfolio
securities in the market), and one for outgoing shareholders
(reflecting the proceeds the fund would receive from selling portfolio
securities in the market).\261\ Dual pricing is permitted and used by
some funds in certain foreign jurisdictions.\262\ In comparison to
swing pricing and liquidity fees, we believe that dual pricing may
impose additional operational burdens and complexity on fund
intermediaries, service providers, and other third parties as they
would need to handle two share prices on each trade date. We understand
that mutual fund order processing systems currently are designed to
accommodate only one price, which is applied both to trades and
valuation, and a fund's share price feeds into many analyses that
intermediaries, funds, or others would need to update if there were two
share prices, such as rebalancing activity. In addition, as recognized
above, there would be operational costs associated with intermediaries
needing to submit purchase and redemption orders separately, rather
than netting purchase and redemption orders.
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\261\ See Swing Pricing Adopting Release, supra note 11, at
n.40. Swing pricing would permit a fund to continue to transact
using one price, as they do today (instead of transacting using
separate prices for purchasing and redeeming shareholders).
\262\ For example, jurisdictions that permit dual pricing
include the UK, Ireland, Australia, and Hong Kong. See Jin, et al,
supra note 163, at n.6 and accompanying text.
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In addition, with a dual pricing framework, we would also address
effects on a fund's financial statements and performance reporting, as
the Commission has already done for swing pricing.\263\ If we were to
adopt a dual pricing framework, we could use the same general framework
as in swing pricing. Under this approach, a fund would use its ``GAAP''
NAV (i.e., the amount of net assets attributable to each share of
capital stock outstanding at the close of the period) in its statement
of assets and liabilities and in performance reporting, while it would
use its two transaction prices in reporting the dollar amounts received
for shares sold and paid for shares redeemed in its statement of
changes in net assets and reflect the impact of dual pricing in the
fund's financial highlights.
---------------------------------------------------------------------------
\263\ See Swing Pricing Adopting Release, supra note 11, at
section II.A.3.g.
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Similar to liquidity fees, dual pricing could be either dynamic
(e.g., calculated to reflect spread, other transaction costs, and
market impact a fund is likely to incur to meet redemptions or invest
the proceeds from subscriptions and based on the magnitude of those
flows) or simplified (e.g., a constant spread around a fund's NAV).
Dynamic dual pricing generally would necessitate timely flow
information, similar to the proposed swing pricing requirement.
However, simplified dual pricing may not necessitate timely flow
information. Between these two types of dual pricing, a dynamic
approach would better reflect the costs associated with the magnitude
of fund purchases or redemptions on a given day. Under a simplified
dual pricing framework, there also is the potential for either
redeeming or subscribing investors to be over-charged for transaction
costs that their investing activity does not trigger, because the fund
would adjust its NAV for both subscribing and redeeming investors daily
without regard to whether the fund has net inflows or net outflows on a
given day. A simplified approach, however, would be less costly to
implement because, among other things, it would not require a hard
close or any alternatives to the hard close to provide actual or
estimated flow information.
On balance, we are proposing a swing pricing requirement because it
may have operational advantages over dual pricing. We request comment
on using a dual pricing framework to impose liquidity costs on
transacting shareholders and whether a dual pricing alternative may
have fewer operational or other burdens than the proposed swing pricing
requirement or a liquidity fee alternative while still achieving the
same overall goals of reducing shareholder dilution.
150. How do the operational implications of swing pricing, as
proposed, differ from the operational implications of dual pricing? As
dual pricing involves calculating and applying two prices on each trade
date, would that approach involve operational burdens and complexity
for fund intermediaries, service providers, and other third parties
that would not exist with a single price under our proposed swing
pricing framework?
151. If we adopt a dual pricing framework instead of a swing
pricing framework, how should the spread around the NAV be determined?
For example, should the spread around the
[[Page 77220]]
NAV be constant or calculated daily or at some other frequency to
reflect transaction costs? If the latter, which transaction costs
(e.g., spread, other transaction costs, and market impact)? Under a
dual pricing framework, would funds need the same investor flow
information that is needed for swing pricing, or would implementation
of dual pricing be less dependent on investor flow information?
152. Should a dual pricing requirement apply differently based on
the type of fund or the type of intermediary through which an investor
trades? If so, what would be the basis for the differences in how dual
pricing applies?
153. If we adopt a dual pricing framework, should we address the
effects of two transaction prices on a fund's financial statements and
performance reporting in a manner similar to how the Commission has
addressed the effects of swing pricing (i.e., by clarifying that the
GAAP NAV must be used in some cases, while transaction prices are used
in others)? Are there additional implications of two transaction prices
that we would need to address and that would lead to a different result
than our current swing pricing approach?
154. Under a dual pricing framework, which value of the fund's
shares would market participants use for analyses that currently are
based on a fund's NAV, such as rebalancing a client's holdings of
different funds to achieve a desired asset allocation or reflecting the
value of an investor's holdings on an account statement? If we adopt
dual pricing, should we provide guidance on which value to use for
these or other purposes?
155. Are there differences between liquidity fees and dual pricing
that make one a better framework than the other to address dilution? If
so, what are the differences and why is one better than the other
(e.g., differences in tax treatment, if any)?
156. What investor flow information, if any, would be required to
implement a dual pricing alternative? To the extent that a dual pricing
alternative requires timely investor flow information, should the
alternative be paired with the proposed hard close requirement? Are
there different considerations or effects related to the proposed hard
close requirement if we were to require funds to use dual pricing?
Would it be effective to implement the dual pricing alternative with an
alternative to the hard close requirement discussed below, such as
indicative flows, estimated flows, or delayed cut-off times for
intermediaries?
157. If we adopt a dual pricing framework, what other changes
should be made to the proposal as a result? For example, what reporting
should be required on Form N-PORT, Form N-CEN, Form N-1A, Form N-RN, or
other forms used by funds that would be subject to the framework? Would
any existing reporting items on these or other forms need to be
modified if we were to adopt a dual pricing framework instead of swing
pricing? Are there other rules (e.g., rule 11a-3 under the Act) that
would require changes if we adopt an alternative framework?
158. Would a dual pricing framework affect investor behavior
differently than a swing pricing framework or a liquidity fee
framework?
2. Alternatives to a Hard Close
We are proposing to require a hard close for open-end funds that
are subject to the proposed swing pricing requirement. Under this
proposal an eligible order to purchase or redeem any redeemable
security of such a fund would be executed at the current day's price
only if the fund, its designated transfer agent, or a registered
clearing agency receives the order before the fund calculates its NAV.
This proposal is designed to facilitate the operation of swing pricing
as well as to help prevent late trading and to modernize order
processing.
In connection with the swing pricing proposal, we have also
considered whether there are alternative methods by which a fund would
be able to generate sufficient investor flow information to determine
whether to apply swing pricing on a given day. As discussed above,
swing pricing requires that funds have significant information about
their order flows to determine with accuracy if the fund should impose
a swing factor and to determine what that swing factor should be.
Instead of requiring that funds operationalize swing pricing based on
actual order flow information received before the pricing time, we have
also considered whether reasonable estimates, calculated by either the
fund or the intermediary, would provide sufficiently accurate
information for a swing pricing determination. We have also considered
whether later cut-off times for flow information and the publication of
the day's NAV would facilitate swing pricing. We discuss each
alternative below. We also considered how these alternatives would work
if, rather than require swing pricing, we were to require funds to
adopt liquidity fees or dual pricing.\264\ Although the below
discussion focuses on swing pricing, we believe similar considerations
would apply in the case of liquidity fees or dual pricing (to the
extent a liquidity fee or dual pricing regime, like swing pricing, was
based on the amount of net flows), and these alternatives therefore
also could be used in combination with a liquidity fee or dual pricing
approach.\265\
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\264\ See supra section II.D.1.
\265\ We provide additional illustrative examples of potential
alternatives and pairings in section II.D.3.
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a. Indicative Flows
We considered whether, instead of requiring a hard close, we should
require that funds receive indicative flow information from
intermediaries by an established time. This approach would require that
intermediaries (e.g., broker-dealers, banks, and retirement plan
recordkeepers) calculate an estimate for what they anticipate the given
flows for a particular day to be either before the fund's pricing time
or a set time thereafter (e.g., by 4:30 p.m. ET or 5 p.m. ET).
Consistent with current practices, intermediaries could submit final
order flow information after the pricing time once the intermediary has
received and calculated the final flows for the day. For example, we
could consider orders to be eligible to receive that day's price if, in
the case of orders submitted through an intermediary: (1) the
intermediary receives the orders from investors before 4 p.m. ET; (2)
the intermediary provides estimated order flow to the fund by the
identified time; and (3) the intermediary provides final order
information by the next morning. Under this approach, a fund would be
permitted to use the indicative flow information provided by
intermediaries to determine whether a swing factor should be applied to
that day's NAV.
In order to calculate the indicative flow information,
intermediaries would need to generate an estimated flow based on, among
other things, the actual flows that they have received before the
pricing time and the prior day's price, as well as any indicative
historical information that is available if the indicative flow
information is provided to the fund before the pricing time.
Alternatively, the intermediary could provide summary net flow
information (for example, estimated net purchases of $3 million,
estimated net redemptions of 250,000 shares, and the purchase of an
unknown quantity of fund shares with proceeds from redeeming 100 shares
from a different identified fund), and the fund could apply the prior
day's NAV to arrive at an estimated net flow. Intermediaries would need
to update
[[Page 77221]]
their systems and processes to calculate indicative flow information by
or shortly after the pricing time while continuing to provide actual
final flow information as it is available. We understand that different
intermediaries may, based on their different characteristics, use
different methods to calculate or provide their indicative flows. A
broker-dealer and a retirement plan recordkeeper would not necessarily
use the same method due to the differences in how they are able to
generate and communicate flow information to funds. Retirement plan
recordkeepers, for example, would need to generate indicative flow
information that accounts for not only purchase and redemption activity
that is a known number of shares or dollars as of the pricing time, but
also estimated loan and withdrawal activity that is subject to
hierarchy provisions under their specific plans. If an intermediary is
unable to provide indicative flow information by the identified time,
the orders would receive the next day's price.
Unlike the proposed hard close requirement, the alternative of
permitting funds to rely on indicative flows provided by intermediaries
would provide intermediaries with more flexibility in providing final
flow information. Thus, the broader changes that may be needed for
intermediaries to comply with the proposed hard close requirement that
are discussed above may not be needed under this alternative. This
approach would not ultimately provide funds with the most accurate
information about anticipated flows. If intermediaries are required to
provide indicative flows before a fund's pricing time, the flow
information may be less reliable, particularly during times of stress
since intermediaries may not be able to account for or anticipate the
effects of a stress event on order flow information. This limitation of
indicative flow information may create down-stream effects on the
accuracy and efficacy of swing pricing, particularly in times of
stress. For swing pricing to serve the goal of mitigating dilution of
shareholders' interests, funds need accurate order flow information,
particularly in times of stress. In addition, an approach based on
indicative flows would be less effective at preventing late trading and
at reducing operational risk through improvements to order processing.
We request comment on the indicative flow alternative, including:
159. Should we allow funds to use indicative flow information to
determine whether or not to apply swing pricing?
160. If intermediaries are required to provide indicative flows to
funds, should the rule establish this requirement by considering an
order as eligible to receive a given day's price only if the
intermediary provides indicative or final order flow information by an
identified time and provides final order information by a later
identified time? Should we instead provide that a fund must prohibit an
intermediary from purchasing the fund's shares in nominee name on
behalf of others if the intermediary does not provide timely indicative
flow information? Should the rule require that funds enter into a
contractual agreement with intermediaries to require the indicative
flow information? If so, should this contract be required to specify
how indicative flows are calculated by the intermediary? In either
case, should we prohibit or restrict an intermediary from charging fees
to funds for the costs associated with providing indicative flow
information?
161. Would intermediaries have sufficient incentives to provide
timely and accurate indicative flow information? Are there other
consequences we should impose for late or materially inaccurate
indicative flow information? For example, if an intermediary has a
pattern of providing late or inaccurate information, should we require
a fund to prohibit the intermediary from purchasing the fund's shares
in nominee name on behalf of others? As another alternative, should we
prohibit orders received from that intermediary from receiving that
day's price and instead require that the orders be executed and settled
on a delayed basis at a future day's price, in order to limit the
dilutive effects of orders that intermediary submits?
162. When should intermediaries be required to provide indicative
flows under this alternative? Are indicative flows needed before the
pricing time, or could funds still make timely swing pricing decisions
if intermediaries provided indicative flows after the pricing time? How
long after the pricing time could funds receive the indicative flow
information and still make timely swing pricing decisions? In
connection with this approach, would funds publish their prices later
than they do today to provide additional time to make swing pricing
decisions?
163. Should the intermediary or the fund apply the prior day's
price to arrive at an indicative flow estimate? Is there value in the
fund performing this calculation because it would have better
information about potential changes to the prior day's price that it
could take into account (e.g., the size of any swing factor adjustment
made on the prior day, as well as potential changes to the value of its
portfolio holdings)?
164. Should intermediaries that have minimal holdings with the fund
be permitted not to provide indicative flows under this approach? If
so, how should we define intermediaries that have minimal holdings of
fund shares? How would this approach work if an intermediary's
customers began to transact in higher volumes of the fund's shares?
165. Should we provide fund managers a safe harbor from liability
under certain circumstances (e.g., absent knowing or reckless behavior)
if the fund relies on indicative flows to determine whether to swing
the fund's NAV and the size of the swing factor and those indicative
flows do not align with the actual flows the fund ultimately receives?
From what statutory provisions or rules should any safe harbor provide
relief (for example, section 34(b) under the Investment Company Act,
rule 22c-1, or other provisions and rules)?
166. If we adopt an indicative flows approach, are there any
changes we should make to the proposed swing pricing requirement? For
example, instead of requiring use of ``reasonable, high confidence''
estimates of investor flow information, should we use a different
standard (e.g., reasonable estimates based on available information)?
167. Do commenters agree with the discussion of the potential
benefits, costs, or drawbacks of this alternative? During times of
stress, would intermediaries be able to generate accurate indicative
flow information?
168. Does this alternative raise different considerations if we
were to require funds to use a liquidity fee framework or dual pricing,
rather than swing pricing? Should an indicative flows approach operate
or be structured differently if paired with a liquidity fee or dual
pricing requirement and, if so, how?
169. Is there information about the indicative flows alternative,
if adopted, that would be important for investors to understand and
that funds should be required to disclose in their registration
statements or elsewhere?
b. Estimated Flows
We also considered an approach that would allow funds to estimate
their flows for the day for the purposes of determining whether to
apply a swing factor to the day's NAV and the amount of the swing
factor (e.g., whether the amount of net redemptions exceeds the market
impact threshold). In order to
[[Page 77222]]
estimate flows for a given day, funds could generate models that
incorporate the information available to them. For example, funds could
use the flow information that they have already received by a pre-
established time as well as historical order flow information in order
to estimate expected flows for the day.
The ability of a fund to estimate flow information may differ based
on the types and number of intermediaries from which the fund is
ultimately receiving flow information. In order to estimate flows,
funds may rely on factors that include the historical pattern of flows
for a particular intermediary while accounting for any observed changes
in the flows for a given fund. This estimate could be based on all of
the information received by the fund by a set time, with additional
adjustments to account for flows from intermediaries that do not submit
orders by that time. For example the fund could base its estimate on
all information that it has received by 5 p.m. ET. For some
intermediaries, however, like retirement plan recordkeepers, funds
would likely need to create models that are able to project estimated
flow information based on historical order flow information as
retirement plan recordkeepers may not have sufficient information
available by the time established by the fund. In addition, to the
extent funds do not already receive large trade notifications, funds
may determine to negotiate arrangements with intermediaries for receipt
of advance notice of certain large transactions that are known in
advance by intermediaries, such as replacing a fund as an investment
option in a retirement plan.
The considerations for whether estimates generated by the fund
provide sufficiently reliable information to implement swing pricing
are similar to those discussed above for the alternative for indicative
flows from intermediaries. Funds have a narrower view of anticipated
flow activity than intermediaries, however, as intermediaries are
closer to investor activity and likely have a more accurate estimate of
their customers' flows for a particular fund. This benefit of
indicative flows over estimated flows may be mitigated to the extent
that intermediaries lack incentives or are otherwise unable to provide
reasonably accurate indicative flows. During times of stress, funds may
have a limited view of anticipated order flow information, which may
impact their ability to effectively implement swing pricing. In
addition, an approach based on estimated flows would be less effective
at preventing late trading and at reducing operational risk through
improvements to order processing than the proposed hard close
requirement. On the other hand, estimated flows would be less costly
than either a hard close or indicative flows.
We request comment on the estimated flow alternative, including:
170. How accurately can funds estimate flows from different
intermediaries? For example, are retirement plan flows relatively
stable and predictable, or do they vary over different periods? To what
extent do retirement plans inform funds in advance of material flows
that deviate from historical patterns, such as changes in funds the
plan offers? Would funds receiving flows from specific intermediaries
be better able to estimate their flows? For example, would it be easier
for funds to estimate flows from broker-dealers because broker-dealers
tend to be able to provide order flow earlier than some other
intermediaries? Would it be easier for funds to estimate flows from
retirement plan recordkeepers because those flows are more predictable?
To the extent that certain events make flows less predictable, such as
changes in the funds a retirement plan offers to its participants,
could funds better estimate their flows if intermediaries were required
to provide advance notice or other information about these events?
171. Should we provide fund managers a safe harbor from liability
under certain circumstances (e.g., absent knowing or reckless behavior)
if the fund relies on estimated flows to determine whether to swing the
fund's NAV and the size of the swing factor and those estimated flows
do not align with the actual flows the fund ultimately receives? From
what statutory provisions or rules should any safe harbor provide
relief (for example, section 34(b) under the Investment Company Act,
rule 22c-1, or other provisions and rules)?
172. Should we require funds to conduct back-testing of estimated
flows using final data to refine their estimation process over time and
help ensure that estimates used for swing pricing are reasonable?
173. Would funds be able to implement swing pricing based on
estimated flow information? If we adopt an estimated flows approach,
are there any changes we should make to the proposed swing pricing
requirement? For example, instead of requiring use of ``reasonable,
high confidence'' estimates of investor flow information, should we use
a different standard (e.g., reasonable estimates based on available
information)?
174. Does this alternative raise different considerations if we
were to require funds to use a liquidity fee framework or dual pricing,
rather than swing pricing? Should an estimated flows approach operate
or be structured differently if paired with a liquidity fee or dual
pricing requirement and, if so, how?
175. Is there information about the estimated flows alternative, if
adopted, that would be important for investors to understand and that
funds should be required to disclose in their registration statements
or elsewhere?
176. To what extent would the estimated flows alternative reduce
costs on funds and intermediaries relative to the proposed hard close?
c. Later Cut-Off Times for Intermediaries
We have considered whether establishing later cut-off times for
intermediaries to submit order flow information would lessen the burden
on intermediaries to comply with the proposed hard close requirement
while continuing to give funds the necessary order flow information to
implement swing pricing. Under this alternative, investors would
continue to need to submit orders before the fund's pricing time to be
eligible to receive that day's price, but intermediaries would have
additional time to provide those orders to a designated party after the
pricing time, such as by 6 or 7 p.m. ET for a fund with a 4 p.m. ET
pricing time. To provide time to assess the flows and determine whether
to apply swing pricing, a fund might push the time of publication of
its price to a later time, such as 8 to 10 p.m. ET. Much like the
proposed hard close, this alternative may have additional benefits
beyond facilitating swing pricing. Ensuring that all order flow
information is provided to a designated party earlier than it is
currently may improve order processing. This alternative would be less
effective, however, at preventing late trading.
Allowing intermediaries more time to provide order flow information
and delaying publication of the NAV would involve many of the systems
costs discussed in connection with the hard close. For example,
intermediaries would still need to transmit orders before the NAV is
available. However, providing intermediaries and funds more time to
compile order flow information and to calculate the price may lessen
the overall burden of the proposed changes, and may reduce the need for
intermediaries to establish cut-
[[Page 77223]]
off times prior to the fund's pricing time for receipt of investor
orders.
We request comment on the alternative of later cut-off times for
intermediaries, including:
177. What would an appropriate delayed cut-off time be (e.g., two
or three hours after the fund's pricing time)? Would a delayed cut-off
time, in combination with a delayed price publication, provide funds
with sufficient time to make swing pricing decisions?
178. If funds were to delay the publication of their price, what
steps would funds need to take? Would they need to amend agreements
with intermediaries? What effects would a delayed publication time have
on intermediaries or other parties?
179. Would a delayed cut-off time for intermediaries to submit
orders to a designated party be less burdensome than the proposed hard
close? Would a delayed price publication time be less burdensome than
the proposed hard close?
180. Would funds be able to implement swing pricing if we require
later cut-off times for intermediaries instead of the proposed hard
close? If we adopt a later cut-off time approach, are there any changes
we should make to the proposed swing pricing requirement? For example,
instead of requiring use of ``reasonable, high confidence'' estimates
of investor flow information, should we use a different standard (e.g.,
reasonable estimates based on available information)?
181. Does this alternative raise different considerations if we
were to require funds to use a liquidity fee framework or dual pricing,
rather than swing pricing? Should a later cut-off time approach operate
or be structured differently if paired with a liquidity fee or dual
pricing requirement and, if so, how?
182. Is there information about the later cut-off times
alternative, if adopted, that would be important for investors to
understand and that funds should be required to disclose in their
registration statements or elsewhere?
3. Additional Illustrative Examples
While there are many potential combinations of swing pricing and
hard close alternatives, several of which we have already discussed in
this release, this section provides additional illustrative examples of
alternatives to the proposed swing pricing and hard close requirements
that are designed to reduce shareholder dilution. The alternatives
discussed in this section are intended to have lower operational costs
than the proposed requirements, although the reduction in costs
involves other trade-offs, as discussed below.
a. Spread Cost Adjustment on Days With Estimated Net Outflows
Spread costs can be a major component of a fund's swing factor.
Instead of the proposed swing pricing and hard close requirements, we
could require a simplified version of swing pricing in which funds
adjust their current NAVs to reflect good faith estimates of spread
costs on days the fund reasonably expects to have net redemptions based
on estimated flows. Under this approach, if a fund determined its NAV
based on the midpoint of each investment's bid-ask spread, on days of
estimated net redemptions the fund would swing its transaction price
down by an amount designed to reflect spread costs in the portfolio.
The adjustment would be based on good faith estimates of spread costs,
consistent with the proposed swing pricing requirement. As with the
swing factor under the proposal, the estimated spread costs could be
determined periodically, as long as significant market developments or
other developments that affect the good faith estimate of spread costs
prompt a quicker reevaluation.\266\ If the fund already uses bid prices
for valuation purposes, it would not be required to adjust its current
NAV to reflect spread costs.\267\
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\266\ This approach would not require a fund to use bid prices
to value each of its investments when determining its NAV. Instead,
as appropriate, a fund could continue to value its investments using
the midpoint to determine its NAV and, on days of estimated net
outflows, the fund would be required to reduce the fund's
transaction price based on good faith estimates of spread costs.
\267\ See supra note 202 (discussing accounting standards that
state that the price within the bid-ask spread that is most
representative of fair value in the circumstances shall be used to
measure fair value and that provide that use of bid prices is
permitted for these purposes, as well as use of mid-market pricing
as a practical expedient).
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This approach would be designed to mitigate dilution from spread
costs associated with selling investments to meet redemptions. The
reflection of costs would be dynamic when a fund expects net outflows,
with the adjustment to reduce a fund's transaction price increasing in
size as spreads widen during times of stress. A fund would need to
estimate the direction of flows (i.e., net redemptions or net
purchases) based on available information before the fund publishes its
price, but the fund would not need to estimate the size of net flows. A
fund's reasonable expectation of the direction of fund flows may be
based on different types of information, depending on the fund. For
example, a fund could consider indicative flow information from
intermediaries, trends in orders submitted that day, general market
intelligence, or historical trends in flows.
This approach would impose lower operational burdens and costs
relative to the proposal, including by not necessitating a hard close
and by simplifying the analysis of a swing factor. At the same time,
the approach would address dilution less fully than the proposal.
Unlike the proposed swing pricing requirement, this approach would not
capture market impact or other costs of selling investments to meet
redemptions. For one, a fund could not assess market impact without an
estimate of the size of net flows and, without a hard close, estimating
the size of net flows with accuracy would be subject to a greater risk
of error than estimating only the direction of flows. In addition, as
previously discussed, there may be operational challenges and
complexities to estimating market impact costs more generally. Another
difference from the proposed swing pricing requirement is that this
approach would not address dilution from sizeable net purchases.
Because smaller levels of net purchases are less likely to result in
dilution than net redemptions (as funds have more time to invest the
proceeds from net purchases than to sell investments to meet
redemptions), it may not be appropriate to require a fund to adjust its
current NAV to reflect spread costs on any day it estimates net
purchases. For this reason, we have a net inflow swing threshold of 2%
in the proposal and, as with the potential inclusion of market impact
in this framework, estimating the size of net flows involves a greater
risk of error than estimating only the direction of net flows.
In addition to other requests for comment related to variations of
swing pricing and estimation of flows, we request comment on requiring
a fund to adjust its current NAV to reflect good faith estimates of
spread costs on days the fund reasonably expects to have net
redemptions, instead of requiring the proposed version of swing pricing
and a hard close.
183. Would this approach reduce operational burdens and costs
relative to the proposed swing pricing and hard close requirements?
Would this approach reduce operational burdens and costs relative to
the liquidity fee alternative? Would this approach reduce operational
burdens and costs relative to the dual pricing alternative? How
effective would this approach be in addressing dilution? To what extent
would this approach protect non-
[[Page 77224]]
transacting investors from dilution due to the bid-ask spread costs and
ameliorate any first-mover advantage? Would the effectiveness of the
tool vary between normal and stressed market conditions? Should this
approach also reflect transaction costs in addition to spreads, for
example, commissions, markups, and/or markdowns?
184. How accurately can funds estimate the direction of daily net
flows? Should the requirement apply on days the fund reasonably expects
to have net redemptions (such that the fund uses this approach only if
it affirmatively expects net redemptions) or on days the fund does not
reasonably expect to have net purchases (such that the fund defaults to
this approach unless it affirmatively expects net purchases)?
185. To what extent do funds already value their portfolio
investments using bid prices? What consequences, if any, would a
requirement to reflect good faith estimates of spread costs when a fund
reasonably expects to have net redemptions have on these funds?
186. Would this approach incentivize funds to value their portfolio
investments using bid prices without properly evaluating whether the
bid price is most representative of fair value in the circumstances, in
order to avoid the need to determine whether the fund reasonably
expects net redemptions each day?
187. If we adopt this approach, how should we amend disclosure and
reporting requirements? For example, if we required funds to use this
simplified version of swing pricing, should current prospectus and
financial statement reporting requirements for swing pricing apply?
Should we require funds to report the frequency and amount of
adjustments made to their current NAVs under this approach? Should a
fund be required to report both its current NAV and its adjusted price?
Should a fund be required to report information about the accuracy of
its estimates of flow information? Where should any such information be
located (e.g., Form N-PORT, fund websites, annual and semi-annual
reports)?
b. Liquidity Fee When Trading Costs Are Significant
Another alternative we considered is a liquidity fee that would
apply only on days when a fund anticipates significant trading costs. A
rule could either define the trigger or require funds to establish
policies and procedures that identify their own fund-specific triggers.
In terms of establishing the trigger, one alternative would be a
trading cost trigger that the fund sets in advance or that the
Commission establishes by rule (for example, with a set size, a set
increase, or a set standard deviation in trading costs based on
criteria such as spreads or transaction volumes for the fund's
portfolio, either in terms of dollars or as a percentage of the fund's
portfolio). As another alternative, the trigger for applying a
liquidity fee could include other factors that indicate an increase in
trading costs, such as increasing net flows (e.g., based on the fund's
flow history or estimated flows) or decreasing liquidity (e.g., based
on declines in the percentage of the fund's investments classified as
highly liquid, or increases in the percentage of investments classified
as illiquid). A fund's trigger for applying liquidity fees could be
required to be made public or kept non-public.
As one example of a policies and procedures based approach, a fund
could be required to establish written policies and procedures that
would define the trigger event(s) that would cause a fund to apply a
fee. The fund's policies and procedures would be required to be
designed to mitigate dilution and recoup the costs the fund reasonably
expects to incur as a result of shareholder redemptions on days when
trading costs are higher. Funds would have discretion to define their
own trigger events, but all funds would be required to consider certain
identified factors, such as trading costs, liquidity of the fund's
portfolio, market conditions, and reasonably estimated investor flows,
in determining their trigger events.\268\
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\268\ Consideration of expected investor flows would not require
a fund to estimate the size of expected flows with accuracy. Rather,
this consideration would be intended to recognize the potential
relevance of flows, to the extent a fund has sufficient information
to reasonably estimate them. Moreover, if a fund anticipates a
significant increase in costs of selling its investments but does
not expect to need to sell investments due to an anticipation of net
inflows, this approach would not require a fund to impose a fee.
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There are several alternatives for setting a fee amount. For
instance, the fund could either base the fee amount on reasonable
estimates of expected transaction costs, including market impact, or if
the fund determined this estimation is not feasible, the fund could
establish a set fee amount, or graduated fee levels, it would apply
when a trigger event occurs. The rule could either allow a fund to
determine that estimating transaction cost amounts is not feasible in
advance, or the rule could require a fund to consider its ability to
estimate transaction costs each time a liquidity fee applies. Under
another possible approach, the rule could establish a default fee
amount, such as 1%, that a fund could opt out of or adjust if
determined to be in the best interest of the fund.
With respect to board oversight, if fee triggers or amounts were
determined based on written policies and procedures, we could require
board approval of the policies and procedures defining a fund's trigger
event or identifying how to determine a fee amount, as well as any
material changes to those policies and procedures. As for determining
when a trigger event occurs and the amount of the fee, similar to the
proposed swing pricing requirement, we could allow a liquidity fee
administrator approved by the board to make some or all of these
determinations.
If designed incorrectly, a fee that only applies when trading costs
are significant could incentivize investors to redeem if investors can
observe in advance that a fee is likely to apply in the near future.
There are various mechanisms we could use to reduce these incentives.
For one, if the rule identified specific trigger events that all funds
would use, in that case, the potential for preemptive redemptions would
be reduced if investors or other market participants could not observe
with certainty if a fund is nearing a trigger event. Another approach
would be to identify specific thresholds for triggering a fee in the
rule and allow a fund to choose to use one or more of those thresholds
to determine when to apply a fee. If funds determined their own fee
triggers, the rule could provide that a fund's trigger event would be
either public or nonpublic. Public disclosure of a fund's trigger for
applying liquidity fees would increase transparency. The rule could
require, however, that the fund's trigger event be kept nonpublic in
order to reduce the potential for preemptive redemptions. Under this
approach, a fund would not disclose its defined trigger event, and
instead would be required to disclose in its prospectus that it applies
a liquidity fee on days its trading costs increase, as well as how it
determines the amount of the fee. A fund could be required to report
information about how frequently it applied a liquidity fee and the
amount of each fee on Form N-PORT.
Unlike the proposed swing pricing requirement, this approach would
not address smaller levels of dilution that may occur in the normal
course. Instead, it would be designed to focus on periods where funds
have heightened dilution risk, such as in stress events. In addition,
this approach would not address dilution that may occur from net
purchases.
In addition to other requests for comment related to liquidity fee
[[Page 77225]]
alternatives, we request comment on whether we should require a fund to
apply liquidity fees only on days when a fund anticipates significant
trading costs, instead of requiring swing pricing and a hard close.
188. Should a fund be required to apply a liquidity fee only when
trading costs are significantly increasing, such as a period of stress?
If so, should the rule identify a trigger when fees apply, or should
funds establish their own trigger events?
189. If the rule establishes a trigger, what should that trigger be
based on? For example, should the rule require a fund to apply a
liquidity fee when spreads are widening or transaction volumes for the
portfolio increase? For instance, should fees be required when spreads
widen beyond a 95% confidence level for key components of the fund's
portfolio, where the mean and standard deviation of these key markets
are measured for the trailing 252 business days (the average number of
trading days in a year), and the trigger occurs if the current spread
is greater than 1.65 standard deviations (i.e., the equivalent of a 95%
confidence in a normal distribution) above the mean for that period?
Should different confidence levels, standard deviations, or measurement
periods be used? Should a liquidity fee trigger be based on an increase
in the transaction volume of the fund's portfolio, such as a trigger
when the dollar- or percentage-based transaction volume for that day
exceeds the 95% confidence level compared to the average daily
transaction volume for the trailing 252 business days? Should different
confidence levels or measurement periods be used? Do funds already
track information that would allow them to identify readily when a
trigger based on widening spreads or increased dollar transaction
volume is crossed, or would they need to collect or monitor additional
information about spreads or transaction volumes? Should the rule use
other or additional triggers? For example, should a trigger be based on
or consider large net outflows or a reasonable expectation of large net
outflows above a certain percentage, such as net redemptions above 1%
or 2% of net assets or net redemptions that are higher than typical for
the individual fund based on historical flows? If the rule included a
numerical threshold for net redemptions, would funds have concerns
about their ability to accurately estimate net flow amounts and
therefore be less likely to apply fees? If so, would a safe harbor
address these concerns? Should a trigger be based on or consider an
identified change in the fund's liquidity classifications, such as an
identified decrease in the percentage of highly liquid investments the
fund holds or an identified increase in the percentage of illiquid
investments the fund holds? Should identification of a trigger event
account for indicators of market stress in the financial markets
overall or in the specific markets in which the fund invests? If so,
what indicators of market stress should the rule include? Should the
rule identify multiple potential triggers and allow funds to choose
whether to use one or more of those triggers to determine when to apply
a fee?
190. Instead of identifying specific trigger points by rule, should
we require funds to establish and implement policies and procedures
that describe when the fund will impose a fee? Would a policies and
procedures approach allow funds to tailor the application of a fee to
scenarios in which transacting investors are likely to cause dilution?
Under a policies and procedures approach, should we identify the
factors a fund must consider in defining its trigger events? If so,
what factors should we require a fund to consider (e.g., trading costs,
liquidity of the fund's portfolio, market conditions, and reasonably
estimated investor flows)? Rather than require funds to consider these
factors, should we require funds to define their trigger events with
respect to these or other specific factors?
191. Should we permit a fund not to apply a fee upon the occurrence
of a defined trigger event? For example, should a fund be required to
apply a fee when a trigger event occurs, unless the board determines
that it is not in the interest of the fund to apply a fee in the
specific circumstance?
192. What risks are associated with requiring a fund to define its
own trigger event, and how could we reduce these risks? Would funds
define a trigger event such that a fund would be delayed in determining
that a fee should apply relative to potentially fast-moving changes in
market conditions? If so, would this delay increase the potential for
preemptive redemptions and contribute to a first-mover advantage? Would
funds define a trigger event in a way that makes it unlikely that a
fund would ever apply a fee? Are there ways to ensure that funds'
policies and procedures are sufficiently robust, such as requirements
to report the policies and procedures to the Commission or to report
when a fund applied a fee? For example, should funds be required to
confidentially report their trigger events to the Commission and to
report how frequently fees applied and in what amounts on Form N-PORT?
193. Should liquidity fees apply only to redemptions if a trigger
event occurs? Or should liquidity fees apply to both redemptions and
purchases under this approach? Should a single trigger event result in
fees applying to both redemptions and purchases, or should funds
establish trigger events that differ between redemptions and purchases?
194. How should the amount of a liquidity fee be determined under
this approach? Should the rule set a specified fee amount that would
occur upon any fund's trigger event, such as 0.5%, 1%, or 2%? Should
any fee amount set by rule be a default amount, such that a fund could
use a higher or lower fee amount if determined to be in the best
interest of the fund? Should funds be required to calculate the amount
of the fee based on reasonable estimates of expected transaction costs,
including market impact? Should fund policies and procedures, or a
rule, establish a set fee amount that would apply if a fund is unable
to reasonably estimate expected transaction costs? Should funds be
required to consider their ability to reasonably estimate transaction
costs each time a trigger event applies, or should funds be able to
determine in advance that estimation is not feasible and opt to use a
set or graduated fee for all trigger events? Should fund policies and
procedures, or a rule, establish graduated fee levels that would apply
for different trigger events? Should we establish a limit on the size
of a liquidity fee under this approach (e.g., 2%, 3%, or 5%)?
195. After a fee is triggered, how should the rule permit or
require a fund to determine when it should no longer apply a fee? For
instance, should a fund reassess daily whether trading costs have
decreased, or should a liquidity fee remain in place for a set number
of days (e.g., 2 to 5 days) and then no longer apply unless the fund
determines a fee continues to be in the best interest of the fund?
196. What information should funds be required to disclose in their
prospectuses under this approach? How much detail should funds be
required to provide about when they will impose a liquidity fee? Should
the prospectus state only that a fund will impose a fee when trading
costs increase, or should the prospectus also discuss the factors a
fund considers to make this determination? Should a fund be required to
disclose its trigger events in its prospectus? Would that disclosure
contribute to potential preemptive redemptions, or would trigger events
be difficult to observe publicly in advance? Should funds be required
to disclose fee
[[Page 77226]]
amounts in their prospectuses, or their methods for calculating fee
amounts?
197. Should the fund's board be required to approve the fund's
written policies and procedures defining the trigger event(s) and how
the fund will determine the amount of the fee? Should the board be
required to approve any material changes to the policies and
procedures? Should other board oversight be required? Should the board
have to determine that a fee is appropriate every time a trigger event
occurs before the fund can impose a fee? Or should the board be
required to designate a liquidity fee administrator that would be
responsible for determining when liquidity fees apply and the size of
the fee? Should the definition of a liquidity fee administrator mirror
the proposed definition of a swing pricing administrator? If not, what
changes should be made? Similar to the proposed swing pricing
requirement, should a liquidity fee administrator be required to
provide periodic reports to the board (at least annually) that
describe: (1) the administrator's review of the adequacy of the
policies and procedures identifying the fund's trigger event and the
effectiveness of their implementation, including the effectiveness in
mitigating dilution; (2) any material changes to the liquidity fee
policies and procedures since the date of the last report (if such
material changes are not subject to board approval); and (3) the
administrator's review and assessment of the fund's method for
determining the size of the liquidity fee?
198. What are the operational implications of this approach for
funds and intermediaries? Would intermediaries be able to apply a
liquidity fee on the same day the fund announces its imposition? What
effects would this approach have on investors?
199. If liquidity fees are only applied rarely under this approach,
how would that affect fund and intermediary preparedness for imposing
fees? Would it increase investor sensitivity to fees and increase the
likelihood of preemptive redemptions?
200. Should we pair a requirement to adjust a fund's current NAV to
reflect spread costs on days the fund estimates it will have net
redemptions with a requirement to apply a liquidity fee when trading
costs increase? Would this combined framework address dilution from net
redemptions in a manner similar to the proposed swing pricing
requirement without the costs of a hard close?
E. Reporting Requirements
1. Amendments to Form N-PORT
Registered management investment companies and ETFs organized as
unit investment trusts are required to file periodic reports on Form N-
PORT about their portfolios and each of their portfolio holdings as of
month-end.\269\ While the reports provide monthly information to the
Commission, funds file these reports on a quarterly basis with a 60-day
delay, and the public only has access to information for the third
month of each quarter. We are proposing to require reports on Form N-
PORT to be filed within 30 days of month-end, which would be followed
by public availability of much of the reported information 60 days
after month-end. We are also proposing to require an open-end fund that
is subject to classification requirements in the liquidity rule to
provide information regarding the aggregate percentage of its portfolio
represented in each of the three proposed liquidity categories, which
would be publicly available. The reported aggregate percentages would
include adjustments to give effect to other aspects of the proposal.
Finally, we are proposing amendments relating to funds' use of swing
pricing, conforming amendments to reflect the proposed amendments to
rule 22e-4, and amendments to certain entity identifiers.
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\269\ For purposes of this section, the term ``fund'' refers to
registrants that currently are required to report on Form N-PORT,
including open-end funds, registered closed-end funds, and ETFs
registered as unit investment trusts, and excluding money market
funds and small business investment companies.
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a. Filing Frequency
We are proposing to amend rule 30b1-9 and Form N-PORT to require
funds to file reports on Form N-PORT on a more timely basis, with
changes to both the frequency with which a fund would file reports on
Form N-PORT and when the reports are due.\270\ Specifically, rather
than filing monthly reports with the Commission 60 days after the end
of each fiscal quarter, we are proposing to require that funds file
reports on a monthly basis.\271\ These monthly filings would be due
within 30 days after the end of the month to which they relate and
would be made public 60 days after the end of the month to which they
relate.\272\ As an example, currently a fund files Form N-PORT reports
for the first, second, and third months of each fiscal quarter with the
Commission 60 days after the end of the third month of the quarter.
Under the proposal, funds would separately file reports for the first,
second, and third months of the quarter, with each month's report due
within 30 days of month-end.
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\270\ The proposal would also make a conforming edit to the
filing instructions for Form N-PORT. See proposed 17 CFR 274.150(a).
\271\ We would also make conforming changes to General
Instruction A of Form N-PORT and rule 30b1-9 to remove references to
the requirement for a fund to maintain in its records the
information that is required to be included on Form N-PORT no later
than 30 days after the end of each month; this would no longer be
necessary because the information would be filed with the
Commission. See Proposed General Instruction A of Form N-PORT;
proposed rule 30b1-9.
\272\ Id; proposed General Instruction F of Form N-PORT. As is
the case currently, if the due date falls on a weekend or holiday,
the filing deadline would be the next business day.
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These changes are intended to provide more timely information
regarding the fund's portfolio, including its liquidity profile. Both
the current quarterly reporting cadence and the 60-day delay after the
end of the quarter before reports are due make it difficult to use
reported data to assess events that are developing quickly, or to
identify early warning signs of potential distress. By the time the
information is filed, it is at least two, and could be as many as four,
months out of date.\273\
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\273\ Because reports are due 60 days after the end of a fund's
fiscal quarter, deadlines vary based on the fund's fiscal year. As
an example, depending on a given fund's fiscal year, reports on Form
N-PORT that included information for Mar. 2020 were due between June
1, 2020, and July 30, 2020. For instance, for funds with fiscal
years ending Dec. 31, Sept. 30, June 30, or Mar. 30--which is just
under half of all funds--the due date of the filing was May 30,
2020. Because this was a Saturday, the filing deadline was extended
until the next business day on Monday, June 1. See General
Instruction A to Form N-PORT.
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As proposed in 2015 and adopted in 2016, Form N-PORT would have
provided for monthly filings with the Commission, within 30 days after
the end of each month.\274\ Only reports for every third month would
have been available to the public.\275\ The Commission originally
required monthly portfolio reporting because it would be useful for
fund monitoring, particularly in times of market stress.\276\ The
Commission originally required funds to file each monthly report within
30 days of month end because more delayed data would reduce the utility
of the information to the Commission and lag times of more than 30 days
would
[[Page 77227]]
make monthly reporting impractical, as reports would overlap with
preparation time.\277\
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\274\ See Investment Company Reporting Modernization, Investment
Company Act Release No. 32314 (Oct. 13, 2016) [81 FR 81870 (Nov. 18,
2016)] (``Reporting Modernization Adopting Release''), at section
II.A; Investment Company Reporting Modernization, Investment Company
Act Release No. 31610 (May 20, 2015) [80 FR 33589 (June 12, 2015)]
(``Reporting Modernization Proposing Release'').
\275\ See Reporting Modernization Adopting Release, supra note
274, at section II.A.
\276\ See id., at paragraph following n.453.
\277\ See id., at nn.461-462 and accompanying text.
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Before the date funds would have been required to comply with this
requirement, the Commission experienced a cybersecurity incident that
resulted in unauthorized access to certain nonpublic information on the
EDGAR system.\278\ As part of the Commission's ongoing assessment of
its internal cybersecurity risk profile, the Commission re-evaluated
and modified the filing frequency for reports on Form N-PORT. The
Commission required funds to file a report with the Commission for each
month in the fund's fiscal quarter no later than 60 days after the end
of each fiscal quarter and to maintain in their records the information
that is required to be included on Form N-PORT not later than 30 days
after the end of each month. In making this change, the Commission
stated that it significantly reduced the sensitivity of the non-public
data, but that the staff would continue to monitor and solicit feedback
on the data received and the use made (or expected to be made) of such
data in furtherance of the Commission's statutory mission, as well as
cybersecurity considerations and other matters deemed relevant by the
staff.\279\
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\278\ See Statement on Cybersecurity (Sept. 20, 2017), available
at https://www.sec.gov/news/public-statement/statement-clayton-2017-09-20; see also Testimony before the Financial Services and General
Government Subcommittee of the Senate Committee on Appropriations
(June 5, 2018), available at https://www.sec.gov/news/testimony/testimony-financial-services-and-general-government-subcommittee-senate-committee.
\279\ See Amendments to the Timing Requirements for Filing
Reports on Form N-PORT, Investment Company Act Release No. 33384
(Feb. 27, 2019) [84 FR 7980 (Mar. 6, 2019)] at nn.36-39 and
accompanying text.
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The Commission applies controls and systems for the use and
handling of filing systems for confidential information and associated
confidential data in a manner that reflects the sensitivity of the data
and is consistent with the maintenance of its confidentiality. The
Commission also has gained additional experience in receiving and
maintaining sensitive portfolio data on the EDGAR system. This
experience includes, for example, the existing non-public portions of
Form N-PORT, which are subject to controls and systems designed to
protect their confidentiality, as well as confidential treatment
requests for reports on Form 13F.\280\
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\280\ See Electronic Submission of Applications for Orders under
the Advisers Act and the Investment Company Act, Confidential
Treatment Requests for Filings on Form 13F, and Form ADV-NR;
Amendments to Form 13F, Investment Company Act Release No. 34635
(June 23, 2022) [87 FR 38943 (June 30, 2022)], at section II.C.
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Market events have reinforced the need for timely data regarding
funds' portfolios and the liquidity of those portfolios. For example,
disruptions in the markets for Treasury securities and corporate bonds
began near the end of the first quarter of 2020, but many funds'
reports on Form N-PORT reflecting these events were not due until June
1, 2020, or as late as the end of July 2020. This meant that Commission
staff were not able to review monthly filings, for example, to assess
and analyze how the events were affecting funds or identify issues for
further inquiry. Similarly, the Russian invasion of Ukraine began in
late February 2022, when many funds were just filing their reports for
the final quarter of 2021. This meant that when Commission staff were
reviewing data to assess funds' exposures to securities that could be
affected by the invasion, the data was several months out of date.\281\
As a result, during major market events, the staleness of Form N-PORT
data limits the Commission staff's ability to develop a comprehensive
understanding of the market. The stale data also can impede our ability
to contribute fully to interagency discussions of and responses to
market events.
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\281\ As evidence mounted that an invasion was likely to occur,
funds may have adjusted their exposure to securities that could be
affected, but Commission staff were unable to review this on a
market-wide basis until months after the invasion due to the delay
in receiving information.
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Although funds are required to maintain the monthly data and
produce it to Commission staff upon request, any such production would
be done on an individual basis. In addition, making individual requests
requires Commission staff to determine the appropriate funds from which
to collect data, which can be particularly challenging when Commission
staff is responding to market events but may not have the market data
necessary to determine quickly which funds to prioritize in responding
to the event.
Requiring funds to file monthly reports on Form N-PORT within 30
days of the end of each month, consistent with the filing frequency the
Commission initially adopted for Form N-PORT, would enhance our ability
to effectively oversee and monitor the activities of investment
companies in order to better carry out our regulatory functions,
consistent with the goals of Form N-PORT reporting.\282\
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\282\ See, e.g., Reporting Modernization Proposing Release,
supra note 274, at section IV.A. See also 2015 Proposing Release,
supra note 31, at text accompanying n.562.
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We request comment on the proposed changes to the timing and
frequency with which fund would be required to file reports on Form N-
PORT, including:
201. As proposed, should we require that funds file reports on Form
N-PORT on a monthly, rather than quarterly, frequency? Because funds
are currently required to maintain the information required to prepare
their reports on Form N-PORT on a monthly basis, within 30 days after
the end of the reporting period, would they have any increased burden
due to filing such information monthly, within 30 days after the end of
the reporting period, as proposed?
202. As proposed, should we shorten the deadline for filing reports
on Form N-PORT to 30 days after the end of the reporting period? Should
we instead use a different deadline, such as 15, 45, or 60 days after
the end of the reporting period?
203. Should we, as proposed, revise General Instruction A of Form
N-PORT and rule 30b1-9 to remove the requirement for a fund to maintain
in its records the information that is required to be included on Form
N-PORT no later than 30 days after the end of each month because this
information would be filed with the Commission under the proposal?
b. Publication Frequency
We are proposing to make funds' monthly reports on Form N-PORT
public 60 days after the end of each monthly reporting period.\283\
Currently, only the report for the third month of every quarter is made
public, meaning the proposal would triple the amount of data made
available to investors on Form N-PORT in a given year. Thus, the
proposal would enhance the ability of investors to review and monitor
information about their funds' portfolios.\284\
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\283\ See proposed General Instruction F of Form N-PORT.
\284\ We also propose to include additional information about
the aggregate liquidity profiles of fund portfolios. See infra
section II.E.1.c.
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We continue to believe that publication of information collected on
Form N-PORT can benefit investors by assisting them in making more
informed investment decisions.\285\ The public availability of monthly
information, rather than information only for the third month of each
quarter, may enhance these benefits. For example, institutional
investors could directly use
[[Page 77228]]
the monthly information reported on Form N-PORT to evaluate fund
portfolios and assess the potential for returns and risks of a
particular fund, and other investors may benefit from third-party
analysis of the monthly data.
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\285\ See Reporting Modernization Adopting Release, supra note
274, at section II.A.4.
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When the Commission first adopted Form N-PORT, it recognized
potential negative effects from frequent publication of Form N-PORT
data. For example, the Commission acknowledged the risk that frequent
public disclosure could allow market participants to use funds' reports
on Form N-PORT to engage in predatory trading such as front-
running.\286\ The Commission also recognized that more frequent public
disclosure could permit free riding on a fund's research or trading
expenditures by allowing other market participants to copy the fund's
trades.\287\ In determining to maintain the status quo of quarterly
public reporting based on the fund's fiscal quarters, the Commission
stated that it was important to assess the impact of the data reported
on Form N-PORT on the mix of information available to the public, and
the extent to which these changes might affect the potential for
predatory trading, before determining whether more frequent or more
timely public disclosure would be beneficial to investors in
funds.\288\
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\286\ See Reporting Modernization Adopting Release, supra note
274, at text accompanying n.488. See also Investment Company
Reporting Modernization, Investment Company Act Release No. 32936
(Dec. 8, 2017) [82 FR 58731 (Dec. 14, 2017)] (noting same concerns).
\287\ Id. But see Morningstar Comment Letter on Reporting
Modernization Proposing Release, File No. S7-08-15, available at
https://www.sec.gov/comments/s7-08-15/s70815-355.pdf (discussing
data that funds providing more frequent disclosure do not appear to
exhibit lower returns as a result of predatory behavior).
\288\ Reporting Modernization Adopting Release, supra note 274,
at text accompanying nn.494-499 and accompanying text.
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Since the adoption of Form N-PORT, funds' practices with respect to
disclosure of information about their portfolios have continued to
evolve. For example, many funds, including actively managed funds,
voluntarily provide their complete portfolio holdings on their websites
on a monthly basis, typically lagged 30 days. Further, ETFs, including
actively managed ETFs, generally are required to provide transparency
into their portfolio holdings on a daily basis.\289\ Many funds also
provide monthly information about their portfolio holdings to third
party data aggregators, generally with a lag of 30 to 90 days, which in
turn make them available to investors for a fee. We believe this
demonstrates that investor demand for monthly portfolio holdings
already exists and that funds providing the information have determined
the potential for predatory trading is justified by the benefit to
investors. The proposal would simply allow all investors to receive
similar data without paying a fee.\290\ Thus, we believe that many
funds already provide public transparency of their portfolio holdings
more frequently than the proposal would require, and that our proposal
would level the playing field by standardizing the reporting timelines
for all funds, putting the data in a single location that all investors
can access without charge, and using a standardized format that enables
investor analysis of reported data.\291\ In addition, under the
proposal, the public information for each fund's monthly report on Form
N-PORT would not be publicly available until 60 days after the end of
the month, which is the same delay that currently exists for funds'
reports for the third month of every quarter. This is designed to
balance the benefits to investors of more frequent portfolio
disclosure, while also retaining the existing 60-day delay, which we
believe is appropriate in order to make the disclosed positions less
timely and thus less likely to facilitate predatory trading
practices.\292\ As a result, and given that the proposal would provide
data for additional monthly periods but would not change the current
60-day delay in making funds' reports on Form N-PORT public, the
proposal is intended to mitigate opportunities for predatory trading or
free riding of funds' trading strategies.\293\
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\289\ See 17 CFR 270.6c-11(c)(1)(i); Exchange-Traded Funds,
Investment Company Act Release No. 33646 (Sep. 25, 2019) [84 FR
57162 (Oct. 24, 2019)] (``ETF Release''), at section II.C.4 (stating
that, although a few commenters raised concerns about front running
or free riding if certain ETFs were required to provide full daily
portfolio transparency, the Commission believed it was likely that
all current ETFs that may rely on the rule already provide full
portfolio transparency as a matter of market practice). In addition,
a small number of ``nontransparent'' ETFs have received an exemptive
order from the Commission permitting them not to disclose their
portfolio holdings on a daily basis. As of Mar. 31, 2022, there were
45 nontransparent ETFs. Several of these nontransparent ETFs
voluntarily disclose their complete portfolios on a monthly basis
with a one-month lag.
\290\ For example, we understand that a majority of funds
provide monthly information regarding their portfolios to a third-
party data aggregator. Individual investors are able to review the
holdings reported by funds providing data to the aggregator using an
analysis tool for which the aggregator charges a fee.
\291\ In addition, because we propose to make funds' reports on
Form N-PORT available for every month, investors could use Form N-
PORT to monitor how their funds respond to events regardless of when
they occur. For example, investors in some funds have access to Form
N-PORT filings for Mar. 2020, while investors in other funds do not.
This is because Form N-PORT data is publicly available for the third
month of each fund's fiscal quarter, but fiscal quarters vary among
funds.
\292\ Section 45(a) of the Investment Company Act requires
information in reports filed with the Commission pursuant to the Act
be made public unless we find that public disclosure is neither
necessary nor appropriate in the public interest or for the
protection of investors. For the reasons discussed above, we
preliminarily believe that keeping the data for the first and second
months of a fund's calendar quarter confidential until the
expiration of the 60-day period provided by the proposal is
necessary or appropriate in the public interest for the protection
of investors.
\293\ Form 13F is due 45 days after the end of each calendar
quarter, meaning that every third month, a fund's disclosure on Form
N-PORT would not be the first mandatory disclosure of its portfolio.
Funds currently have the ability to designate certain holdings for
the third month in every quarter as ``miscellaneous securities,''
which are not disclosed publicly on Form N-PORT. Because we propose
that all filings would eventually become public, we are extending
this to filings for each month. See text accompanying infra note
319.
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Furthermore, the proposal is intended to benefit investors through
increased transparency of Form N-PORT information, especially because
it is provided in structured format and made in a single, centralized
database. Giving investors access to this information in monthly
reports on Form N-PORT may result in investors being better able to
monitor the portfolios of their funds in a systematic fashion, and
assist investors in choosing the investment products that most closely
align with their desired levels of risk, asset exposures, and liquidity
profiles.
The proposed reporting requirement also takes into account the
cybersecurity risk profile of the information we are collecting. Under
the proposal, we would receive the monthly information 30 days after
the end of each month. Because the monthly information reported on Form
N-PORT would be made public 30 days after it is filed with the
Commission, the Commission would retain less confidential information
than under the final rules the Commission adopted in 2016. This is
because, under the proposal, information for each month would become
public shortly after filing instead of information in only the third
month of each quarter being publicly disclosed.
Currently, certain information reported on Form N-PORT is
nonpublic, even in the report for the third month of the quarter that
is otherwise publicly available. This aspect of the form is unchanged
in this proposal, and that information--which includes liquidity
classifications for individual portfolio investments--would remain
nonpublic in individual reports. However, Commission staff may publish
aggregate or other anonymized information about the nonpublic
[[Page 77229]]
elements of reports on Form N-PORT.\294\
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\294\ See General Instruction F of Form N-PORT.
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We request comment on the proposed changes to the frequency with
which funds' reports on Form N-PORT would be made public, including:
204. Should we, as proposed, make funds' reports on Form N-PORT
public on a monthly basis, 60 days after the end of the month to which
they relate? How would investors use the additional information? Are
there other potential users of public portfolio disclosures, including
third-party users that provide services to investors, who find the
additional information useful, and through whom investors could benefit
indirectly?
205. Many funds already provide monthly information about their
portfolio holdings on their websites. Would investors benefit from
having centralized information on Form N-PORT that includes all funds,
rather than having to look at each fund's website? Would investors
benefit from having the information in a structured format rather than
the format the fund uses on its website? Would the proposed requirement
reduce costs for investors who currently use data aggregators to obtain
holdings information regarding the funds in which they invest?
206. Should the lag between filing and publication be extended, for
example to 45 days after filing, or shortened, for example to 15 days
after filing? Should reports be made public immediately upon filing?
207. Previously, some have suggested that more frequent public
disclosure could raise costs for investors due to predatory trading or
copy-catting of fund strategies. Given that the proposal would provide
data for additional monthly periods but would not change the current
60-day delay in making funds' reports on Form N-PORT public, would the
proposal raise costs for investors due to predatory trading or copy-
catting? What empirical data exists that supports these assertions?
208. Would actively managed nontransparent ETFs, which generally do
not disclose their complete portfolios on a daily basis, be affected by
the proposed requirement to disclose their portfolio on a 60-day delay
differently than other actively managed funds, and should we permit
these funds to disclose their portfolios less frequently as a result?
209. Do funds voluntarily publish data about their portfolios to
compete for investors, notwithstanding potential effects on their
performance?
210. Are there certain items on Form N-PORT that we propose to make
public on a monthly basis that should only be public on a quarterly
basis? If so, why is monthly disclosure of the relevant item neither
necessary nor appropriate in the public interest or for the protection
of investors?
c. Public Reporting of Aggregate Liquidity Classifications
We are proposing to require that funds' monthly reports on Form N-
PORT would include the percentage of a fund's assets that fall into
each of the three liquidity categories.\295\ To give effect to the
proposed adjustments to a fund's calculations of its level of highly
liquid investments and illiquid investments in the liquidity rule, a
fund would be required to make the same adjustments to its reported
amount of highly liquid investments and illiquid investments, rather
than simply report the percent of assets the fund has classified in
each category. Specifically, a fund would reduce its reported amount of
highly liquid assets by the amount of highly liquid assets that it
posts as margin or collateral for derivatives transactions that are not
highly liquid and by the amount of the fund's liabilities. A fund also
would increase its reported amount of illiquid assets by the amount of
collateral available upon exit of illiquid derivatives
transactions.\296\ The fund's adjustments are intended to more
accurately reflect the availability of assets to meet redemptions. We
propose to require that a fund's reported aggregate liquidity
classifications include these adjustments, rather than report the
adjustments separately, to make it easier for investors to understand
the information a fund reports about its liquidity.
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\295\ See proposed Item B.12.a of Form N-PORT.
\296\ See proposed Items B.8 and B.12.b of Form N-PORT. In
certain situations, the adjustments could result in the amounts of a
fund's investments in all three categories not summing to 100% of
assets. For example, the reduction in the reportable amount of
highly liquid assets may be greater than the increase in the
reportable amount of illiquid assets, resulting in the percentages
of the fund's assets in each category summing to an amount below
100%. Funds would be required to increase their reported amounts of
moderately liquid investments if necessary to make the amounts the
fund reports sum to 100%. See proposed Item B.12.b of Form N-PORT.
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The public disclosure framework we are proposing is similar to the
framework the Commission adopted in 2016.\297\ At that time, the
Commission determined to require a fund to publicly disclose the
aggregate percentage of its portfolio assets representing each of the
classification categories to balance some commenters' concerns about
potential adverse effects that could arise from public reporting of
detailed portfolio liquidity information with investors' need for
improved information about funds' liquidity risk profiles.\298\
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\297\ See Liquidity Rule Adopting Release, supra note 8, at
section III.C.6.c.
\298\ See id., at text accompanying n.621.
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As funds began to implement the liquidity rule's classification
requirements, and before funds were required to provide public
disclosure of aggregate liquidity classifications, the Commission
received additional information about the potential challenges and
concerns of publicly disclosing a fund's aggregate liquidity profile at
that time, namely the risk that the data would be subjective, that it
was presented in isolation, and that it lacked the context of other
disclosures about the fund.\299\ In response, the Commission replaced
this disclosure with narrative liquidity disclosure in 2018.\300\ In
removing the requirement to report aggregate liquidity classifications,
the Commission stated that the subjectivity involved in the
classification process raises concerns when applied to public
disclosure. Specifically, the Commission expressed concern that the
quantitative presentation of the aggregate liquidity information may
imply precision and uniformity in a way that obscures its subjectivity,
and that funds may face incentives to classify their investments as
more liquid in order to make their funds appear more attractive to
investors, while also potentially increasing the risk of herding if
funds adjusted their portfolios in response to the disclosure
requirement. In addition, the Commission believed that it would not be
appropriate to adapt Form N-PORT to provide narrative context to help
investors appreciate the fund's liquidity risk profile and the
subjective nature of classification.
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\299\ See Investment Company Liquidity Disclosure, Investment
Company Act Release No. 33046 (Mar. 14, 2018) [83 FR 11905 (Mar. 19,
2018)] (``2018 Liquidity Disclosure Proposing Release'') at nn.9-13
and accompanying text.
\300\ See 2018 Liquidity Disclosure Adopting Release, supra note
22. For discussion generally of the Commission's stated rationale
for making this change, see generally id. and 2018 Liquidity
Disclosure Proposing Release, supra note 299.
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The Commission judged at that time that effective disclosure of
liquidity risks and their management would be better achieved through
prospectus and shareholder report disclosure rather than Form N-PORT,
and adopted a requirement to disclose in a narrative format a brief
discussion of the operation and effectiveness of its liquidity risk
management program in the fund's shareholder reports. The
[[Page 77230]]
intent of the narrative framework was to provide investors with a
holistic view of the liquidity risks of the fund and how effectively
the fund's liquidity risk management program managed those risks on an
ongoing basis over the reporting period.\301\
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\301\ See, e.g., supra section II.A.1. To the extent a fund
would be incentivized to manage its portfolio so as to report higher
amounts of highly liquid investments, we believe this would be
consistent with the focus in section 22 of the Act on preserving the
redeemability of open-end funds.
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In practice, though, the narrative disclosure did not meaningfully
augment other disclosure requirements.\302\ Instead, based on staff
experience with several years of shareholder reports covering a range
of market conditions, including a market crisis in March 2020 that
included substantial liquidity concerns for certain securities, we
found that the narrative disclosure often appeared as a lengthy,
boilerplate recitation of the requirements of rule 22e-4 that was not
tailored to a particular fund and did not change as conditions in the
market changed. For example, many funds' liquidity disclosures did not
change after the events of March 2020, even for funds that invested in
assets that had experienced severe liquidity issues. This meant that
investors had limited information about the liquidity of fund
investments or how the fund managed that liquidity risk through these
stressful events. We believe that this prevented investors from fully
evaluating the liquidity risks associated with a particular fund for
purposes of making more informed investment decisions.
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\302\ Tailored Shareholder Reports Adopting Release, supra note
26, at text accompanying n.463.
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Investors and funds have made similar observations. In 2020, when
the Commission proposed amendments designed to streamline fund
shareholder reports, some commenters requested that we require funds to
disclose their aggregate liquidity buckets.\303\ Other commenters
stated that the narrative disclosure is not particularly relevant to
investment decision making.\304\ Several other commenters also stated
that they believed the narrative disclosure should be moved from
shareholder reports.\305\ We recently adopted amendments that remove
the requirement to disclose the narrative disclosure in the shareholder
reports.\306\
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\303\ See, e.g., Comment Letter of Consumer Federation of
America on 2020 Tailored Shareholder Reports Proposing Release, File
No. S7-09-20 (``[S]trongly encourag[ing] the Commission to
reconsider its decision'' to remove aggregate liquidity disclosure
and characterizing narrative disclosure as ``boilerplate.''); see
also Comment Letter of Tom and Mary on 2020 Tailored Shareholder
Reports Proposing Release, File No. S7-09-20 (``We think funds
should be required to disclose their aggregate liquidity bucketing
in their annual report. We believe this information is important to
investors and will help them appreciate any liquidity risk.''). The
comment file for the 2020 Tailored Shareholder Reports Proposing
Release, where these comment letters are available, is at https://www.sec.gov/comments/s7-09-20/s70920.htm.
\304\ See, e.g., Comment Letter of Ubiquity on 2020 Tailored
Shareholder Reports Proposing Release, File No. S7-09-20
(``Disclosure [of liquidity information in narrative format] is
currently worthless and even with'' the proposed changes which were
designed to retain the narrative format, it ``will continue to be
worthless.''); see also Comment Letter of Tom Williams on 2020
Tailored Shareholder Reports Proposing Release; Feedback Flier of
Olivia Brightly on 2020 Tailored Shareholder Reports Proposing
Release.
\305\ See, e.g., Comment Letters of Morningstar Trustees, ICI,
SIFMA. Fidelity, Dechert, James Angel, Lisa Barker, and T. Rowe
Price on 2020 Tailored Shareholder Reports Proposing Release.
\306\ See Tailored Shareholder Reports Adopting Release, supra
note 26.
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Our proposed amendments to the liquidity rule, along with the years
of experience that funds have gained in complying with the current
rule, also have made the concerns the Commission identified in 2018
less relevant. Since 2018, the staff has conducted outreach with
numerous market participants, including fund complexes, liquidity
classification vendors, and others, and we are proposing several
changes to rule 22e-4 that would prescribe additional parameters for
many aspects of the classification process. These changes include
introducing the concept of a 10% stressed trade size, establishing a
minimum value impact standard, and removing asset class
classifications, which would reduce subjectivity in classifications and
reduce variation in funds' classification practices, even if incentives
for a fund to mis-classify its investments remain.\307\ These changes
are intended to reduce the risk of subjectivity impeding an investor's
understanding.
---------------------------------------------------------------------------
\307\ See, e.g., supra section II.A.1 and note 301.
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To the extent that subjectivity remains, investors reviewing this
information on Form N-PORT also will have access to additional
information in fund prospectuses and shareholder reports, which are
delivered directly to investors. Prospectuses and shareholder reports
would provide additional information about the fund and context for the
liquidity disclosure in Form N-PORT, such as information about the
factors affecting a fund's risks, returns, and performance.\308\ In
addition, the fact that the aggregate liquidity information would be
required to change as liquidity conditions in the market change, and
that investors would be able to review these changes on a monthly basis
and compare them against the fund's prior reports would provide
additional context for investors who desire this information. Investors
could also compare the fund's reports to reports of similar funds,
which could aid their understanding by allowing them to focus on the
differences. Finally, the proposed aggregate liquidity disclosure could
improve the mix of information available to investors. Though reports
on Form N-PORT do not provide information regarding a fund's investment
strategy and risk factors, the information reported on Form N-PORT may
complement the other information already available to investors in
order to allow them to develop a fuller understanding of the fund and
its risks.
---------------------------------------------------------------------------
\308\ See Reporting Modernization Adopting Release, supra note
274, at text following n.486 (``Form N-PORT is not primarily
designed for disclosing information to individual investors . .
.'').
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We request comment on the proposed public availability of the
aggregate liquidity classifications funds would report on Form N-PORT,
including:
211. Should we, as proposed, require funds to report publicly
information regarding the aggregate percentage of their portfolio in
each of the three proposed liquidity classification categories? Should
we, as proposed, require that this information be reported publicly on
a monthly basis and, if not, what factors are unique to liquidity
information that should result in it being publicized on a different
frequency than other information on Form N-PORT? Instead of, or in
addition to, the percentages of a fund's investments in each of the
three proposed liquidity categories, should we require additional
information to be reported? Is there any additional context, such as
narrative disclosure, that would also be useful to investors? Should
that narrative disclosure be located in Form N-PORT or somewhere else
(e.g., a fund prospectus, shareholder report, or website)?
212. Instead of, or in addition to, aggregate liquidity
information, should we require position-level liquidity classifications
to be reported publicly on Form N-PORT? Should we instead require
position-level liquidity classifications to be reported publicly on a
different form, such in a fund's annual and semi-annual reports? How
frequently should this information be reported? Would position-level
liquidity reporting improve funds' liquidity classifications by
allowing the public to review and scrutinize liquidity classifications?
Would position-level liquidity reporting improve consistency in
classification practices across funds by allowing funds to see how
other
[[Page 77231]]
similarly situated funds had classified the same or similar
investments? Would position-level liquidity reporting improve investor
access to or understanding of liquidity information, or would this
information be difficult for investors to synthesize or understand?
Would position-level liquidity reporting simplify the reporting
framework for funds if this disclosure were in lieu of separate
aggregate presentations? Would changes to the proposal, such as changes
to how funds report the effect of the collateral they hold against
derivatives that are not highly liquid, or the effect of liabilities,
be necessary if we were to require position-level liquidity reporting?
Would there be potential negative effects of position-level liquidity
reporting? For example, would position-level liquidity reporting result
in investors being able to infer information about a fund or company,
such as being able to determine that a fund has material nonpublic
information about an issuer because the fund categorizes the issuer's
securities as illiquid? Would position-level liquidity reporting result
in funds' counterparties engaging in predatory trading practices with
funds, for example by adjusting the prices they bid for certain assets
of a fund due to granular knowledge of how the fund categorizes the
liquidity of its portfolio?
213. Should we, as proposed, require adjustments to the percentages
of funds' assets in the proposed liquidity categories to account for
certain derivatives transactions? Should we instead require information
about derivatives transactions to be reported separately? Should
certain derivatives transactions be treated differently for these
purposes, for example by making differing adjustments based on whether
a derivative is exchange-traded, centrally cleared, made with certain
categories of counterparty, or otherwise? Should we require differing
adjustments for derivatives transactions depending on the purpose, for
example whether they are intended to hedge currency or interest rate
risks associated with one or more specific equity or fixed-income
investments held by the fund as described in rule 18f-4(c)(4)(i)(B)?
Are there any changes we should make to aid investor understanding of
how funds' use of derivatives affects their liquidity?
214. We propose to require that if the reported sum of a fund's
investments in each of the three categories does not equal 100%, the
fund must adjust the percentage of assets attributed to the moderately
liquid investment category so that the sum of the fund's investments in
each category equals 100%. Should we take a different approach, such as
making the adjustment optional, or permitting a fund to report
aggregate percentages that do not sum to 100%? Should we permit or
require funds to provide additional information, such as an explanatory
note that the totals have been adjusted and the amount of the
adjustment? Are there other metrics for which we should permit or
require funds to modify the reported amounts?
215. Would fund prospectuses and shareholder reports delivered
directly to investors provide sufficient context for the fund's
aggregate liquidity information that would be disclosed on Form N-PORT
under the proposal? Because Form N-PORT is not delivered to investors,
would investors who have sought out Form N-PORT disclosure in the first
instance be more likely to consider the information in the context of
other publicly available information about the fund? If investors would
not have sufficient context when reviewing Form N-PORT, should we
address this by requiring that funds send their most recent report on
Form N-PORT to investors when they send other communications, such as
their periodic reports or prospectus updates?
216. Instead of, or in addition to, including information regarding
funds' aggregate liquidity profiles in Form N-PORT, as proposed, should
we require that it be included in other documents, such as funds'
annual and semi-annual shareholder reports? If so, should the
disclosure included in funds' annual and semi-annual shareholder
reports, or other documents, differ from what we propose to include in
Form N-PORT? For example, should any disclosure in funds' annual and
semi-annual shareholder reports, or other documents be in a different
format, such as a pie chart, or also include narrative disclosure to
allow funds to provide additional context?
d. Other Proposed Amendments to Form N-PORT
In addition to our proposed amendments to require more timely
reporting of information and to enhance public transparency of funds'
portfolio holdings and liquidity classifications, we are proposing a
few additional amendments to Form N-PORT. These additional amendments
include a new reporting item related to swing pricing, amendments to
certain existing items to account for the proposal to make monthly Form
N-PORT information available to the public, other conforming amendments
to reflect the proposed amendments to rule 22e-4, and amendments to
certain entity identifiers.
In connection with our proposed amendments to swing pricing, we are
proposing to require enhanced transparency into the frequency and
amount of a fund's swing pricing adjustments. Currently, if a fund were
to engage in swing pricing, it would only be required to report on Form
N-CEN if the fund engaged in swing pricing during a given year and, if
so, the swing factor upper limit established by the fund.\309\ We are
proposing to remove that reporting requirement on Form N-CEN and
replace it with a new reporting requirement on Form N-PORT that would
require information about the number of times the fund applied a swing
factor during the month and the amount of each swing factor
applied.\310\ To recognize that a swing factor adjustment could be
positive (when the fund has net purchases) or negative (when the fund
has net redemptions), we propose to specify that a fund must use a plus
sign before a positive swing factor and a minus sign before a negative
swing factor.\311\ More frequent and detailed information about a
fund's use of swing pricing is intended to help the Commission assess
the size of the price adjustments funds are making during normal and
stressed market conditions, as well as how often funds apply swing
factor adjustments. The public may also benefit from this information
to help facilitate an understanding of the frequency and size of swing
factor adjustments.
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\309\ See Item C.21 of current Form N-CEN.
\310\ See proposed Item B.11 of Form N-PORT. Funds would be
instructed to respond with ``N/A'' when appropriate.
\311\ We also propose to add a definition of ``swing factor'' to
Form N-PORT, which would cross reference the definition of this term
in proposed rule 22c-1(d). See General Instruction E of proposed
Form N-PORT.
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In addition, we are proposing to amend items that currently require
funds to report certain return and flow information for each of the
preceding three months.\312\ Rather than require information for the
preceding three months, we are proposing to instead require a fund to
report that information only for the month that the Form N-PORT report
covers.\313\ The Commission currently requires return and flow
information for the preceding three months in a single report to
provide investors access to monthly data for a given quarter, given
that investors currently only have access to Form N-PORT reports for
the third month of
[[Page 77232]]
each quarter.\314\ Monthly data for the preceding three months was also
intended to avoid a potential investor misperception that one month's
returns or flows represented returns or flows for the full
quarter.\315\ Because, under our proposal, investors would have access
to monthly Form N-PORT reports, we propose to amend the period for
which a fund must report return and flow information to align with
monthly public reporting.
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\312\ See Item B.5 and Item B.6 of current Form N-PORT.
\313\ See Item B.5 and Item B.6 of proposed Form N-PORT.
\314\ See Reporting Modernization Adopting Release, supra note
274, at paragraphs accompanying nn.225, 232, and 250.
\315\ See id., at paragraphs accompanying nn.225 and 250.
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For similar reasons, we are proposing to amend Part F of Form N-
PORT, which currently requires a fund to attach its complete portfolio
holdings for the end of the first and third quarters of the fund's
fiscal year, presented in accordance with Regulation S-X, within 60
days after the end of the reporting period. We are proposing to require
funds to file this disclosure within 60 days of the end of the
reporting period for each month, with the exception of the last month
of the fund's second and fourth fiscal quarters, because the latter
portfolio holdings information is already available in funds' annual
and semi-annual reports.\316\ That is, we propose that funds would be
required to file the portfolio disclosure on Part F of Form N-PORT ten
times per year, instead of the current requirement to file twice per
year. When the Commission adopted Part F of Form N-PORT, it recognized
that not all investors may prefer to receive portfolio holdings
information in a structured XML format, and instead might prefer
portfolio holdings schedules presented using the form and content
specified by Regulation S-X.\317\ The Commission stated that requiring
funds to attach these portfolio holdings schedules to reports on Form
N-PORT would provide the Commission, investors, and other potential
users with access to funds' current and historical portfolio holdings
for those funds' first and third fiscal quarters, as well as
consolidate these disclosures in a central location, together with
other fund portfolio holdings disclosures in reports on Form N-CSR for
funds' second and fourth fiscal quarters.\318\ In conformance with the
proposed requirement for funds to file their structured portfolio
schedules on a monthly basis, and to make the monthly disclosure more
useable for investors, we propose to amend Part F of Form N-PORT so
that investors would be able to access unstructured portfolio schedules
presented in accordance with Regulation S-X on the same frequency.
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\316\ See Part F of proposed Form N-PORT. Currently, Part F of
Form N-PORT does not require information for the second and fourth
quarters of the fund's fiscal year for the same reason. See Item 6
of Form N-CSR and Reporting Modernization Adopting Release, supra
note 274, at section II.J.
\317\ Id. at section II.A.2.j.
\318\ Id.
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Similarly, we are proposing to amend Part D of Form N-PORT
regarding miscellaneous securities to align with the proposal to make
monthly Form N-PORT reports publicly available. Form N-PORT currently
contemplates that detailed information about miscellaneous securities,
which would remain nonpublic, would only be included in reports filed
for the last month of each fiscal quarter.\319\ This is because today
all information reported on Form N-PORT for the first and second months
of each quarter is nonpublic, which means there is no need for funds to
designate any of their investments for those reporting periods as
miscellaneous securities.\320\ Although our proposed shift from
quarterly to monthly public reporting is intended to improve public
transparency of funds' portfolio holdings, we continue to believe that
treating information related to miscellaneous securities as nonpublic
may serve to guard against the premature release of those securities
positions and thus deter front-running and other predatory trading
practices, and that for this reason public disclosure of miscellaneous
securities continues to be neither necessary nor appropriate in the
public interest or for the protection of investors.\321\ At the same
time, it is important for the Commission to receive more detailed
information about miscellaneous securities holdings so the Commission
has a complete record of the portfolio for monitoring, analysis, and
checking for compliance with Regulation S-X.\322\ As a result, we are
proposing to amend Part D of Form N-PORT to remove the language that
limits reporting of nonpublic information about individual
miscellaneous securities holdings to reports filed for the last month
of each fiscal quarter. The proposed amendment would allow funds in
their monthly Form N-PORT reports to report publicly the aggregate
amount of miscellaneous securities held in Part C, while requiring
funds to provide more detailed information in Part D about the
individual holdings in the miscellaneous securities category to the
Commission on a nonpublic basis.
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\319\ See Part D of current Form N-PORT. The form permits funds
to report as ``miscellaneous securities'' an aggregate amount of
portfolio investments that does not exceed 5% of the total value of
the fund's portfolio investments, provided that the securities
included in this category are not restricted, have been held for not
more than one year prior to the date of the related balance sheet,
and have not previously been reported by name to the shareholders,
or set forth in any registration statement, application, or report
to shareholders or otherwise made available to the public.
\320\ See Reporting Modernization Adopting Release, supra note
274, at text following n.424.
\321\ See id. at n.421 and accompanying text.
\322\ See Reporting Modernization Adopting Release, supra note
274, at section II.A.2.h (requiring that information about
miscellaneous securities be reported to the Commission on a
nonpublic basis).
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We are also proposing amendments to Form N-PORT to reflect the
proposed amendments to rule 22e-4. For example, because we are
proposing to remove the concept of a reasonably anticipated trade size
from rule 22e-4, we are proposing to replace references to this concept
in an instruction related to classifying portions of a single holding
in multiple liquidity categories with references to the stressed trade
size concept.\323\ We are also proposing to revise the liquidity
classifications a fund will report to reflect the revisions to the
liquidity categories in rule 22e-4.\324\ Because we are proposing
improvements to the way that a fund treats collateral for certain
derivatives transactions when calculating whether it holds sufficient
assets to meet its highly liquid investment minimum or holds an amount
of illiquid assets that exceeds the 15% limit, we also are proposing to
revise the information open-end funds must report about the collateral
posted as margin or collateral in connection with certain derivatives
transactions.\325\ We are similarly proposing to revise the information
a fund would report about the fund's highly liquid investments to
reflect that not all highly liquid investments will count toward the
fund's highly liquid investment minimum.\326\ In addition to reflecting
changes to rule 22e-4, these changes are also designed to provide
additional information to Commission staff regarding a fund's level of
highly liquid assets and illiquid assets and the
[[Page 77233]]
effect of derivatives transactions on that amount.
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\323\ See Instructions to Item C.7 in proposed Form N-PORT.
\324\ See Item B.8 in proposed Form N-PORT; General Instruction
E (Definitions) in proposed Form N-PORT.
\325\ See Item B.8 in proposed Form N-PORT. The proposed
revisions would require a fund to report the value of its highly
liquid investments that are assets that are posted as margin or
collateral in connection with moderately liquid or illiquid
investments, and would require a fund to report the value of any
margin or collateral posted in connection with an illiquid
derivatives transaction, where the fund would receive the value of
the margin or collateral if it exited the derivatives transaction.
\326\ See Item B.7.b in proposed Form N-PORT.
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In addition, we propose to amend certain items and definitions
related to entity identifiers in the form. Specifically, we propose to
amend the definition of LEI in the form to remove language providing
that, in the case of a financial institution that does not have an
assigned LEI, a fund should instead disclose the RSSD ID assigned by
the National Information Center of the Board of Governors of the
Federal Reserve System, if any.\327\ Instead of classifying an RSSD ID
as an LEI for these purposes, we propose to provide separate line items
where a fund would report an RSSD ID, if available, in the event that
an LEI is not available for an entity.\328\ This change is designed to
improve consistency and comparability of information funds report about
the instruments they hold, including issuers of those instruments and
counterparties to certain transactions.
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\327\ See General Instruction E of proposed Form N-PORT.
\328\ See Items B.4, C.1, C.10, and C.11 of proposed Form N-
PORT.
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217. Should we require funds to report the number of times the fund
applied a swing factor and each swing factor applied, as proposed?
Should we require the median, highest, and lowest (non-zero) swing
factor applied for each reporting period on Form N-PORT, rather than
require disclosure of each swing factor applied?
218. Should we require funds to provide additional information
about swing pricing in Form N-PORT reports, such as the swing pricing
administrator's determination to use a lower market impact threshold or
lower inflow swing threshold, if applicable? Should we separately
require funds to disclose information about market impact factors, such
as how many times a market impact factor was included in the swing
factor each month and the size of those market impact factors (e.g.,
either the size of any market impact factor applied, or the median,
highest, and lowest (non-zero) amount)? Should we require funds to
provide information about their imposition of redemption fees under
rule 22c-2, which funds can use to recoup some of the direct and
indirect costs incurred as a result of short-term trading strategies,
such as market timing? If so, should we require funds to disclose in
reports on Form N-PORT the number of times they imposed redemption fees
during the period and the amount of the fees? Should funds be required
to itemize each fee charged, disclose the total amount charged during
the period and the average fee charged, or some other presentation?
219. Instead of, or in addition to, requiring information about
swing pricing on Form N-PORT, should we require funds to provide
information about their use of swing pricing in other locations? For
example, would investors find this information more accessible if it
were on fund websites, in registration statements, or in shareholder
reports?
220. Should we require funds to provide return and flow information
only for a single month, as proposed, or should we continue to require
funds to provide return and flow information for the preceding three
months? Even though investors would have access to monthly reports on
Form N-PORT, is it helpful to have return or flow information for
previous months in a single report to have a readily available point of
comparison?
221. Should we amend Form N-PORT to continue to maintain the
confidentiality of information about a fund's miscellaneous securities
for each reporting period, as proposed? Are there other conforming
amendments we should make to align Form N-PORT reporting requirements
with the proposed changes to the frequency funds must file these
reports and the timeline for filing and public availability?
222. Should we amend Form N-PORT to require a fund to attach its
complete portfolio holdings presented in accordance with Regulation S-X
within 60 days after the end of each month except for the last month of
the fund's second and fourth fiscal quarters, as proposed? Should we
instead require a fund to file this information on a different
frequency, such as every month, without exception? Should we maintain
the current filing schedule? Should we require funds to attach this
information within a different timeframe, such as no later than 45 days
or 75 days after the end of the reporting period? If we make changes to
other aspects of the proposal, such as changes to the frequency funds
file reports on Form N-PORT, the delay between the end of the reporting
period and filing, or the time at which filings are made public, should
we also make conforming changes to Part F?
223. Are our proposed amendments to remove references to the
concept of a reasonably anticipated trade size in Form N-PORT and
replace them with references to the stressed trade size effective? Are
there other conforming amendments we should make to align Form N-PORT
with the liquidity rule amendments?
224. Should we, as proposed, amend Form N-PORT to require funds to
identify the value of margin or collateral the fund has posted as
margin or collateral in connection with an illiquid derivatives
transaction in order to provide a complete picture of the amount of
illiquid investments for purposes of the liquidity rule's 15% limit?
225. As proposed, should we amend the definition of LEI in the form
and provide a separate item for providing an RSSD ID as an identifier,
as applicable?
2. Amendments to Form N-CEN
We are proposing amendments to Form N-CEN to identify and provide
certain information about service providers a fund uses to fulfill the
requirements of rule 22e-4. The amendments would require a fund to: (1)
name each liquidity service provider; (2) provide identifying
information, including the legal entity identifier and location, for
each liquidity service provider; (3) identify if the liquidity service
provider is affiliated with the fund or its investment adviser; (4)
identify the asset classes for which that liquidity service provider
provided classifications; and (5) indicate whether the service provider
was hired or terminated during the reporting period. This information
would allow the Commission and other participants to track certain
liquidity risk management practices.\329\ As liquidity classification
services have become more widely used, the proposal would require
information about whether and which liquidity service providers are
used, for what purpose, and for what period. Among other things, this
information would help us better understand potential trends or
outliers in funds' liquidity classifications reported on Form N-PORT;
for example, by analyzing classifications trends of specific vendors,
we might distinguish patterns in how classifications might differ due
to vendor models or data.
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\329\ See Liquidity Rule Adopting Release, supra note 8, at
n.973.
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As described above, we also propose to remove the current
disclosure in Item C.21 of Form N-CEN and replace it with a new
reporting requirement on Form N-PORT to provide enhanced transparency
into the frequency and amount of a fund's swing pricing
adjustments.\330\ In addition, consistent with our proposed amendments
to the definition of LEI in Form N-PORT, we are proposing to make the
same changes
[[Page 77234]]
in Form N-CEN to separate the concepts of LEIs and RSSD IDs.\331\
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\330\ Item C.21 of Form N-CEN is proposed to be revised to
require disclosure on liquidity classification services, as
described above.
\331\ See Items B.16, B.17, C.5, C.6, C.9, C.10, C.11, C.12,
C.13, C.14, C.15, C.16, C.17, D.12, D.13, D.14, E.2, F.1, F.2, F.4,
and Instructions to Item G.1 of proposed Form N-CEN.
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We request comment on the proposed amendments to Form N-CEN:
226. Would the proposed reporting on liquidity classification
service providers assist investors and funds in better understanding
how liquidity risk is managed at a fund? Should any other information
be provided about the liquidity classification service provider?
227. Should we require any information about a fund's use of swing
pricing on Form N-CEN? How would this information relate to the
information we propose to require on Form N-PORT?
228. As proposed, should we amend Form N-CEN to separate the
concepts of LEI and RSSD ID? As proposed, should funds be required to
provide an RSSD ID, if available, when an LEI is not available?
F. Technical and Conforming Amendments
In September 2019, the Commission adopted new rule 6c-11 to allow
ETFs that satisfy certain conditions to operate without obtaining an
exemptive order from the Commission.\332\ We are proposing to make a
technical amendment to the definition of ETF in rules 22e-4 and 22c-1,
as well as in Forms N-CEN and N-PORT, as a result of this rulemaking.
Specifically, the proposed amendments would replace language in each
definition that refers to ``an exemptive rule adopted by the
Commission'' with a direct reference to rule 6c-11.\333\
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\332\ See ETF Release, supra note 289.
\333\ See proposed rule 22e-4(a) and proposed rule 22c-1(d);
General Instruction E of proposed Form N-CEN and General Instruction
E of proposed Form N-PORT.
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We are also proposing to make a conforming amendment to rule 31a-2.
Specifically, this proposed amendment to the recordkeeping rule would
replace the reference to the current swing pricing provisions in rule
22c-1(a)(3) with a reference to the proposed swing pricing provisions
in rule 22c-1(b).\334\
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\334\ See proposed rule 31a-2(a)(2).
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G. Exemptive Order Rescission and Withdrawal of Commission Staff
Statements
In light of the scope of our proposed amendments to the liquidity
rule, and pursuant to our authority under the Act to amend or rescind
our orders when necessary or appropriate to the exercise of the powers
conferred elsewhere in the Investment Company Act, we are proposing to
rescind an exemptive order that relates to rule 22e-4.\335\ As this
order's representations and conditions, and the relief provided, are
predicated on rule 22e-4 in its current form, the proposed amendments,
if adopted, would render the order moot, superseded, and inconsistent
with the final rule amendments. In addition, staff in the Division of
Investment Management is reviewing its no-action letters and other
statements addressing compliance with rules 22e-4 and 22c-1 to
determine which letters and other staff statements, or portions
thereof, should be withdrawn in connection with any adoption of this
proposal. Upon the adoption of any final rule amendments, some of these
letters and other staff statements, or portions thereof, would be moot,
superseded, or otherwise inconsistent with the final rule amendments
and, therefore, would be withdrawn. The staff review would include, but
would not necessarily be limited to, the staff no-action letters and
other staff statements listed below:
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\335\ See J.P. Morgan Investment Management Inc., et al.,
Investment Company Act Release No. 34180 (Jan. 21, 2021). See also
section 38(a) of the Act, 15 U.S.C. 80a-37(a).
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Investment Company Liquidity Risk Management Programs
Frequently Asked Questions (April 10, 2019);
Reflow, SEC Staff No-Action Letter (July 15, 2002);
Charles Schwab & Co., Inc., SEC Staff No-Action Letter
(July 7, 1997);
Investment Company Institute, SEC Staff No-Action Letter
(Feb. 9, 1973);
United Benefit, SEC Staff No-Action Letter (July 13,
1971);
Investment Company Institute, SEC Staff No-Action Letter
(Mar. 24, 1970); and
Investment Companies: Share Pricing: SEC Staff Views,
Investment Company Act Release No. 5569 [34 FR 383 (Dec. 27, 1968)].
Additionally, the staff statements, or portions thereof, may be
withdrawn following the relevant underlying transition period discussed
in section II.H below, if adopted, as determined appropriate in
connection with the staff's review of those staff statements.
We request comment on the proposed rescission or withdraw of past
Commission or staff statements, and specifically on the following
items:
229. Are there additional letters or other statements, or portions
thereof, that should be withdrawn or rescinded? If so, commenters
should identify the letter or statements, state why it is relevant to
the proposed rule, how it or any specific portion thereof should be
treated, and the reason.
230. If the amendments to the liquidity rule are adopted, are there
any questions and responses in the staff FAQs that would still be
relevant and helpful to retain?\336\
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\336\ See Liquidity FAQs, supra note 79.
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H. Transition Periods
We propose to provide a transition period after the effective date
of the proposed amendments to give affected funds sufficient time to
comply with any of the proposed changes and associated disclosure and
reporting requirements, if adopted, as described below. Based on our
experience, we believe the proposed compliance dates would provide an
appropriate amount of time for funds to comply with the proposed rules,
if adopted.
Twenty-Four-Month Compliance Date. We propose that 24
months after the effective date of the amendments, all registered open-
end management investment companies, except for money market funds and
exchange-traded funds, must comply with the proposed swing pricing
requirement in rule 22c-1, as well as the swing pricing disclosures
applicable to these funds in the proposed amendments to Forms N-PORT
and N-1A.\337\ We also propose that 24 months after the effective date
of the amendments, funds, transfer agents, registered clearing
agencies, and intermediaries must comply with the proposed ``hard
close'' requirement in rule 22c-1, and funds must comply with related
disclosure requirements we propose to require in Form N-1A.\338\
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\337\ See proposed rule 22c-1(b); Item B.11 of proposed Form N-
PORT; and Item 6(d) of proposed Form N-1A.
\338\ See proposed rule 22c-1(a); Item 11(a) of proposed Form N-
1A.
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Twelve-Month Compliance Date. The proposed compliance
period for all other aspects of the proposal is 12 months after the
effective date of the amendments, if adopted, and includes the
following:
[cir] The proposed amendments to rule 22e-4, which include: (1)
amending the rule's liquidity categories, including reducing the number
of liquidity categories from four to three; (2) providing specific and
consistent standards that funds would use to classify investments,
including by setting a stressed trade size and defining when a sale or
disposition would significantly change the market value of an
investment; and (3) requiring daily classifications; \339\ and
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\339\ See proposed rule 22e-4.
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[cir] The proposed amendments to Forms N-PORT and N-CEN, except the
swing pricing-related disclosure on Form N-PORT.
[[Page 77235]]
We request comment on the proposed transition dates, and
specifically on the following items:
231. Are the proposed compliance dates appropriate? If not, why
not? Is a longer or shorter period necessary to allow affected funds to
comply with one or more of these particular amendments, if adopted? If
so, what would be a recommended compliance date? Should we provide a
longer compliance date for smaller funds, and if so what should this be
(for example, 36 months for compliance with the swing pricing
requirements, and 18 months for the other aspects of the proposal)? How
should we define a ``smaller fund'' for this purpose? For example,
should a smaller fund be a fund that, together with other investment
companies in the same group of related investment companies, has net
assets of less than $1 billion as of the end of its most recent fiscal
year?
232. In particular, is a longer period necessary for funds to
comply with the proposed removal of the less liquid investment category
and the amendment to the scope of illiquid investments? How long might
it take for funds and other parties to reduce the settlement times for
bank loans and other investments that funds currently classify as less
liquid investments? Is a longer period necessary for retirement plan
recordkeepers or other intermediaries to make necessary changes to
their systems?
233. Should the compliance dates be staggered for certain
provisions? For example, should the compliance date for the hard close
occur prior to the compliance date for swing pricing?
III. Economic Analysis
A. Introduction
The Commission is mindful of the economic effects, including the
benefits and costs, of the proposed amendments. Section 2(c) of the
Act, Section 202(c) of the Advisers Act, and Section 3(f) of the
Exchange Act direct the Commission, when engaging in rulemaking where
it is required to consider or determine whether an action is necessary
or appropriate in the public interest, to consider, in addition to the
protection of investors, whether the action will promote efficiency,
competition, and capital formation. In addition, Section 23(a)(2) of
the Exchange Act, requires the Commission, when making rules under the
Exchange Act, to consider among other matters the impact that the rules
would have on competition, and prohibits the Commission from adopting
any rule that would impose a burden on competition not necessary or
appropriate in furtherance of the purposes of the Exchange Act. The
analysis below addresses the likely economic effects of the proposed
amendments, including the anticipated benefits and costs of the
amendments and their likely effects on efficiency, competition, and
capital formation. The Commission also discusses the potential economic
effects of certain alternatives to the approaches taken in this
proposal.
Open-end funds serve as intermediaries between investors seeking to
allocate capital and issuers seeking to raise capital by pooling a
portfolio of investments and selling the shares of this portfolio to
investors. A prominent feature of open-end funds is the mismatch
between the immediate liquidity funds provide to their shareholders
\340\ and the potential illiquidity of fund portfolio investments
(``liquidity mismatch''). In order to pay net redemptions or invest
proceeds from net subscriptions, a fund generally incurs trading costs,
which can, among other things, take the form of bid-ask spreads,
commissions, markups, markdowns, or market impact (the tendency of
large trades to shift prices in the market). Therefore, the liquidity
mismatch can lead to non-negligible trading costs associated with
selling the fund's less liquid portfolio investments in order to meet
investor redemptions or buying portfolio investments in order to
accommodate investor subscriptions.\341\
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\340\ Section 22(e) of the Act establishes a shareholder right
of prompt redemption in open-end funds by requiring such funds to
make payments on shareholder redemption requests within seven days
of receiving the request.
\341\ Unless otherwise specified, we use the term ``less
liquid'' in this section to refer to investments that are on the
lower end of the liquidity spectrum, and not solely investments that
are classified as ``less liquid investments'' under the current rule
22e-4.
---------------------------------------------------------------------------
As such, the liquidity mismatch and associated trading costs in the
open-end fund sector present several potential problems, including: (1)
funds may not be able to meet the statutory obligation to satisfy
investor redemptions within seven days without incurring significant
trading costs; (2) fund investors are subject to the risk of dilution;
(3) fund investors' anticipation that they may be diluted may create a
first-mover advantage that incentivizes them to redeem their shares
before other investors do; and (4) fire sales that can be provoked by
an increased pressure to meet redemptions could further disrupt already
stressed markets.\342\
---------------------------------------------------------------------------
\342\ See infra section III.B.3 for additional discussion of
these issues.
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Market stress events, such as the one that occurred during March
2020, may exacerbate these issues.\343\ For example, during stress
events investors may rebalance away from some investments into others
for many reasons, including but not limited to, their general risk
tolerance, legal or investment policy restrictions, or short-term cash
needs. To the extent that such rebalancing activity is correlated
across investors of the same fund or is correlated with deterioration
in the liquidity of the fund's underlying assets, trading costs for the
funds' underlying investments may increase and non-transacting fund
shareholders may become exposed to increased dilution risk, which may
lower future fund returns. In addition, the risk of investor dilution
associated with the illiquidity of funds' underlying investments may
create a first-mover advantage that could lead to increased mutual fund
redemptions.\344\
---------------------------------------------------------------------------
\343\ See supra section I.B for a detailed discussion of the
Mar. 2020 market events.
\344\ See infra section III.B.3 for additional discussion.
---------------------------------------------------------------------------
Fund managers may not fully incorporate potential future fund
shareholder dilution into their investment decisions for several
reasons. First, potentially misaligned incentives between fund
shareholders and fund managers may cause some fund managers to hold
portfolios with liquidity levels that could be insufficient to meet
redemptions without imposing significant dilution costs on non-
transacting fund investors, especially during periods of market stress.
Second, fund investors may not have granular and timely enough
information to adequately assess the extent of the liquidity risk they
are taking on and, therefore, cannot discipline the extent to which a
fund manager exposes the fund's shareholders to dilution risk. Finally,
to the extent that first-mover advantage can lead to anticipatory
mutual fund redemptions that could impose costs on other market
participants,\345\ fund managers do not necessarily have an incentive
to factor such costs into their investment decisions.
---------------------------------------------------------------------------
\345\ See e.g., Bing Zhu & Ren[eacute]-Ojas Woltering, Is Fund
Performance Driven by Flows into Connected Funds? Spillover Effects
in the Mutual Fund Industry, 45 J. Econ. & Fin. 544, no. 9 (2021).
See infra section III.B.3 for additional discussion.
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In light of these issues and our associated regulatory experience,
\346\ the proposal seeks to further address liquidity externalities in
the open-end fund sector. In particular, we expect the proposal to: (1)
enhance open-end funds' liquidity; (2) improve funds' anti-dilution and
resilience mechanisms for
[[Page 77236]]
any given level of liquidity; and (3) increase the transparency of
open-end funds' liquidity management practices. Together, the proposed
amendments may mitigate liquidity externalities in the open-end fund
sector by improving the ability of funds to meet redemptions without
imposing significant trading costs on investors. This, in turn, may
reduce the first-mover advantage associated with the dilution from
trading costs and curtail run risk in open-end funds,\347\ which is
consistent with recent analyses discussing how more robust liquidity
management may mitigate this risk.\348\ The proposed amendments may
also reduce the likelihood or the extent of future government
interventions.\349\
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\346\ See supra sections I and II for the discussion of
regulatory experience.
\347\ We recognize that factors other than dilution related to
trading costs--such as dilution from falling asset prices (market
risk) and from potential differences between prices of underlying
investments used for a fund's net asset value calculation and
execution prices for these investments--may also contribute to the
first-mover advantage in redemptions and potential runs in open-end
funds. These and other considerations are discussed in greater
detail in section III.B.3 below.
\348\ See Nicolas Valderrama, Can the Liquidity Rule Keep Mutual
Funds Afloat? Contextualizing the Collapse of Third Avenue
Management Focused Credit Fund, 70 Cath. U. L. Rev. 317 (2021). See
also Landon Thomas Jr., A New Focus on Liquidity After a Fund's
Collapse, N.Y. Times, Jan. 11, 2016, available at https://www.nytimes.com/2016/01/12/business/dealbook/a-new-focus-on-liquidity-after-a-funds-collapse.html.
\349\ See e.g., Antonio Falato et. al., Financial Fragility in
the COVID-19 Crisis: The Case of Investment Funds in Corporate Bond
Markets, 123 J. Monetary Econ. 35 (2021). The authors discuss how
the Federal Reserve bond purchase program helped to reverse mutual
funds' outflows during the Mar. 2020 period.
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The proposed amendments to the liquidity risk management (``LRM'')
program \350\ are designed to support funds' ability to meet
redemptions without significant trading costs, such as larger haircuts
associated with less liquid investments that open-end funds may hold in
their portfolios. Although less liquid investments generally offer a
higher return, the trading costs associated with selling these assets
during periods of increased redemptions may offset this risk premium,
potentially resulting in a lower overall return for fund
investors.\351\ Therefore, a more robust liquidity management program
that requires funds to hold more highly liquid investments may benefit
fund investors in the longer term. In addition, requiring funds to hold
a greater share of highly liquid investments may help limit the price
impact that funds impose on underlying markets when they sell less
liquid assets to meet investor redemptions, especially during periods
of market stress.\352\
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\350\ See supra section II.A.
\351\ See e.g., Mikhail Simutin, Cash Holdings and Mutual Fund
Performance, 18 Rev. Fin. 1425, no. 4 (2014), See also Aleksandra
R[zacute]eznik, Skilled Active Liquidity Management: Evidence from
Shocks to Fund Flows, (Jul. 29, 2021), available at SSRN: https://ssrn.com/abstract=4106412 (retrieved from SSRN Elsevier database).
\352\ See e.g., Sergey Chernenko & Adi Sunderam, Liquidity
Transformation in Asset Management: Evidence From the Cash Holdings
of Mutual Funds (National Bureau of Economic Research (NBER) working
paper no. w22391, Jul. 11, 2016), available at https://ssrn.com/abstract=2807702.
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The goal of the proposed swing pricing and hard close requirements
is to reduce the dilution of non-transacting fund shareholders by
charging redeeming and subscribing investors the trading costs they
impose on a fund,\353\ which may mitigate the first-mover advantage
associated with the dilution from trading costs. Although swing pricing
has not yet been implemented by any fund in the U.S., usage of swing
pricing in other jurisdictions has been shown in certain cases to
mitigate redemption pressure during periods of elevated market
volatility.\354\ We recognize that swing pricing may not always fully
reduce the potential first-mover advantage associated with increasing
trading costs and discourage associated investor redemptions.\355\
However, even in these cases, we believe that investors would
nevertheless benefit from the proposed requirement because it would
reduce the dilution of non-transacting fund shareholders, regardless of
the amount of trading activity by redeeming or subscribing investors.
---------------------------------------------------------------------------
\353\ See supra sections II.B and II.C.
\354\ See e.g., CSSF Paper, supra note 61; Dunghong Jin et. al.,
Swing Pricing and Fragility in Open-End Mutual Funds 35 Rev. Fin.
Stud. (2022); Benjamin King & James Semark, Reducing Liquidity
Mismatch in Open-Ended Funds: A Cost-Benefit Analysis (Bank of
England working paper no. 975, Apr. 22, 2022), available at https://ssrn.com/abstract=4106646.
\355\ See CSSF Paper, supra note 61; Claessens & Lewrick, supra
note 61; ESMA, Recommendation of the European Systemic Risk Board
(ESRB) on Liquidity Risk in Investment Funds (Nov. 12, 2020),
available at https://www.esma.europa.eu/document/recommendation-european-systemic-risk-board-esrb-liquidity-risk-in-investment-funds.
---------------------------------------------------------------------------
Coupled with the proposed amendments to the LRM program and the
proposed swing pricing and hard close requirements, the proposed
reporting and public disclosure requirements are aimed at promoting
transparency and facilitating investors' understanding of liquidity
risk in the open-end fund sector, as well as promoting transparency
regarding funds' application of liquidity management tools.\356\ As a
result, the proposed public disclosure requirements may aid investors
in making more efficient portfolio allocation decisions.
---------------------------------------------------------------------------
\356\ See supra section II.E.
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Many of the benefits and costs discussed below are difficult to
quantify. For example, we lack data that would help us predict how
funds may adjust the liquidity of their portfolios in response to the
proposed liquidity rule amendments; the extent to which investors may
reduce their holdings in open-end funds as a result of the proposed
swing pricing requirement and other amendments; the extent to which
investors may move capital from mutual funds to other investment
vehicles, such as closed-end funds, ETFs, or CITs; and the reduction in
dilution costs to investors in open-end funds as a result of the
proposed amendments (which would depend on investor subscription and
redemption activity and the liquidity risk of underlying fund
investments). Form N-PORT data is not sufficiently granular to allow
such quantification, and many of these effects will depend on how
affected funds and investors would react to the proposed amendments.
While we have attempted to quantify economic effects where possible,
much of the discussion of economic effects is qualitative in nature. We
seek comment on all aspects of the economic analysis, especially any
data or information that would enable a quantification of the
proposal's economic effects.
B. Baseline
1. Regulatory Baseline
a. Liquidity Risk Management Program
Under the current rule,\357\ open-end funds classify each portfolio
investment into one of the four defined liquidity categories, based on
the number of days within which a fund reasonably expects the
investment to be convertible to cash or sold or disposed of, without
significantly changing the investment's market value. The four
categories are: (1) ``highly liquid investments,'' which are cash and
investments convertible into cash in current market conditions in three
business days or less; (2) ``moderately liquid investments,'' which are
convertible into cash in current market conditions in more than three
calendar days but in seven calendar days or less; (3) ``less liquid
investments,'' which are those the fund reasonably expects to be able
to sell or dispose of in current market conditions in seven calendar
days or less, but where the sale or disposition is reasonably expected
to settle in more than seven calendar days; and (4)
[[Page 77237]]
``illiquid investments,'' which cannot be sold or disposed of in
current market conditions in seven calendar days or less.
---------------------------------------------------------------------------
\357\ See Liquidity Rule Adopting Release, supra note 8.
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A fund may generally classify and review its investments by asset
class unless the fund or adviser has information about any market,
trading, and investment-specific considerations that it reasonably
expects to affect significantly the liquidity characteristics of an
investment compared to the fund's other portfolio holdings within that
asset class.\358\ Among other requirements, open-end funds generally
are required to determine a minimum amount of highly liquid investments
they should maintain. In addition, all open-end funds are prohibited
from acquiring any illiquid investment if, immediately after the
acquisition, the funds would have invested more than 15% of their net
assets in illiquid assets; however, an investment in a liability
position, such as a derivative, is not subject to this limitation.
Under the current rule, a fund is required to identify the percentage
of the fund's highly liquid investments that it has posted as margin or
collateral in connection with derivatives transactions that the fund
has classified as less than highly liquid.\359\
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\358\ See rule 22e-4(b)(1)(ii)(A).
\359\ See rule 22e-4(b)(1)(ii)(C). In addition, funds currently
are also required to exclude highly liquid assets that are posted as
margin or collateral in connection with non-highly liquid
derivatives transactions when determining whether the fund primarily
holds highly liquid assets. See rule 22e-4(b)(1)(iii)(B).
---------------------------------------------------------------------------
In classifying its investments under the current rule, a fund
analyzes how quickly it can sell an investment without the sale
``significantly'' changing the investment's market value. Funds are
required to determine two key inputs for this analysis. The first is
the fund's reasonably anticipated trade size.\360\ Reasonably
anticipated trade size interacts with a fund's assessment of future
redemption/subscription activity: for example, if the fund would
anticipate selling a large position relative to trading volume, the
sale may depress the price. The second is the determination of what
constitutes a ``significant'' change in value. In both cases, the rule
allows funds to make their own reasonable assumptions.
---------------------------------------------------------------------------
\360\ Funds' current practices in classifying the liquidity of
their investments and otherwise complying with rule 22e-4 may take
consideration of the staff's Liquidity FAQs. See, e.g., supra note
79.
---------------------------------------------------------------------------
Rule 22e-4 currently requires that funds review their liquidity
classifications at least monthly in connection with reporting on Form
N-PORT, and more frequently if changes in relevant market, trading, and
investment-specific considerations are reasonably expected to
materially affect one or more of their investments'
classifications.\361\ The current rule also requires a fund to monitor
and take timely actions related to the liquidity of its investments,
including changes to its liquidity profile. Specifically, the rule
prohibits a fund from acquiring any illiquid investment, if immediately
after the acquisition, the fund would have invested more than 15% of
its net assets in illiquid investments that are assets.\362\ In
addition, the rule requires a fund to provide timely notice to its
board, and to the Commission on Form N-RN, if the fund exceeds the 15%
limit on illiquid investments, or if there is a shortfall of the fund's
highly liquid investments below its highly liquid investment minimum
for seven consecutive calendar days.\363\
---------------------------------------------------------------------------
\361\ See rule 22e-4(b)(1)(ii).
\362\ See rule 22e-4(b)(1)(iv).
\363\ See rule 22e-4(b)(1)(iv)(A) and rule 22e-
4(b)(1)(iii)(A)(3); Form N-RN Parts B through D.
---------------------------------------------------------------------------
Rule 22e-4 currently requires a fund to determine a highly liquid
investment minimum if it does not primarily hold investments that are
highly liquid. Funds that are subject to the highly liquid investment
minimum requirement must determine a highly liquid investment minimum
considering several factors, review this minimum at least annually, and
adopt policies and procedures to respond to a shortfall of the fund's
highly liquid investments below the minimum.\364\ The current exclusion
for funds that invest primarily in highly liquid investments provides
some discretion to determine the level of highly liquid investments
that constitutes primarily.
---------------------------------------------------------------------------
\364\ See rule 22e-4(b)(1)(iii).
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b. Swing Pricing
Currently, the rule allows open-end funds that are not excluded
funds to use swing pricing. The required swing pricing policies and
procedures provide that funds must adjust their NAV per share by a
single swing factor or multiple factors that may vary based on the
swing threshold(s) crossed once the level of net purchases into or net
redemptions from such fund has exceeded the applicable swing threshold
for the fund. The current rule permits a fund to determine its own
swing threshold for net purchases and net redemptions, based on a
consideration of certain factors the rule identifies.\365\ The fund's
swing factor is permitted to take into account only the near-term costs
expected to be incurred by the fund as a result of net purchases or net
redemptions on that day and may not exceed an upper limit of 2% of the
day's NAV per share.
---------------------------------------------------------------------------
\365\ See supra note 176.
---------------------------------------------------------------------------
The determination of whether the fund's level of net purchases or
net redemptions has exceeded the applicable swing threshold is
permitted to be made based on receipt of sufficient information about
the fund investors' daily purchase and redemption activity to allow the
fund to reasonably estimate whether it has crossed the swing threshold
with high confidence. This investor flow information may consist of
individual, aggregated, or netted orders, and may include reasonable
estimates where necessary.
In addition, rule 2a-4 requires, when determining the NAV, that
funds reflect changes in holdings of portfolio securities and changes
in the number of outstanding shares resulting from distributions,
redemptions, and repurchases no later than the first business day
following the trade date. This calculation method provides funds with
additional time and flexibility to incorporate last-minute portfolio
transactions into their NAV calculations on the business day following
the trade date, rather than on the trade date.\366\
---------------------------------------------------------------------------
\366\ See Adoption of rule 2a-4 Defining the Term ``Current Net
Asset Value'' in Reference to Redeemable Securities Issued by a
Registered Investment Company, Investment Company Act Release No.
4105 (Dec. 22, 1964) [29 FR 19100 (Dec. 30, 1964)].
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c. Reporting Requirements
Registered management investment companies and ETFs organized as
unit investment trusts are required to file periodic reports on Form N-
PORT about their portfolios and each of their portfolio holdings as of
month-end.\367\ Funds file these reports on a quarterly basis, with
each report due 60 days after the end of a fund's fiscal quarter. Only
information about the fund's holdings for the third month of each
fiscal quarter is available to the public. In addition to the publicly
available information on Form N-PORT, investors also have access to
information about the holdings of ETFs, including actively managed
ETFs, which generally are required to provide transparency into their
portfolio holdings on a daily basis.\368\ Many funds also provide
monthly information about their portfolio holdings to third
[[Page 77238]]
party data aggregators, generally with a lag of 30 to 90 days, which in
turn make them available to the public for a fee.
---------------------------------------------------------------------------
\367\ For purposes of discussions of filing requirements on Form
N-PORT, the term ``fund'' refers to registrants that currently are
required to report on Form N-PORT, including open-end funds,
registered closed-end funds, and ETFs registered as unit investment
trusts, and excluding money market funds and small business
investment companies.
\368\ See supra note 289.
---------------------------------------------------------------------------
Registered investment companies other than face amount certificate
companies also report census-type information to the Commission
annually on Form N-CEN, including information related to fund service
providers and whether a fund engaged in swing pricing during the fiscal
year and if so, what was the upper limit for the swing factor. The
current definition of LEI in Forms N-PORT and N-CEN provides that, in
the case where a financial institution does not have an assigned LEI, a
fund should instead disclose the RSSD ID assigned by the National
Information Center of the Board of Governors of the Federal Reserve
System, if any.\369\
---------------------------------------------------------------------------
\369\ See General Instruction E of proposed Form N-PORT and
Instructions to Item G.1 of the Form N-CEN.
---------------------------------------------------------------------------
Item 6 of Form N-1A also requires disclosure of a fund's use of
swing pricing if the fund chooses to use swing pricing. Specifically,
these provisions require that a fund that uses swing pricing explains
the fund's use of swing pricing, including its meaning, the
circumstances under which the fund will use it, and the effects of
swing pricing on the fund and investors, as well as the upper limit the
fund has set on the swing factor. Open-end funds are also required to
file Form N-RN with the Commission if more than 15% of the registrant's
net assets are, or become, illiquid investments as defined in rule 22e-
4 and if a registrant's holdings in assets that are highly liquid
investments fall below its highly liquid investment minimum for more
than 7 consecutive calendar days. The form is required to be filed
within one business day of the occurrence of these events.
2. Overview of Certain Industry Order Management Practices
Mutual fund orders can be submitted to funds directly or via an
intermediary. An order will be executed at a given day's NAV if an
intermediary--rather than solely the fund, its designated transfer
agent, or a registered securities clearing agency--receives the order
by the fund's pricing time, typically 4 p.m. ET, unless an intermediary
specifically established an earlier cut-off time for investor orders.
In particular, a financial intermediary currently can submit an order
that it received before 4 p.m. ET to a designated party after 4 p.m. ET
for execution at that day's NAV.\370\ A fund discloses in its
prospectus its pricing time and that a purchase or redemption is
effected at a price that is based on the next NAV calculation after the
order is placed.\371\ After a fund finalizes its NAV calculation for a
day, it disseminates the NAV to pricing vendors, media, and
intermediaries, typically between 6 p.m. ET and 8 p.m. ET. We
understand that certain intermediaries use order-processing systems
that require knowledge of a fund's NAV. In addition, certain investor
orders may also require knowledge of a fund's NAV before the order is
sent to the fund.\372\ As a result, a fund does not receive certain
orders until after the fund distributed its NAV. For example, most
retirement plan recordkeepers currently do not process orders from
investors until they receive a fund's NAV and funds typically receive
orders from these intermediaries the next morning.
---------------------------------------------------------------------------
\370\ We note that this practice differs from other
jurisdictions. See supra note 225.
\371\ See Item 11(a) of Form N-1A.
\372\ See supra section II.C.3.d.
---------------------------------------------------------------------------
We understand that for orders submitted to funds by an
intermediary, an intermediary may net orders to varying degrees before
their submission to a fund, a practice known as omnibus accounting. In
addition, intermediaries may submit one or more netted orders at a
single time, or may submit netted orders in batches at different times.
For example, if an intermediary does not submit orders until after it
has received the fund's final price, it may submit a single order to
the fund that reflects the net dollar amount or the number of fund
shares to be purchased or redeemed across all investors that submitted
orders through that intermediary. If an intermediary does not wait
until the fund's final price is received, it may submit two orders: one
order expressed in the net number of shares purchased or sold and one
order expressed in the net amount of dollars purchased or sold. Other
intermediaries may aggregate orders at finer levels, providing
aggregate purchase and sale figures separately. While netting practices
vary, they may generally save intermediaries money, to the extent that
intermediaries incur per transaction costs when submitting orders to a
fund.
Intermediaries may track investor orders to various degrees before
they send the finalized orders to funds. As such, the processing time
of investor order may vary depending on the tracking and netting
process of an intermediary. For example, retirement accounts track
holdings and trades at the level of individual participants. Each
participant account typically has multiple sub accounts that are
organized by contribution type or source (pretax, after-tax, employer
match, profit sharing, and other). We understand that, at least
according to some plan rules, compliance restrictions require plans to
track an account according to contribution type or source. For example,
we understand that in at least some 401(k) plans, the third party
administrator or retirement plan recordkeeper receives participant
trades at the participant account level, after which, trades must be
pro-rated (usually done based on today's market value) and posted to
each contribution type or source. The administrator or recordkeeper
then aggregates all participant trades for a particular plan and sends
them to the trustee/custodian. The trustee then posts the aggregated
plan trades on a trust/custody system (i.e., for mandatory plan
reporting purposes). Most trust companies then aggregate all of their
client trades at the asset level, generally to minimize trading or NSCC
costs.
A significant portion of mutual fund orders is processed through
NSCC's Fund/SERV platform. Within this platform, there exists a
separate system that processes orders from defined contribution plans
called Defined Contribution Clearance & Settlement (``DCC&S''). Fund/
SERV for non-retirement clients allows firms to submit orders in
currency, shares, or exchanges before knowing the NAV.\373\ DCC&S, on
the other hand, as a matter of practice does not initiate order
processing until the recordkeeper/third party administrator receives
NAVs, as well as daily and periodic distribution (dividend and capital
gain) rates.\374\
---------------------------------------------------------------------------
\373\ See https://www.dtcc.com/wealth-management-services/mutual-fund-services/fund-serv.
\374\ Id.
---------------------------------------------------------------------------
We recognize that the current industry practices related to
intermediaries' order submissions prevent funds from knowing their
final net flows until later hours, which may be one reason why no funds
in the U.S. have implemented the optional swing pricing. We also
recognize that swing pricing has been employed in Europe, including by
U.S.-based fund managers that also operate funds in Europe.\375\ There
can be various reasons why swing pricing has been successfully
implemented in certain jurisdictions. For example, we understand that
intermediary order submission practices in Europe differ from those in
the U.S.,\376\ allowing funds to have more complete flow information
before funds' pricing time. Another factor that may contribute to
successful implementation of swing pricing in Europe is that the
---------------------------------------------------------------------------
\375\ See supra section I.B for a more detailed discussion about
use of swing pricing in Europe.
\376\ See supra note 225.
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[[Page 77239]]
European mutual fund sector does not depend as much as the U.S. mutual
fund sector on defined contribution retirement plans. According to
ECB's investment fund statistics, as of Q2 2022, pension funds held
approximately EUR 1.4 trillion (10%) in investment fund shares \377\
out of 14.8 trillion in aggregate value of European investment fund
shares issued.\378\ This is in contrast to U.S. where 54% of all mutual
fund assets were held in retirement accounts as of Q1 2022.\379\
Further, according to one estimate, defined contribution retirement
plans which, at least in the U.S., have certain transactions that
require knowledge of NAV in order to be processed by an intermediary
represent only 17% of Europe's total pension assets.\380\
---------------------------------------------------------------------------
\377\ See Aggregated Balance Sheet of the Euro Area Pension Fund
Sector, Section 1.1.1, European Central Bank Statistical Data
Warehouse, available athttps://sdw.ecb.europa.eu/
reports.do?node=1000006465.
\378\ See Aggregated Balance Sheet of Euro Area Investment
Funds, Section 1.1.2, European Central Bank, Statistical Data
Warehouse, available at https://sdw.ecb.europa.eu/reports.do?node=1000003516.
\379\ See infra section III.B.4.ii.
\380\ See Press Release, Cerulli Associates, Europe's Defined
Contribution Market Is Set to Keep Growing, (Mar. 3, 2022),
available at https://www.cerulli.com/press-releases/europes-defined-contribution-market-is-set-to-keep-growing.
---------------------------------------------------------------------------
3. Liquidity Externalities in the Mutual Fund Sector
As discussed above, the liquidity mismatch can lead to non-
negligible trading costs (e.g., spread or market impact costs)
associated with selling the fund's less liquid portfolio investments in
order to meet investor redemptions or buying portfolio investments in
order to accommodate investor subscriptions. The magnitude of these
costs can vary depending on market conditions, the liquidity of the
underlying investments held in a fund's portfolio, and the size of
funds' transactions in the market. Consequently, if investors transact
at a NAV that does not account for ex-post trading costs, investors
remaining in the fund have to bear these trading costs because they are
ultimately reflected in the fund's future NAV.\381\ Therefore, the
value of shares held by non-transacting investors can be diluted due to
the trading costs associated with the past trading activity of
transacting fund investors, lowering the future returns of non-
transacting fund shareholders.
---------------------------------------------------------------------------
\381\ For example, suppose a fund is fully invested in an
underlying asset which can be bought at $1.01 and sold at $0.99. If
the NAV is struck at the ``mid,'' the fund's share price is $1, and
that is what redeeming investors receive for each fund share
redeemed. However, after paying the spread costs, the fund receives
only $0.99 for each unit of the underlying asset that is sold to
meet redemptions. The fund therefore needs to sell more of its
underlying asset position relative to the size of the redemptions it
experiences, reducing the assets held by non-transacting
shareholders and the fund's subsequent NAV. For example, if 10% of
the fund's investors redeem their shares at the NAV of $1, the fund
needs to sell 10% / $0.99 = 10.1% of its underlying asset position
to meet redemptions and pay the spread costs. This leaves the
remaining 90% of fund shares held by non-transacting fund investors
with 100%-10.1% = 89.9% of the fund's prior asset position. Valued
at the mid-price of $1, this reduces the fund's NAV to 89.9% / 90% =
$0.999.
---------------------------------------------------------------------------
We recognize that factors other than trading costs may contribute
to dilution. For example, some funds may hold investments that do not
have an active and robust secondary market (e.g., high-yield bonds or
municipal securities), making them opaque and difficult to accurately
price in a timely manner, especially during times of market stress when
some of these assets may stop trading. In such events, the last
reported prices for these assets may be prices realized during pre-
stress market conditions. As a result, the risk that the fund's NAV may
be based on ``stale'' information if contemporaneous information about
an asset's current value is unavailable or less reliable may increase.
If a fund's NAV on a given date is based on such stale information, net
redemptions at that NAV can dilute non-transacting fund shareholders
when assets are eventually sold at prices that reflect their true,
lower value.\382\ Prior to the compliance date with the recent rule 2a-
5,\383\ which aims to improve fund valuation practices, the stale
pricing phenomenon has been documented in fixed income funds, and has
been found to contribute to strategic redemptions.\384\ However, we
recognize that while trading costs are strictly dilutive, pricing based
on stale information can also result in accretion for non-transacting
fund investors if realized sale prices are higher than prices that were
based on stale information and used for the NAV calculation.
---------------------------------------------------------------------------
\382\ We recognize that fund investors can also be diluted due
to factors other than trading costs or stale pricing, such as market
risk. Market risk can also result in accretion for non-transacting
fund investors. For example, if a fund redeems shareholders at an
NAV of $100 based on market prices at the time NAV is struck, but is
then able to liquidate assets at a higher valuation on subsequent
days due to changes in market prices, the value of shares held by
non-transacting shareholders will increase beyond the increase due
solely to the change in the value of the underlying investments held
by the fund. While the value of the fund's holdings can go both up
and down, such market risk amplifies the risk fund shareholders
would otherwise experience. However, since market prices may be very
difficult to forecast, the degree to which such dilution contributes
to the first-mover advantage is unclear.
\383\ The Commission adopted rule 2a-5 in Dec. 2020, and the
compliance date for funds was Sept. 8, 2022. See Valuation Adopting
Release, supra note 110.
\384\ See, e.g., Jaewon Choi et. al., Sitting Bucks: Stale
Pricing in Fixed Income Funds, 145 J. Fin. Econ. 296, no. 2, Part A,
(Aug. 2022).
---------------------------------------------------------------------------
The stylized example illustrated in Figure 4 below shows how
trading costs can dilute a fund that experiences net redemptions under
two scenarios.\385\ Under the first scenario (the dotted line), the
fund is able to sell investments to accommodate redemptions prior to
striking its NAV for the day and to reflect these trades as well as
trading costs in the calculated NAV for that day.\386\ This scenario is
a theoretical benchmark that shows the minimum amount of dilution that
must occur in order to accommodate redemptions. Under the second
scenario (the solid line), the fund trades to accommodate redemptions
after striking its NAV for the day. This scenario is generally the way
U.S. funds currently accommodate investor redemptions, possibly because
funds do not have complete order flow information before the end of the
trading day.\387\
---------------------------------------------------------------------------
\385\ The examples in the figure assume that a fund holds a
portfolio of assets whose value is constant and that liquidating any
portion of the portfolio to meet redemptions incurs a haircut of
10%. By assuming that the value of the asset does not change, the
examples isolate the effect of trading costs on dilution from the
effects of other sources of dilution such as market risk or stale
NAVs. See supra note 384. The haircut assumption in these stylized
examples is used purely for illustrative purposes; haircuts on most
assets held by open-end funds generally tend to be smaller.
\386\ We recognize that under the current rule 2a-4 under the
Investment Company Act, funds are permitted to reflect changes in
their portfolio holdings in the first NAV calculation following the
trade date and, thus, are not required to include today's trades in
the calculation of today's NAV.
\387\ We recognize that there may be other operational
considerations that result in this common practice. Therefore, even
if a fund has complete order flow information before the trading day
is over, it may choose to trade at a later date to accommodate
today's redemptions.
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[[Page 77240]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.004
While these two scenarios result in similar dilution for lower
levels of redemptions, larger levels of redemptions can contribute
nonlinearly to higher fund dilution under the second scenario.\388\
This occurs because increasing redemptions result in increasing trading
costs for the fund. These trading costs are borne solely by
shareholders remaining in the fund, the number of which decreases as
more investors redeem. Under this hypothetical scenario, the fund
eventually runs out of assets to sell and is unable to meet further
redemptions. In contrast, under the theoretical benchmark, the trading
costs are borne by both redeeming investors and investors remaining in
the fund; therefore, the shareholder base absorbing the trading costs
remains constant regardless of the extent of redemptions. Accordingly,
dilution increases proportionally to the amount of redemptions and the
corresponding increase in trading costs.
---------------------------------------------------------------------------
\388\ To the degree that funds determine their NAV using
holdings as of the prior trading day, such practices may also
contribute to dilution.
---------------------------------------------------------------------------
Figure 5 removes the theoretical benchmark scenario illustrated in
Figure 4 and focuses on how dilution affects both redemptions and
subscriptions when trading to accommodate investor transactions occurs
after the fund's NAV has been struck.\389\
---------------------------------------------------------------------------
\389\ To model the effect of net subscriptions, the example
assumes that any new cash received by the fund is invested in the
same underlying portfolio of investments, and that doing so incurs
the same 10% spread cost. Redemptions are represented as negative
net flows to the left of 0 on the x-axis and subscriptions are
represented as positive net flows to the right of 0 on the x-axis.
We recognize that dilution due to subscriptions does not occur until
a fund incurs costs investing the subscription proceeds. Therefore,
a fund that holds its subscription proceeds in cash indefinitely
will not experience dilution.
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[[Page 77241]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.005
The theoretical example in Figure 5 illustrates that the dilutive
effect of trading costs is asymmetric for redemptions and
subscriptions: while redemptions and subscriptions are similarly
dilutive for small levels of net flows, their effects are different for
more extreme levels of net flows. This occurs because a fund is not
able to redeem 100% of its shares due to the non-linear impact of
trading costs related to meeting redemptions being absorbed solely by
investors remaining in the fund, as described above. In contrast, the
trading costs related to subscriptions are shared by both new
subscribers and existing fund shareholders, which limits the maximum
amount of dilution that can occur due to subscriptions.
The simplified examples above illustrate that non-transacting fund
investors are exposed to the dilution risk that arises from
accommodating redemptions and subscriptions of transacting fund
investors. Incentives of mutual fund managers may not be sufficient to
alleviate this risk for various reasons. For example, it is possible
that investors do not have enough information to fully understand the
nature of the risk they are exposed to by investing in funds that hold
less liquid investments. In addition, investors in a fund may have
varying preferences for risk and return, with some investors preferring
investments with higher expected returns. Although investments that
face increased liquidity risk may deliver such higher returns, the
returns of funds that hold these investments may also be subject to
greater amounts of volatility.\390\ A fund manager may choose to hold
investments that are less liquid because of their potentially higher
returns, or because they offer exposure to a different set of risks
(e.g., some investments may be less correlated with the market) than
other investments in the fund's portfolio. Because higher returns tend
to be associated with future inflows, it is possible that a fund
manager's incentives are tilted towards earning higher returns relative
to the risk they are taking on (though the opposite is also
possible).\391\ In particular, to the extent that holding less liquid
investments may increase a fund's return (e.g., during normal market
conditions) and consequently its AUM, which determine the amount of
management fees a fund manager collects, the fund manager may choose to
over-invest in such assets,\392\ not accounting for potential future
trading costs these investments may impose on a fund if the market
conditions change, which would result in a higher dilution risk for the
fund's investors. Investors may currently lack sufficiently granular
information to monitor for this possibility and to discipline the
extent to which a fund manager exposes the fund's shareholders to
dilution risk.
---------------------------------------------------------------------------
\390\ See, e.g., Kuan-Hui Lee, The World Price of Liquidity
Risk, 99 J. Fin. Econ. 136 (2011). See also Viral V. Acharya & Lasse
H. Pedersen, Asset Pricing with Liquidity Risk, 77 J. Fin. Econ. 375
(2005). See also Lubos Pastor & Robert Stambaugh, Liquidity Risk and
Expected Stock Returns, 111 J. Pol. Econ. 642 (2003).
\391\ In an open-end fund context, fund inflows are sensitive to
fund returns, which can incentivize fund managers to take on more
risk. See, e.g., Jaewon Choi & Mathias Kronlund, Reaching for Yield
in Corporate Bond Mutual Funds, 31 Rev. Fin. Stud. 1930 (2018); Jon
A. Fulkerson et. al., Return Chasing in Bond Funds, 22 J. Fixed
Income, 90 (2013); Ferreira, Miguel A., et al., The Flow-Performance
Relationship around the World, 36 J. Banking & Fin. 1759, no. 6
(2012).
\392\ See, e.g., Linlin Ma et. al., Portfolio Manager
Compensation in the U.S. Mutual Fund Industry, 74(2) J. Fin. 587
(2019). See also Abhishek Bhardwaj et. al., Incentives of Fund
Managers and Precautionary Fire Sales (Oct. 29, 2021), available at
https://ssrn.com/abstract=3952358.
---------------------------------------------------------------------------
Investor dilution associated with illiquidity of funds' underlying
investments may create a first-mover advantage that may lead to
increased mutual fund redemptions similar to bank runs.\393\ Such
redemptions have been observed prior to the adoption of the current
liquidity rule.\394\ More specifically, fund investors may have an
incentive to redeem their shares quickly if they believe that other
investors will also redeem their shares and, by doing so, these other
investors will dilute the fund's non-transacting shareholders. This
first-mover advantage effect in mutual funds has been documented \395\
[[Page 77242]]
and studied as a mechanism for runs on mutual funds in the academic
literature.\396\ In addition, it has been shown that the effect of the
first-mover advantage may be larger for funds that hold less liquid
investments.\397\ While the academic literature on mutual fund runs
generally relies on an exogenous mechanism to generate initial
redemptions from a fund or relies on frictions such as an inability of
a fund to raise capital and exogenous shocks such as negative fund
returns, the results may extend to trading costs to the degree that
dilution due to trading costs may reduce subsequent fund returns, which
would trigger runs in these models. At the same time, we recognize that
while dilution risk arising from trading costs can create incentives
for early redemptions, redemptions may also occur for reasons
unconnected to the pooled vehicle nature of the fund. For example, a
recent working paper \398\ concludes that the behavior of mutual fund
investors is similar to that of direct investors with overlapping
holdings, and suggests that systemic implications of mutual fund
investors' activities are not necessarily due to the liquidity
transformation feature of the mutual fund structure, but rather to the
fact that mutual funds' investors compete for finite asset market
liquidity when they decide to sell assets.
---------------------------------------------------------------------------
\393\ Liquidity mismatch between assets and liabilities is a
mechanism that creates bank run dynamics that is well-accepted in
the academic literature. See, e.g., Douglas Diamond & Philip Dybvig,
Bank Runs, Deposit Insurance, and Liquidity, 91 J. Pol. Econ., 401
(1983).
\394\ See Third Avenue Trust and Third Avenue Management LLC;
Notice of Application and Temporary Order, Investment Company Act
Release No. 31943 (Dec. 16, 2015). See also note 348.
\395\ See Qi Chen et. al., Payoff Complementarities and
Financial Frailty: Evidence From Mutual Fund Outflows, 97 J. Fin.
Econ. 239 (2010). See also Itay Goldstein et. al., Investor Flows
and Fragility in Corporate Bond Funds, 126 J. Fin. Econ. 592 (2017);
Yiming Ma et. al., Bank Debt Versus Mutual Fund Equity in Liquidity
Provision (working paper, May 29, 2020), available at https://ssrn.com/abstract=3489673; Luis Molestina et. al., Burned by
Leverage? Flows and Fragility in Bond Mutual Funds (European Central
Bank (ECB) working paper no. 20202413, May 19, 2020) available at
https://ssrn.com/abstract=3605159 (retrieved from SSRN Elsevier
database); Michael Feroli et. al., Market Tantrums and Monetary
Policy (Chicago Booth Research Paper no. 14-09, Mar. 15, 2014),
available at https://ssrn.com/abstract=2409092 (retrieved from SSRN
Elsevier database).
\396\ See e.g., Yao Zeng, A Dynamic Theory of Mutual Fund Runs
and Liquidity (working paper no. 42, Apr. 2017), available at
https://ssrn.com/abstract=2907718 (retrieved from SSRN Elsevier
database). See also Stephen Morris et. al., Redemption Risk and Cash
Hoarding by Asset Managers, 89 J. Monetary Econ. 71 (2017); Yiming
Ma et. al., Mutual Fund Liquidity Management, Transformation and
Reverse Flight to Liquidity (working paper, Jul. 29, 2020),
available at https://ssrn.com/abstract=3640861(retrievedfromSSRNElsevierdatabase); and Philipp
K[ouml]nig & David Pothier, Safe but Fragile: Information
Acquisition, Liquidity Support and Redemption Runs, J. Fin.
Intermediation (in press, corrected proof Dec. 15, 2020).
\397\ For example, one paper argues that fund investors'
behavior is affected by the expected behavior of other investors in
the fund and finds that funds with less liquid assets (where this
investor effect is stronger) exhibit stronger sensitivity of
outflows to bad past performance than funds with more liquid assets.
See Qi Chen et. al., Payoff Complementarities and Financial Frailty:
Evidence From Mutual Fund Outflows, 97 J. Fin. Econ. 239 (2010).
Also see Meijun Qian and Ba[scedil]ak Tanyeri, Litigation and
Mutual-Fund Runs, 31 J Fin. Stability 119, (2017); and Sirio
Aramonte et. al., Measuring the Liquidity Profile of Mutual Funds
(FEDS working paper no. 2019-55, Oct. 22, 2019), available at
https://ssrn.com/abstract=3473039 (retrieved from SSRN Elsevier
database).
\398\ See Christof W. Stahel, Strategic Complementarity Among
Investors with Overlapping Portfolios (working paper, May 1, 2022),
available at https://ssrn.com/abstract=3952125 (retrieved from SSRN
Elsevier database).
---------------------------------------------------------------------------
Mutual fund shareholders' transactions may also affect markets for
funds' underlying portfolio holdings. Academic research suggests that
redemption-induced sales of securities by mutual funds can create price
pressure in underlying markets which may result in a fire-sale for
these securities.\399\ Two studies have constructed measures of mutual
fund outflow-induced price pressure on various securities that are
widely-used in the academic literature.\400\ Subsequent studies use
these price impact measures and claim that fire sales induced by
investor redemptions hurt peer funds' performance and flows, leading to
further asset sales that have a negative price impact.\401\ Another
paper suggests that redemptions from mutual fund that hold less liquid
investments may contribute further to already existing poor market
conditions by putting further downward pressure on prices of illiquid
stocks.\402\ In addition, one paper suggests that the exposure of
stocks to fire-sale risk is bigger when mutual funds represent a larger
share of the stock's owners.\403\ Moreover, academic research also
documents the potential effect of mutual fund flows on market-wide
return volatility,\404\ on a wide array of corporate decisions,\405\ on
the choices of ETF security baskets,\406\ and on sell-side analysts'
recommendations on stocks subject to mutual-fund flow-driven stock
mispricings.\407\ However, several recent studies argue that the
aforementioned price impact measures are biased and that with the
removal of this bias many established in the prior literature results
above no longer hold.\408\ Notwithstanding, while we recognize that
there is an ongoing debate in the academic literature as to the size of
these effects, the literature does point to a potential link between
mutual fund flows and prices in the underlying markets.
---------------------------------------------------------------------------
\399\ See e.g., Shiyang Huang et. al., Does Liquidity Management
Induce Fragility in Treasury Prices: Evidence From Bond Mutual Funds
(Dec. 30, 2021), available at https://ssrn.com/abstract=3689674
(retrieved from SSRN Elsevier database). See also Hao Jiang et. al.,
Does Mutual Fund Illiquidity Introduce Fragility Into Asset Prices?
Evidence From the Corporate Bond Market, 143 J. Fin. Econ. 277
(2021); Joshua D. Coval & Erik Stafford, Asset Fire Sales (and
Purchases) in Equity Markets, 86 J. Fin. Econ. 479, no. 2 (2007);
Donald J. Berndt et. al., Using Agent-Based Modeling to Assess
Liquidity Mismatch in Open-End Bond Funds, Summer Sim '17:
Proceedings of the Summer Simulation Multi-Conference (Society for
Computer Simulation International, San Diego, CA) (Jul. 2017);
Valentin Haddad et. al., When Selling Becomes Viral: Disruptions in
Debt Markets in the COVID-19 Crisis and the Fed's Response, 34 Rev.
Fin. Stud. 5309, no.11 (2021).
\400\ See Coval & Stafford, supra. Also see Alex Edmans et. al.,
The Real Effects of Financial Markets: The Impact of Prices on
Takeovers, 67 J. Fin. 933 (2012).The constructed measures exploit
the idea that large investor redemptions place pressure on mutual
funds to sell portfolio holdings, and if these sales are
sufficiently large, the funds' liquidity needs may put downward
pressure on prices that is unrelated to the fundamental value of the
underlying stocks.
\401\ See e.g., Pekka Honkanen & Daniel Schmidt, Learning From
Noise? Price and Liquidity Spillovers Around Mutual Fund Fire Sales,
12(2) Rev. Asset Pricing Stud. 593 (Jun. 2022); Antonio Falato et.
al., Fire-Sale Spillovers in Debt Markets, 76 J Fin. 3055 no. 6
(2021).
\402\ See Azi Ben-Rephael, Flight-to-Liquidity, Market
Uncertainty, and the Actions of Mutual Fund Investors, 31 J. Fin.
Intermediation 30 (2017).
\403\ See George O. Aragon & Min S. Kim, Fire Sale Risk and
Expected Stock Returns (Mar. 11, 2022), available at https://ssrn.com/abstract=3663567 (retrieved from SSRN Elsevier database).
\404\ See e.g., Charles Cao et. al., An Empirical Analysis of
the Dynamic Relationship Between Mutual Fund Flow and Market Return
Volatility, 32 J. Banking & Fin. 2111, no. 10 (2008).
\405\ See e.g., Alex Edmans, supra. The authors find that mutual
fund investor flows lead to pressure on the price of underlying
securities, which may in turn affect the probability of takeover of
the firm issuing the security. Also see Derrien, Fran[ccedil]ois et.
al., Investor Horizons and Corporate Policies, 48 J. Fin. &
Quantitative Analysis 1755 no. 6 (2013). Also see Norli,
[Oslash]yvind et. al., Liquidity and Shareholder Activism, 28 Rev.
Fin. Stud. 486 (2015). Also see B. Espen Eckbo et. al., Are Stock-
Financed Takeovers Opportunistic? 128 J. Fin. Econ. 443 (2018).
\406\ See Han Xiao, The Economics of ETF Redemptions (Apr. 10,
2022), available at https://ssrn.com/abstract=4096222 (retrieved
from SSRN Elsevier database).
\407\ See Johan Sulaeman & Kelsey D. Wei, Sell-Side Analysts and
Stock Mispricing: Evidence From Mutual Fund Flow-Driven Trading
Pressure, 65 Mgmt. Sci. 5427 no. 11 (2019).
\408\ See Elizabeth Berger, Selection Bias in Mutual Fund Fire
Sales (Apr. 18, 2021), available at https://ssrn.com/abstract=3011027 (retrieved from SSRN Elsevier database). See also
Malcolm Wardlaw, Measuring Mutual Fund Flow Pressure as Shock to
Stock Returns, 75(6) J. Fin. 3221 (2020). See also Aleksandra and
R[uuml]diger Weber, Money in the Right Hands: The Price Effects of
Specialized Demand (Jan. 27, 2022), available at https://ssrn.com/abstract=4022634 (retrieved from SSRN Elsevier database). Also see
Simon Schmickler, Identifying the Price Impact of Fire Sales Using
High-Frequency Surprise Mutual Fund Flows (Jul. 8, 2020) available
at https://ssrn.com/abstract=3488791 (retrieved from SSRN Elsevier
database).
---------------------------------------------------------------------------
We recognize that the proposed rules may not address all of the
mechanisms that amplify dilution in the mutual fund sector, such as
system-wide market stress, misaligned incentives of fund managers and
investors, or stale information used for pricing of funds' portfolio
holdings. However, even if these dilution-amplification
[[Page 77243]]
mechanisms were not present, several factors may inhibit mutual fund
managers' ability to allocate trading costs to transacting investors by
using currently available swing pricing. First, as discussed above,
funds generally do not have complete information regarding their order
flows at the time the NAV is struck, which may restrict the ability to
operationalize swing pricing. These U.S.-market specific operational
impediments cannot be mitigated by any single fund, which presents a
collective action problem. Second, even if funds were currently able to
obtain complete flow data prior to striking their NAVs, funds may be
hesitant to implement swing pricing to the extent that some investors
are averse to bearing the full costs of their transactions via swing
pricing, even if it is in the best interest of fund shareholders
overall, or because investors in U.S. funds are unfamiliar with swing
pricing.\409\ In addition, there may be a stigma attached to being the
first fund to implement swing pricing. To the extent that such a stigma
effect is present in relation to swing pricing, it may deter investors
from choosing funds that could implement swing pricing under the
optional approach, and that could be a reason why no fund currently
chooses to implement swing pricing. Finally, even where fund managers
are willing and able to employ liquidity risk management tools, they
may not be able to forecast accurately the extent to which episodes of
market stress can create challenges for mitigating dilution and meeting
shareholder redemptions.\410\
---------------------------------------------------------------------------
\409\ We recognize, however, that open-end funds in other
jurisdictions have successfully implemented swing pricing, as
discussed in section I.B and accompanying notes 59-63.
\410\ See supra section I.B for a discussion of how market
stress events in Mar. 2020 caused some funds to explore the
potential of various emergency relief actions due to the combination
of abnormally large redemptions and deteriorating liquidity in
markets for underlying fund investments.
---------------------------------------------------------------------------
4. Affected Entities
a. Registered Investment Companies
The proposed amendments would mainly affect open-end funds
registered with the Commission that are ETFs and mutual funds,
excluding money-market funds (hereafter ``mutual funds''). Based on
Form N-CEN filing data as of December 2021, we estimate that there are
11,488 of such funds that hold approximately $26 trillion in net
assets.\411\ Among these, there are 9,043 mutual funds that hold
approximately $21 trillion in net assets and 2,445 ETFs that hold
approximately $5.1 trillion in net assets.\412\ In addition, there are
1,650 mutual funds of funds that hold approximately $3.1 trillion in
net assets,\413\ as well as 150 feeder funds structured as ETFs that
hold $0.6 trillion in net assets.\414\
---------------------------------------------------------------------------
\411\ We use information reported on Form N-CEN to the
Commission for each fund as of Dec. 2021, incorporating filings and
amendments to filings received through May 15, 2022. Net assets are
monthly average net assets during the reporting period identified on
part C.19.a of Form N-CEN, and validated with Bloomberg (for ETFs).
Current values are based on the most recent filings and amendments,
which are based on fiscal years and are therefore not synchronous.
We exclude money market funds identified in Item C.3.g of the Form
N-CEN from the count of the affected open-end funds. These
exclusions were also applied to the estimates that follow.
We note that the submission on the Form N-CEN is required on a
yearly basis. Therefore, these estimates do not include newly
established funds that have not completed their first fiscal year
and, therefore, have not filed the Form N-CEN yet, as well as they
do not account for the funds that have been terminated since the
last Form N-CEN was filed. Therefore, the estimates for the number
of funds and their net assets may be over- or under-estimated.
\412\ See id. ETFs are identified on Form N-CEN, Item C.3.a.i
and include 781 in-kind ETFs with average total net assets of $1.2
trillion. UIT ETFs and exchange-traded managed funds are excluded
from ETF totals. Mutual funds are identified as those funds that are
not identified as ETFs or money market funds.
\413\ Funds of funds are identified in Item C.3.e. A fund of
funds means a fund that acquires securities issued by any other
investment company in excess of the amounts permitted under
paragraph (A) of section 12(d)(1) of the Act (15 U.S.C. 80a-
12(d)(1)(A)), but does not include a fund that acquires securities
issued by another investment company solely in reliance on rule
12d1-1 under the Act (CFR 270.12d1-1). We note that at most 29
closed-end funds of funds with net assets of $10 billion may be
affected by the proposal indirectly, to the extent that they hold
shares of open-end funds.
\414\ See note 411. Master-feeder fund means a two-tiered
arrangement in which one or more funds (each a feeder fund) holds
shares of a single fund (the master fund) in accordance with section
12(d)(1)(E) of the Act (15 U.S.C. 80a-12(d)(1)(E)) or pursuant to
exemptive relief granted by the Commission. See Instruction 4 to
Item C.3 of Form N-CEN. Feeder funds are identified on Form N-CEN,
Item C.3.f.ii.
---------------------------------------------------------------------------
Different parts of the proposal would affect these two subsets of
open-end funds differently. In particular, the proposed amendments to
the liquidity management program and certain reporting requirements
would affect both mutual funds and ETFs and the proposed hard close and
swing pricing requirements and related reporting requirements would
affect only mutual funds that are not feeder funds.
We estimate that there are 12,153 funds currently required to file
reports on Form N-PORT \415\ and there are 2,754 registrants required
to file reports on Form N-CEN that would be affected by the proposed
reporting requirements.\416\ Among these, we estimate that the proposed
changes to the reporting requirements on Form N-PORT would also affect
660 closed-end funds and 5 ETFs registered as unit investment trusts
with assets of $0.4 trillion and $0.7 trillion, respectively.\417\
---------------------------------------------------------------------------
\415\ See infra note 540 and accompanying text.
\416\ See infra note 547 and accompanying text.
\417\ Closed-end investment companies are identified on Form N-
CEN, Item B.6.b. Unit investment trust (UIT) ETFs are funds of Form
N-8B-2 registrants identified in Item B.6.g. which are also reported
in Item E.
---------------------------------------------------------------------------
i. Open-End Fund Characteristics
Table 2 below shows the number and total assets of open-end funds
by fund type.\418\ The largest share (by assets) of funds
(approximately 63.5% of assets held by all open-end funds) that would
be affected by the proposal are equity funds, including U.S. and
international equity funds. The second largest type of funds affected
by the proposal is taxable bond funds, which on aggregate holds
approximately 19.6% of all open-end fund assets.
---------------------------------------------------------------------------
\418\ We note that these statistics are estimated with the
Morningstar data; therefore, there is a discrepancy in the number of
funds estimated based on the Form N-CEN and the number of funds
estimated based on the Morningstar data. This discrepancy exists for
two reasons. First, Morningstar data may not include all open-end
funds due to its voluntary submission nature; as such, the number of
funds based on the Morningstar data may be under-estimated. Second,
funds may submit their data to Morningstar on a monthly data, while
the submission on the Form N-CEN is required on a yearly basis.
Therefore, the number of funds estimated based on the Form N-CEN may
be under-estimated because it may not include new funds that haven't
filed the Form yet.
\419\ Morningstar data, excluding funds of funds, feeder funds,
and money market funds. 5 UIT ETFs, with assets of approximately
$0.7 trillion are included in the Morningstar ETF totals.
Table 2--Number of Affected Funds by Fund Type, as of December 2021 419
--------------------------------------------------------------------------------------------------------------------------------------------------------
ETFs 1 Other open-end (not including MMFs) Total
--------------------------------------------------------------------------------------------------------------------
Category Assets, $ % of Total Assets, $ % of Total Assets, $ % of Total
# of funds trln assets # of funds trln Assets # of funds trln assets
--------------------------------------------------------------------------------------------------------------------------------------------------------
Allocation......................... 90 $0.03 0.37 377 $1.58 7.59 467 $1.61 5.72
Alternative........................ 193 0.01 0.21 167 0.13 0.64 360 0.15 0.53
[[Page 77244]]
Bank Loan.......................... 7 0.02 0.26 53 0.10 0.47 60 0.12 0.42
Commodities........................ 116 0.14 1.88 28 0.03 0.16 144 0.17 0.60
Intern. Equity..................... 507 1.10 15.20 1,108 3.18 15.30 1,615 4.29 15.27
Miscellaneous...................... 246 0.14 1.86 90 0.01 0.03 336 0.14 0.51
Municipal Bond..................... 68 0.08 1.13 546 0.98 4.71 614 1.06 3.79
Nontrad. Equity.................... 33 0.02 0.23 92 0.03 0.13 125 0.04 0.15
Sector Equity...................... 481 0.84 11.62 398 0.63 3.02 879 1.47 5.24
Taxable Bond 2..................... 426 1.17 16.06 1,268 4.32 20.77 1,694 5.49 19.55
US Equity.......................... 684 3.72 51.18 1,952 9.82 47.18 2,636 13.54 48.22
--------------------------------------------------------------------------------------------------------------------
Total.......................... 2,851 7.26 100 6,079 20.82 100 8,930 28.08 100
--------------------------------------------------------------------------------------------------------------------------------------------------------
1. Includes ETFs that are UITs.
2. Excludes bank loan funds.
The proposal would disproportionally affect open-end funds that
hold less liquid investments. Among the investments classified by open-
end funds in December 2021, $27.3 trillion of all investments were
reported as highly liquid, $441 billion of all investments were
reported as moderately liquid, $276 billion of all investments were
reported as less liquid, and $198 billion of all investments were
reported as illiquid. Among the investments reported as less liquid,
71% ($194 billion) are bank loan interests, 10% ($26 billion) are debt
securities, 9% ($25 billion) are equities, and 6% ($17 billion) are
mortgage-backed securities.\420\ Therefore, we believe that the
proposal to remove the less liquid category would primarily affect
open-end funds that hold bank loan interests. As of December 2021,
there are 746 open-end funds that classified approximately $204 billion
in bank loan interests, which represents approximately 0.7% of all
open-end fund investments classified,\421\ and makes up approximately
15% of the bank loan market.\422\ Among these bank loan interests, 95%
were reported as less liquid. We recognize that some open-end funds
have large concentrations in bank loan interests and are typically
referred to as ``bank loan'' funds. As shown in Table 2 above, as of
December 2021, there are 53 bank loan funds that hold approximately
0.5% of total open-end fund assets.
---------------------------------------------------------------------------
\420\ In addition to these, a smaller number of other categories
are classified as less liquid investments.
\421\ Source: Form N-PORT. Loan investments are identified via
Form N-PORT, Item C.4.a and liquidity classifications are from Form
N-PORT, Item C.7.
\422\ See Leveraged Loan Primer, supra note 99 (stating that the
S&P/LSTA Loan Index, which is used as a proxy for market size in the
U.S., totaled approximately $1.375 trillion as of Feb. 2022).
---------------------------------------------------------------------------
The proposal would also disproportionally affect open-end funds
that hold investments whose fair value is measured using an
unobservable input that is significant to the overall measurement.\423\
We estimate that, as of December 2021, 2,006 open-end funds reported
$76.5 billion in investments that were valued using unobservable inputs
that are significant to the overall measurement, which is approximately
0.27% of all open-end fund assets.\424\ Among these, $16.9 billion were
classified as highly liquid investments and $2.1 billion as moderately
liquid investments by 541 funds.\425\ In addition, $7.8 billion were
classified into less liquid category and $49.8 billion were classified
into the illiquid category.
---------------------------------------------------------------------------
\423\ See supra note 111.
\424\ Source: Form N-PORT. The fair value hierarchy for an
investment are identified on Form N-PORT, Item C.8., and liquidity
classifications are identified on Form N-PORT, Item C.7. We observed
that the investments classified as highly liquid that were Level 3
investments primarily were mortgage-backed securities.
\425\ Id.
---------------------------------------------------------------------------
ii. Open-End Fund Flows
To inform our understanding of historical redemption and
subscription patterns, we analyzed daily fund flow data during the
period between January 2009 and December 2021.\426\ Table 3 below shows
net fund flow percentiles pooled across time and funds. Figure 6 below
shows the time series of daily fund flow percentiles for equity and
fixed income funds, showing 1st, 5th, 50th, 95th, and 99th percentiles
of fund flows for each day. Similarly, Figure 7 shows the time series
of weekly fund flow percentiles for equity and fixed income funds,
showing the 1st, 5th, 50th, and 95th, and 99th percentiles of fund
flows for each week.
---------------------------------------------------------------------------
\426\ Data source: Morningstar Fund Flow Data. We restrict our
analysis to funds that have a ``Global Broad Category Group'' of
Equity or Fixed Income because we believe the data for other types
of funds (e.g., Alternative and Commodity funds) contain more
extreme values that may be spurious. We restrict our analysis to
include fund flow data starting 2009. While some Morningstar data is
available for 2008, we have not included that data in our historical
flow analyses because of gaps in the 2008 data (e.g., the 2008
dataset covers a more limited set of funds). We trim outliers from
the dataset by restricting outflows from a fund to be no more than
100% of AUM and inflows to be no more than 300% of AUM on a given
day or 1000% of AUM for a given week when analyzing weekly flows.
For daily flows, we determine the flow percentage by dividing dollar
flows on date T by total net assets on date T. This assume that
total net assets on a given day do not account for that day's flows.
Similarly, for weekly flows, we aggregate by business week, summing
dollar flows over the course of the week and dividing by the first
available day's net assets in that week. Making the opposite
assumption, that total net assets on a given day do incorporate that
day's flows, does not significantly alter our results.
---------------------------------------------------------------------------
Table 3 shows, for example, that weekly outflows exceed roughly 7%
in one out of one hundred fund-week observations and that weekly
outflows exceed 1.3% in five out of one hundred observations.\427\ To
help put these figures in context statistically, we see that the fund
flow distribution exhibits heavy left (and right) tails relative to the
normal distribution. That is, events such as outflows of 6.6% should
occur far fewer than one out of one hundred times if fund flows were
normally distributed. Similarly, events such as inflows of 8.3% should
occur far fewer than one out of one hundred times if fund flows are
normally distributed.
---------------------------------------------------------------------------
\427\ See supra note 426 for a description of how the data set
was constructed.
---------------------------------------------------------------------------
Whereas Table 3 looks at percentages across all funds and days or
weeks, Figure 6 shows the cross-section of daily fund flows at each
point in time and breaks up the fund universe into fixed income and
equity funds. Figure 6 shows that the dispersion of flows exhibits
significant variation; there are times when percentiles widen out
considerably, even during non-stressed market conditions.\428\ Times of
[[Page 77245]]
substantial flows into bond funds do not necessarily correspond to
flows into equity funds. What this implies is that looking at the
distributions separately may reveal greater dispersion, as flows across
the sectors diversify each other. For equities, a number of time
periods exhibit cross-sections in which the lowest percentile of funds
have daily outflows in excess of 10%. For bond funds, flows of this
magnitude are rarer. However, such episodes do occur for bond funds and
correspond with times of broader stress in fixed income markets.
Similarly, Figure 7, which shows weekly flows, also shows that outflows
in the lowest percentile of funds of below 10% are not uncommon, both
in bonds and in equities.\429\ For fixed income funds, both the daily
and weekly flow plots in Figures 6 and 7 show that during March 2020,
some funds experienced significant outflows, consistent with the
aggregate monthly outflows discussed in section I.B.
---------------------------------------------------------------------------
\428\ See id. Daily flows for equity funds have notable seasonal
spikes that tend to occur during the month of Dec., independent of
market stress events. These flow spikes may be attributable to any
year-end rebalancing of investors from, e.g., underperforming funds
into outperforming funds; to year-end distributions that are
characterized as flows by Morningstar and subsequently re-invested;
or to spurious or errant data points. We believe that latter is less
likely because these seasonal spikes are still evident when the data
is aggregated to the weekly level in Figure 7. To the extent
seasonal fund flow spikes are driven by predictable events such as,
e.g., capital gains distributions, fund managers are more likely to
be able to plan for any impacts of such events on a fund, include
funds that hold investments with lower liquidity.
\429\ See id.
Table 3--Pooled Fund Flows, as a % of Net Assets
----------------------------------------------------------------------------------------------------------------
Percentile
-------------------------------------------------------------------------------
1st 5th 50th 95th 99th
----------------------------------------------------------------------------------------------------------------
Daily fund flows................ -1.60 -0.30 0 0.40 2
Weekly fund flows............... -6.60 -1.30 0 1.80 8.30
----------------------------------------------------------------------------------------------------------------
BILLING CODE 8011-01-P
[[Page 77246]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.006
[[Page 77247]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.007
BILLING CODE 8011-01-C
b. Fund Intermediaries
As discussed above, the proposed hard close requirement would
affect a large group of intermediaries. Specifically, under the hard
close requirement, intermediaries generally would need to submit orders
for fund shares earlier than they currently do for those orders to
receive that day's price. As discussed in greater detail below, this
may affect all market participants sending orders to relevant funds,
including broker-dealers, registered investment advisers, retirement
plan recordkeepers and administrators, banks, insurance companies, and
other registered investment companies.
[[Page 77248]]
i. Broker-Dealers
Based on an analysis of Financial and Operational Combined Uniform
Single (FOCUS) Reports filings as of December 2021, there were
approximately 3,508 registered broker-dealers with over 240 million
customer accounts.\430\ In total, these broker-dealers have over $5
trillion in total assets as reported on Form X-17A-5.\431\ More than
two-thirds of all broker-dealer assets and just under one-third of all
customer accounts are held by the 21 largest broker-dealers, as shown
in Table 4.\432\ Of the broker-dealers registered with the Commission
as of December 2021, 434 broker-dealers were dually registered as
investment advisers.\433\
---------------------------------------------------------------------------
\430\ The data is obtained from FOCUS filings as of Dec. 2021.
There may be a double-counting of customer accounts among, in
particular, the larger broker-dealers as they may report introducing
broker-dealer accounts as well in their role as clearing broker-
dealers. Customer Accounts includes both broker-dealer and
investment adviser accounts for dual-registrants.
\431\ Assets are estimated by Total Assets (allowable and non-
allowable) from Part II of the FOCUS filings (Form X-17A-5 Part II
and Part IIA, available at https://www.sec.gov/files/formx-17a-5_2.pdf) and correspond to balance sheet total assets for the
broker-dealer. The Commission does not have an estimate of the total
amount of customer assets for broker-dealers because that
information is not included in FOCUS filings. The Commission
estimates broker-dealer size from the total balance sheet assets as
described above.
\432\ Approximately $4.97 trillion of total assets of broker-
dealers (98.7%) are at broker-dealers with total assets in excess of
$1 billion.
\433\ This estimate includes the number of broker-dealers who
are also registered with either the Commission or a state as an
investment adviser.
Table 4--Number of Broker-Dealers by Total Assets, as of December 2021
----------------------------------------------------------------------------------------------------------------
Cumulative
Total number Cumulative number of
Size of broker-dealer (total assets) of BDs total assets customer
($ bln) accounts
----------------------------------------------------------------------------------------------------------------
>$50 billion.................................................... 21 3,682 75,808,084
$1 billion to $50 billion....................................... 124 1,581 153,243,391
$500 million to $1 billion...................................... 30 22 518,545
$100 million to $500 million.................................... 147 31 9,559,082
$10 million to $100 million..................................... 532 19 128,669
$1 million to $10 million....................................... 1,065 4 885,269
<$1 million..................................................... 1,589 0.5 10,854
-----------------------------------------------
Total....................................................... 3,508 5,338 240,153,894
----------------------------------------------------------------------------------------------------------------
ii. Retirement Plans
Retirement plans and accounts are major holders of mutual funds. We
estimate that, as of 2022Q1, approximately 54% of non-MMF mutual fund
assets were held in retirement accounts, which include employer-
sponsored defined contribution (``DC'') plans and individual retirement
accounts (``IRAs'').\434\ At year-end 2021, mutual funds accounted for
58% ($6.4 trillion) of DC plan assets and 45% ($6.2 trillion) of IRA
assets.\435\ Among DC plans, 401(k) plans held $5 trillion of assets in
mutual funds, 403(b) plans held $670 billion, other private-sector DC
plans held $539 billion, and 457 plans held $177 billion.\436\
Combined, the mutual fund assets held in DC plans and IRAs at the end
of 2021 accounted for 32% of the $39.4 trillion U.S. retirement
market.\437\
---------------------------------------------------------------------------
\434\ See Inv. Co. Inst. (ICI), The U.S. Retirement Market,
First Quarter 2022 (June), Table 28, available at https://www.ici.org/system/files/2022-06/ret_22_q1_data.xls.
\435\ See ICI, 2022 Investment Company Factbook, Chapter 8,
available at https://www.icifactbook.org/pdf/2022_factbook.pdf.
\436\ Id.
\437\ Id.
---------------------------------------------------------------------------
According to a recent study, DC plans vary in size by both number
of participants and plan assets.\438\ For example, as shown in the
Table 5 below, among 401(k) plans, 94.1% of plans had less than $10
million of plan assets. While the number of plans with plan assets over
$1 billion is relatively small, these largest plans manage
approximately 47.8% of all assets held in 401(k) plans.
---------------------------------------------------------------------------
\438\ See BrightScope & Investment Company Institute, 2021, The
BrightScope/ICI Defined Contribution Plan Profile: A Close Look at
401(k) Plans, 2018 (``BrightScope/ICI Report''), at 7, Ex. 1.2,
available at www.ici.org/files/2021/21_ppr_dcplan_profile_401k.pdf.
These data is limited to 401(k) plans covered in the Department of
Labor Form 5500 research file, as we do not have data on the size
distribution for other types of DC plans. We note, however, that
401(k) plans represent approximately 70.4% of all DC plan assets.
Investment Company Institute, ``The US Retirement Market, First
Quarter 2022'' (June), Table 6, available at https://www.ici.org/system/files/2022-06/ret_22_q1_data.xls.
Table 5--Distribution of 401(k) Plans by Plan Assets, 2018
--------------------------------------------------------------------------------------------------------------------------------------------------------
Plans Participants Assets
--------------------------------------------------------------------------------------------------
Plan assets Billions of
Number Percent Thousands Percent dollars Percent
--------------------------------------------------------------------------------------------------------------------------------------------------------
Less than $1M........................................ 343,108 58.5 6,007.5 8.4 $107.1 2.1
$1M to $10M.......................................... 208,789 35.6 13,660.6 19.1 620.7 12.2
>$10M to $50M........................................ 26,458 4.5 9,894.5 13.9 532.4 10.4
>$50M to $100M....................................... 3,564 0.6 4,808.0 6.7 247.1 4.8
>$100M to $250M...................................... 2,407 0.4 6,744.8 9.5 374.7 7.3
>$250M to $500M...................................... 1,034 0.2 5,395.1 7.6 362.1 7.1
>$500M to $1B........................................ 603 0.1 4,763.9 6.7 424.1 8.3
More than $1B........................................ 659 0.1 20,073.4 28.1 2,439.7 47.8
All plans............................................ 586,622 100.0 71,347.7 100.0 5,108.0 100.0
--------------------------------------------------------------------------------------------------------------------------------------------------------
[[Page 77249]]
The same study shows that mutual funds held 43% of private-sector
401(k) plan assets in the sample in 2018. CITs held 33% of assets,
guaranteed investment contracts (GICs) held 7%, separate accounts held
3%, and the remaining 14% were invested in individual stocks (including
company stock), individual bonds, brokerage, and other
investments.\439\ While mutual funds accounted for at least 55% of
assets in plans with less than $1 billion of plan assets, they
accounted for only 23% of assets in plans with more than $1 billion of
plan assets (dominated by CITs that accounted for 49% of plan
assets).\440\
---------------------------------------------------------------------------
\439\ Id.
\440\ Id.
---------------------------------------------------------------------------
iii. Retirement Plan Recordkeepers
According to one source, as of September 2021, the total DC
recordkeeping assets were approximately $9.7 trillion, as shown in
Table 6 below.\441\ The largest recordkeeper managed approximately 33%
of all recordkeeping assets, and the 10 largest recordkeepers managed
approximately 83% of all recordkeeping assets.
---------------------------------------------------------------------------
\441\ Larry Rothman, Large Record Keepers Keep Dominating
Market, Pensions & Investments, (Apr. 11, 2022), available at
https://www.pionline.com/interactive/large-record-keepers-keep-dominating-market.
Table 6--Largest Retirement Plan Recordkeepers, as of September 30, 2021
------------------------------------------------------------------------
Recordkeeping assets, $
Recordkeeper billion
------------------------------------------------------------------------
Fidelity Investments...................... $3,1698
Empower................................... 1,048
TIAA-CREF................................. 710
Vanguard Group............................ 702
Alight Solutions.......................... 545
Voya Financial............................ 499
Principal Financial Group................. 449
Bank of America........................... 346
Prudential Financial...................... 283
T. Rowe Price Group....................... 268
All others................................ 1,676
-----------------------------
Total................................. 9,695
------------------------------------------------------------------------
c. Other Affected Entities
A significant portion of mutual fund orders are processed through
NSCC's Fund/SERV platform: in 2021 Fund/SERV processed 261 million
mutual fund transactions with the aggregate value of $8.5
trillion,\442\ which we estimate to be at least 36.8% of the value of
all mutual fund transactions.\443\ A part of the platform, referred to
as Defined Contribution Clearance & Settlement, focuses on purchase,
redemption, and exchange transactions in defined contribution and other
retirement plans. This service handled a volume of nearly 154 million
transactions in 2021.\444\
---------------------------------------------------------------------------
\442\ See Depository Trust and Clearing Corporation (DTCC), 2021
Annual Report, pg. 57, available at https://www.dtcc.com/~/media/
files/downloads/about/annual-reports/DTCC-2021-Annual-Report.
\443\ We do not have data to calculate the value of all mutual
fund transactions directly. Therefore, we use ICI data on long-term
mutual funds' portfolio purchases and sales as a proxy for the total
value of transactions in mutual fund shares, assuming that a
significant portion of portfolio purchases reflects investor
subscriptions and a significant portion of portfolio sales reflects
investor redemptions. We estimate this value to be $27.07 trillion
by adding the total value of purchases and the total value of sales
for long-term mutual funds. See ICI, 2022 Investment Company
Factbook, Table 31, available at https://www.icifactbook.org/22-fb-data-tables.html.
We estimate the share of the value of mutual fund transactions
processed by Fund/SERV as the aggregate value reported by Fund/SERV
divided by the long-term mutual funds' portfolio purchases and
sales. We recognize that mutual funds may effect portfolio purchases
and sales for purposes other than investing new cash from
subscribing investors and meeting investor redemptions, such as
portfolio rebalancing. Therefore, the total value of transactions in
long-term mutual fund shares may be overestimated. Accordingly, the
share of mutual fund transaction value processed by Fund/SERV may be
underestimated. We also recognize that the aggregate value reported
by Fund/SERV may or may not include the value of mutual fund
transactions via DCC&S. To the extent that the reported value
excludes such transactions, the share of mutual fund transaction
value processed by Fund/SERV may be further underestimated. We
solicit comments on these statistics.
\444\ See id.
---------------------------------------------------------------------------
Mutual funds may employ the services of third-party or affiliate
transfer agents. We estimate that, as of March 2022, there are 99
mutual fund transfer agents that serve both open- and closed-end funds
for the 2021 reporting year.\445\
---------------------------------------------------------------------------
\445\ Mutual fund transfer agents are those transfer agents that
answered with a positive value for any of Items 5(d)(iii-iv), 6(a-
c)(iii-iv), or 10(a) on a Form TA-2. We note that the identified
mutual fund transfer agents may serve both open-end and closed-end
funds. To the extent that some of the identified transfer agents
only serve closed-end funds, the number of affected transfer agents
may be over-estimated.
---------------------------------------------------------------------------
We expect that a range of other entities would be affected by the
proposal:
Mutual fund order processing entities (besides Fund/SERV);
Mutual fund liquidity service providers;
Other third-party service providers.
We do not currently have data on the number and size of these
entities. We solicit comments on these statistics. In addition, we
solicit comment on what other entities would be affected by the
proposed amendments.
C. Benefits and Costs of the Proposed Amendments
1. Liquidity Risk Management Program
The proposed rule would make several changes to the liquidity risk
management framework adopted in 2016. In particular, it makes changes
to (1) the manner and frequency in which funds must classify each of
their portfolio holdings into one of several liquidity buckets; (2) the
minimum amount a fund must hold in the highly liquid investment
category; (3) the treatment of margin and collateral for certain
derivatives transactions, for purposes of the highly liquid investment
minimum and 15% limit on illiquid investments, as well as the treatment
of a fund's liabilities for purposes of the highly liquid investment
minimum; and (4) the
[[Page 77250]]
definition of the liquidity buckets, including illiquid investments.
Whereas the existing rule provides funds with a considerable level of
discretion regarding how fund investments are classified, as well as
regarding the determination of a highly liquid investment minimum, the
proposed rule would reduce that discretion and is intended to prepare
funds for future stressed conditions by improving the quality of
liquidity classifications by preventing funds from over- or under-
estimating the liquidity of their investments, including in times of
stress. The proposed rule is also intended to provide classification
standards that are consistent with more effective practices the staff
has observed across funds. As a result, we expect enhanced liquidity
across open-end funds and lower risk of a fund not being able to meet
shareholder redemptions without significant investor dilution, which
could reduce the risk of runs arising from the first-mover advantage.
Thus, the proposed amendments may improve overall market resiliency.
The proposed amendments to the liquidity risk management program
would impose costs on open-end funds. We estimate, for Paperwork
Reduction Act purposes, that the modification of existing collection of
information requirements of rule 22e-4 will result in an annual cost
increase of $7,101 per fund.\446\ In addition, funds may experience
other costs related to changing business practices, computer systems,
integrating new technologies, etc. We are not able to quantify many of
these costs for several reasons. First, we do not have granular data on
the current systems, business practices, and operating costs of all
affected parties, which would allow us to estimate how their systems
and practices would change along with any associated costs. Second, we
cannot predict how many funds would respond to the proposed changes to
the liquidity risk management program by changing their portfolio
allocation in order to be compliant with the proposed highly liquid
investment minimum and the 15% limit on the illiquid investments and
how many funds may choose to convert to the closed-end form or cease to
exist. Finally, we cannot predict how many investors would decide to
exit open-end funds in a response to the portfolio allocation changes
that funds may implement as a result of the proposed amendments to the
liquidity risk management. We request comment on these and other
potential costs of the proposed changes to the liquidity risk
management program, particularly any dollar estimates of the costs that
funds and other affected parties will incur as a result of the rule.
---------------------------------------------------------------------------
\446\ See infra section IV.B.
---------------------------------------------------------------------------
a. Methodology for Liquidity Classifications
The proposed rule would substitute the fund's reasonably
anticipated trade size determination with a stressed trade size
(``STS'') determination, with an STS being a set percentage of the
fund's net assets. The proposed rule would also prescribe specific
methods to determine when a price change should be considered
``significant'' and remove the funds' ability to perform liquidity
classification at the asset-class level.
Generally, the three proposed amendments to the liquidity
classification methodology may help funds to prepare better for future
stress events or periods of high levels of redemptions by improving the
quality of liquidity classifications via the requirement for more
frequent classification and making the methodology more disciplined,
objective, and consistent across funds. This, in turn, may help funds
meet investor redemptions without significant trading costs,
potentially decreasing dilution risk. We recognize, however, that the
proposed liquidity classification methodology would still be dependent
on the size of an investment position within a fund's portfolio
relative to the size of the market for the investment. Therefore,
although funds would follow a more standardized methodology for
liquidity classifications, the same investment could be classified
differently by different funds, depending on how much of this
investment a fund holds, thereby reducing comparability of liquidity
classifications between different funds. The specific economic effects
for each of three proposed amendments are discussed below.
i. Replacing Reasonably Anticipated Trade Size With Stressed Trade Size
Funds may currently use their subjective judgment when determining
the meaning and calculation of reasonably anticipated trade size. The
proposed requirement to replace the reasonably anticipated trade size
with the STS as a set percentage of a fund's net assets would decrease
such subjectivity because funds would no longer have discretion in
determining the amount of each investment they should assume will be
sold or disposed of in determining the liquidity classifications. A
stricter methodology for liquidity classifications of funds'
investments may be more objective and consistent, which would benefit
investors by improving funds' ability to meet investor redemptions
without significant levels of dilution in both normal and stressed
market conditions. In particular, requiring a fund's classification
model to assume the sale of the proposed stressed position size would
better emulate the potential effects of stress on the fund's portfolio
and help better prepare a fund for future stress or other periods where
the fund faces higher than typical redemptions. In addition, to the
extent that the proposed STS would be simpler and more objective than
the determination of a reasonably anticipated trade size, all else
equal, the operational burden or costs that funds currently experience
in making liquidity classifications may be reduced.
We also propose to set the STS minimum of 10%. Based on an analysis
of historical weekly fund flows for equity and fixed income funds, we
estimate that a random fund in a random week has approximately a 0.5%
chance of experiencing redemptions in excess of the 10% STS, and there
were 3.4% of weeks where more than 1% of funds experienced net
redemptions exceeding 10%.\447\ Although this data analysis implies
that funds infrequently experience redemptions of 10% or more, we
believe that the 10% STS has the advantage of simulating a stress event
and would better prepare funds to accommodate redemptions during such
events. Although funds could consider events larger than 10% for their
STS calculation voluntarily, we believe that the proposed requirement
would achieve a more consistent methodology for liquidity measurement
across funds.
---------------------------------------------------------------------------
\447\ An analysis of historical Morningstar weekly fund flow
data for equity and fixed income funds from 2009 through 2021 shows
that the 1st percentile flow is approximately -6.6% while the 5th
percentile flow is approximately -1.3%. The same analysis shows that
the 10% STS corresponds to approximately the 0.5th percentile of
pooled weekly fund flows. The same analysis shows that if the 5th
percentile fund flow is computed for each week, it never exceeds the
10% STS. If the 1st percentile fund flow is computed for each week,
it exceeds the 10% STS for approximately 3.4% of the weeks in the
sample.
---------------------------------------------------------------------------
[[Page 77251]]
However, we recognize that specific funds may experience varying costs
and benefits associated with the 10% STS. For example, two funds with
comparable levels of AUM but with underlying investments that have
different liquidity characteristics may experience stress at different
levels of redemptions. For example, a large-cap equity fund may not
experience stress at the 10% level of redemptions, whereas a fixed
income fund with comparable AUM might. As such, the extent to which
investors of a given fund benefit from the 10% STS will vary based on
the liquidity of its underlying investments.\448\
---------------------------------------------------------------------------
\448\ See also section III.B.4.a.ii for discussion of fund flows
based on fund type.
---------------------------------------------------------------------------
Funds and their investors may incur costs as a result of replacing
reasonably anticipated trade size with the STS. To the extent that
funds would assign a higher liquidity category under the current
reasonably anticipated trade size approach compared to the liquidity
category that would be assigned using the proposed STS, the proposed
amendment may result in funds rebalancing their portfolios in order to
meet the highly liquid investment minimum and to comply with the limit
on the illiquid investments. As such, a fund either may have to
increase its holdings of highly liquid investments or decrease its
holdings of moderately liquid and illiquid investments. As a result,
the risk-return profile of the fund's portfolio would change towards
more liquid and less risky investments that may have lower returns. To
the extent that such reallocation would result in deviations from a
benchmark return (if any), funds may experience higher tracking
error.\449\ In addition, to the extent that investors seek particular
risk exposures and returns that would be difficult for the affected
funds to provide under the proposed amendments, the proposed amendments
may drive them towards other investment vehicles that do not face daily
redemptions, such as closed-end funds, or to other vehicles or means of
investing that are not subject to the liquidity rule, such as
separately managed accounts or CITs. However, to the extent that these
other vehicles or means of investing do not offer the same investment
strategies or do not provide the same benefits and protections as the
open-end funds to investors, investors may find such investment avenues
less favorable compared to open-end funds. As a result, the set of
investment options available to investors with particular risk-return
preferences may decrease.
---------------------------------------------------------------------------
\449\ Tracking error is the difference between the fund's return
and that of the benchmark which measures how closely a fund
replicates the returns of the identified benchmark.
---------------------------------------------------------------------------
ii. Determining a Significant Change to Market Value
Under the current rule, a fund may determine value impact (a
``significant price change'') in a variety of ways, including methods
that depend on the type of asset, or vendor, model, or system used. The
proposed amendments would establish a uniform standard of how funds
should determine what constitutes a significant price change, which
would improve consistency and objectivity of liquidity classification
methodologies across mutual funds. To the extent that some funds may
currently use definitions of a significant price change that result in
under-estimation of the price impact and classification of investments
in more liquid categories, the proposal would limit the extent to which
funds are able to do so. This, in turn, would help funds to prepare
better for potential stress events and potentially reduce the risk of
not being able to meet investors' redemptions without incurring
significant trading costs, thereby decreasing dilution risk. The
proposed amendment may also decrease ongoing costs related to the
liquidity classification process, all else equal, by reducing the
number of determinations a fund must perform during the liquidity
classification process.
For shares listed on a national securities exchange or a foreign
exchange, the proposed rule would require funds to use an average daily
trading volume threshold of 20% to determine whether a trade will cause
a significant price change.\450\ Funds will have less discretion in
this circumstance than under the existing rule. This should result in a
more robust and consistent liquidity classification process that would
help ensure that the liquidity classifications for all holdings of a
certain investment of particular size are classified in the same manner
across funds which, in turn, may help all funds to prepare better for
periods of high investor redemptions.
---------------------------------------------------------------------------
\450\ See supra section II.A.1.a.ii.
---------------------------------------------------------------------------
For any investments other than shares listed on a national
securities exchange or a foreign exchange, the proposed rule would
define a significant change in market value as any sale or disposition
that a fund reasonably expects would result in a decrease in sale price
of more than 1%, which is the measure used in several commonly employed
liquidity models.\451\ This alternative measure is proposed because we
recognize that average daily trading volume in, for example, a single
bond issue would not be representative because it does not represent
the full pool of liquidity available for a debt security, since bonds
are split into many different issues and differ from common shares,
where volume is concentrated because there generally is only one class
of shares for each issuer.
---------------------------------------------------------------------------
\451\ Id.
---------------------------------------------------------------------------
Although not all liquidity classification models currently specify
a price decrease explicitly as the determination for a significant
change in market value, we believe it would improve the quality of
classifications to require a more objective principle. However, the
proposed rule may still result in some heterogeneity in how funds
classify otherwise similar holdings because funds and liquidity
classification vendors would still be able to choose which price impact
model to use for their classifications,\452\ depending on the
assumptions of the fund or a liquidity classification provider. As a
result, liquidity classifications for the same investment of the same
size may vary across funds, to the extent that funds or liquidity
classification vendors have different theoretical assumptions about the
same investment. For example, it may be difficult to choose a price
impact model for assets that do not have readily available recent price
information, and funds may have to use subjective judgment in
determining the sale amount that constitutes a significant change in
market value. To the extent that such subjectivity could still result
in over-estimation of liquidity of funds' investments, the potential
increase in the ability of funds to meet investors' redemptions without
significant dilution under the proposed rule may be lower than
anticipated. In addition, to
[[Page 77252]]
the extent that the reference price against which the price impact is
calculated is stale for some investments (i.e., investments that are
traded infrequently), the estimated trading volume that would not cause
a significant price change may be less accurate for such investments.
---------------------------------------------------------------------------
\452\ There are various estimation techniques for price impact
(market impact), such as those that use linear models, power law
models, log models, I-STAR model, and other. See, e.g., Albert S.
Kyle, Continuous Auctions and Insider Trading, 53 Econometrica, 1315
(1985), Robert Almgren et. al., Direct Estimation of Equity Market
Impact, 18 Risk 58 (2005); Elia Zarinelli et. al., Beyond the Square
Root: Evidence for Logarithmic Dependence of Market Impact on Size
and Participation Rate, Market Microstructure and Liquidity no. 2
(Dec. 5, 2014) available at https://arxiv.org/pdf/1412.2152.pdf;
Bence Toth, et.al, Anomalous Price Impact and the Critical Nature of
Liquidity in Financial Markets (working paper, Nov. 1, 2011),
available at https://arxiv.org/abs/1105.1694; Robert Kissell et.
al., Optimal Trading Strategies: Quantitative Approaches for
Managing Market Impact and Trading Risk, (AMACON 2003); Saerom Park
et. al., Predicting Market Impact Costs Using Nonparametric Machine
Learning Models (research article Feb. 29, 2016), available at
https://journals.plos.org/plosone/article?id=10.1371/journal.pone.0150243.
---------------------------------------------------------------------------
iii. Removing Asset Class Classification
The proposal to remove funds' ability to perform liquidity
classifications at the asset-class level may improve the quality of
liquidity classifications by reducing the potential of funds over- or
under-estimating the liquidity of their investments. Currently, because
the definitions of asset classes are not consistent across funds in
terms of their scope and granularity, an investment (of the same size)
could be classified as belonging to different asset classes by
different funds. Moreover, if a classification is performed on an
asset-class basis, changes in liquidity profiles of individual
investments may not be accounted for in the way these investments are
classified, which may lead to an over- or under-estimation of funds'
investments' liquidity. In contrast, under the proposal, funds would
more specifically gauge the liquidity of each investment, which could
strengthen their liquidity management, potentially decreasing the risk
of not being able to meet investors' redemptions without significant
costs that could arise from an over-estimation of fund's investments'
liquidity. To the extent that the liquidity classifications of
investments within the same asset class would not differ between asset-
level and investment-level classifications, the proposal to remove
funds' ability to perform liquidity classifications on the asset-class
level may increase ongoing operational burden for funds that rely on
this classification method without any commensurate benefits. However,
the asset-class level classification is not expected to be compatible
with other proposed changes to the liquidity risk management program,
such as the value impact standard. Specifically, a fund would not be
able meaningfully to apply a standard based on average daily trading
volume or a price decline in a given investment at the asset class
level because the average trading volume, or market depth generally,
can vary from investment to investment even within the same asset
class.
b. Removal of the Less Liquid Category
We propose to eliminate the less liquid investment category.
Currently, investments are defined as less liquid if it is reasonably
expected that they could be sold within seven calendar days but the
sale is reasonably expected to settle in more than seven days. Under
the proposal, investments that do not sell and settle within seven
calendar days without significant price change would be classified as
illiquid. We believe that the proposal to remove the less liquid
category would primarily affect open-end funds that hold bank loan
interests, as the most common type of investment in this category is
bank loan interests.\453\
---------------------------------------------------------------------------
\453\ See supra section III.B.4.a.
---------------------------------------------------------------------------
On the one hand, recent research suggests that during the period
between March 1 and 23 of 2020, bank loan mutual funds experienced
outflows of approximately 11% of their AUM; substantially higher than
high-yield bond funds (which investors may consider close substitutes
to bank loan funds) and all other types of funds.\454\ Moreover, these
outflows had longer duration, which suggests greater risk of investor
runs in these funds. On the other hand, other research \455\ examines
the resilience of bank loan funds to liquidity shocks and does not find
substantial evidence of lower liquidity among bank loan funds compared
to corporate bond funds generally. However, the risk of not being able
to meet investor redemptions within seven days without significant
costs may be higher for bank loan funds compared with other types of
funds, as the trading costs related to bank loan fund outflows
(including costs associated with obtaining financing to bridge the
settlement gap) may be larger than those of other types of funds.
Specifically, as noted by LSTA, over the course of the first three
weeks of March of 2020, bid-ask spreads for bank loans widened by 288
basis points to a record 422 basis points.\456\ In contrast, recent
research shows that, between February 3 and March 20 of 2020, high-
yield corporate bonds' bid-ask spreads widened by an estimated range
between 79 \457\ and 166 \458\ basis points to 102 and 223 basis points
respectively.
---------------------------------------------------------------------------
\454\ Nicola Cetorelli et. al., Outflows From Bank-Loan Funds
During COVID-19, Federal Reserve Bank of New York, Liberty Street
Economics (June 16, 2020), available at https://libertystreeteconomics.newyorkfed.org/2020/06/outflows-from-bank-loan-funds-during-covid-19/. See also Ayelen Banegas & Jessica
Goldenring, Leveraged Bank Loan Versus High Yield Bond Mutual Funds,
Fin. & Econ. Discussion Series 2019-047 (Board of Governors of the
Federal Reserve System, Washington, DC), Jun. 2019, (``Banegas/
Goldenring paper'') available at https://www.federalreserve.gov/econres/feds/leveraged-bank-loan-versus-high-yield-bond-mutual-funds.htm. This paper finds that, as of end of 2018, flows as a
share of assets have been larger and more volatile for bank loan
funds than for high-yield bond funds.
\455\ Mustafa Emin et. al., How Fragile Are Loan Mutual Funds?
(working paper, Nov. 18, 2021) available at https://ssrn.com/abstract=4024592 (retrieved from SSRN Elsevier database).
\456\ See Loan Syndication & Trading Association (LSTA), March
Loan Returns (April 2, 2020), available at https://www.lsta.org/news-resources/march-loan-returns-total-12-37.
\457\ See Nina Boyarchenko, et. al., It's What You Say and What
You Buy: A Holistic Evaluation of the Corporate Credit Facilities
(working paper no. 8679, Nov. 11, 2020), available at https://ssrn.com/abstract=3728422 (retrieved from SSRN Elsevier database).
\458\ See Simon Gilchrist, et. al., The Fed Takes On Corporate
Credit Risk: An Analysis of the Efficacy of the SMCCF (working paper
no. 2020-18, Apr. 20, 2021), available at https://ssrn.com/abstract=3829900 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------
Moreover, bank loan funds, unlike other funds, experience specific
trading costs related to bridging the settlement gap, i.e., the costs
related to using financing during the time it takes for a loan trade to
settle. Although other types of open-end funds may use bank credit
lines, most instruments held by open-end funds do not come with the
same level of settlement uncertainty. Because the process of trade
settlement for bank loans is not standardized and involves many
parties, the settlement process can take longer. Therefore, when an
open-end fund sells a bank loan interest, it is possible that the trade
will not be settled for an extended amount of time. As shown in Table 7
below, bank loan funds on average use higher amounts of financing via
credit lines and use them for longer/shorter period of time on average.
---------------------------------------------------------------------------
\459\ N-1A RIC credit line usage is from Form N-CEN, and
excludes ETFs and MMFs. Data is as of Dec. 2021, incorporating
filings received through June 3, 2022.
Table 7--Open-End Funds' Use of Credit Lines by Fund Type, as of December 2021 459
----------------------------------------------------------------------------------------------------------------
Number of Has line of Used line of Avg. credit Avg. number of
funds credit credit line use days used
----------------------------------------------------------------------------------------------------------------
Bank Loan....................... 56 48 9 $29,411,240 114
[[Page 77253]]
Other Categories................ 8,979 5,462 969 8,431,142 24
-------------------------------------------------------------------------------
Total....................... 9,035 5,510 978 8,624,210 24
----------------------------------------------------------------------------------------------------------------
In contrast, high yield bonds primarily have T+2 settlement.
Although high yield bonds may have the same or lower liquidity compared
to bank loans,\460\ from the perspective of funding investor
redemptions, bank loans are less certain to be converted to U.S.
dollars within a specific timeframe. As a result, when engaging in
financing to bridge the settlement gap, a fund that sells a high-yield
bond would likely use the credit line only for two days while a fund
that sells a bank loan will have to use it for a longer period. This,
in turn, may increase the risk of bank loan funds not being able to
meet investor redemptions within seven days without imposing additional
financing costs on fund investors, which may increase dilution.
Therefore, we believe that a limit on the amount of time a trade is
reasonably expected to settle and convert to U.S. dollars to qualify as
a non-illiquid investment is intended to promote liquidity in open-end
funds and reduce investor dilution from trading costs, including wide
bid-ask spreads and the costs related to bridging the gap between the
maximum time allowed to meet investor redemptions and prolonged
settlement of certain investments.\461\
---------------------------------------------------------------------------
\460\ See supra, note 455. Authors show that, controlling for
the fund size and rating, bank loan liquidity is similar to or
greater than liquidity of similarly rated public bonds. The authors
construct two indirect measures of liquidity: the first measure is
based on the difference between the transaction prices and net asset
values (NAVs) of shares of loan and high yield bond ETFs; the second
measure is the perceived liquidity of corporate bonds based on the
relationship among cash holdings, flow volatility, and fund
holdings. See also Sergey Chernenko & Adi Sunderam, Measuring the
Perceived Liquidity of the Corporate Bond Market (working paper no.
27092, May 2020), available at https://www.nber.org/papers/w27092.
\461\ See also section II.A.1.b.iii.
---------------------------------------------------------------------------
The removal of the less liquid category may also reduce the risk of
runs in the open-end fund sector. As discussed above, bank loan funds
may be more prone to sector-wide outflows compared to other types of
funds due to the low dispersion of returns across bank loan funds
(i.e., the correlation of bank loan fund returns is higher relative to
the correlation of returns for other types of funds), which may lead to
further redemptions and higher investor dilution, and may consequently
be amplified by a fund's usage of financing for a prolonged period of
time. To the extent that bank loan funds rebalance their portfolios to
hold bank loans with shorter settlement times, investor dilution and
the risk of runs on bank loan funds may be reduced.
Open-end funds may experience costs as a result of this
amendment.\462\ First, open-end funds would experience a one-time
switching cost to adapt the classification and reporting systems for
the removal of the less liquid category, which would be passed on to
funds' investors. To the extent that the settlement time for bank loan
interests cannot be reduced, these loan interests would have to be
reclassified as illiquid. As a result, funds that hold these
investments may be required to rebalance their portfolio by divesting
from bank loans interests in order to comply with the maximum allowed
allocation towards illiquid investments, which may result in both
aggregate holdings and individual portfolio concentrations of bank loan
interests among open-end funds to be reduced. Such portfolio
reallocation may result in one-time switching costs that would be
passed on to investors. In addition, to the extent that portfolio
concentration of bank loan interests decreases significantly for some
bank loan funds as a result of the proposal, these funds' investment
strategy would have to be redefined. Moreover, to the extent that some
funds would not be able to successfully rebalance their portfolios away
from bank loan interests with longer settlement times without losing
investors, these funds may cease to exist or may seek shareholder
approval to convert to a closed-end form.
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\462\ We recognize that those funds that primarily hold bank
loan interests with shorter settlement times may be less affected by
this proposed amendment. For example, loans that are larger in size,
more standardized, and more frequently traded, such as those that
are a part of S&P/LSTA U.S. Leveraged Loan 100 Index, may have
shorter settlement times.
---------------------------------------------------------------------------
Furthermore, to the extent that such portfolio reallocation results
in lower fund returns, this may drive investors of these funds to
either substitute their investments in open-end bank loan funds to
other types of open-end funds or choose other types of funds or
investment vehicles that are able to hold higher amounts of bank loan
interests. To the extent that these other vehicles or means of
investing do not offer the same investment strategies or do not provide
the same benefits and protections as the open-end bank loan funds to
investors, investors may find such investment avenues less favorable
compared to open-end bank loan funds. As a result, the set of
investment options available to investors with this particular strategy
preference may decrease. This effect may be more pronounced for retail
investors who generally have limited access to the bank loan market and
to private funds that may hold bank loan interests.
To the extent that investor demand for holding bank loans in a fund
structure is high, some funds may choose to restructure as closed-end
funds, in order to be able to keep their current holdings of bank loan
interests. The funds that choose to do so may experience one-time
switching costs related to shareholder votes for the fund conversion,
such as costs of preparing and distributing proxy materials and costs
associated with the solicitation process.\463\ In addition, some
investors may rush to redeem their shares before the conversion which
may increase dilution of the remaining investors.
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\463\ We recognize that there may be other costs funds could
incur to convert to a closed-end fund, such as potential exchange
listing costs or costs of conducting periodic repurchase offers.
---------------------------------------------------------------------------
However, we recognize that while operational constraints may play a
role in why settlement times for bank loan interests are prolonged,
misaligned incentives of trading parties (such as delayed settlement
compensation) and a collective action problem may also be important
factors in determining settlement time for bank loan interests.\464\
Therefore, to the extent that it is currently operationally possible to
have a shorter settlement time for bank loan interests, and to the
extent that non-fund transaction parties would be able to speed up the
settlement process at a relatively low cost, open-end bank loan funds
may not have to rebalance their portfolios or restructure to a closed-
end form under the proposal.
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\464\ See supra section II.A.1.b.i and note 106.
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[[Page 77254]]
c. Definition of Illiquid Investments
We propose to amend the definition of illiquid investments to
include investments whose fair value is measured using an unobservable
input that is significant to the overall measurement.\465\ We recognize
that, in light of the proposed removal of the less liquid category,
only a small fraction of these investments that are classified as
highly liquid or moderately liquid would be affected by this proposed
amendment. We estimate that approximately 0.07% of all open-end fund
assets would be affected by this amendment.\466\ Therefore, we do not
anticipate that this amendment would significantly impact open-end fund
sector.
---------------------------------------------------------------------------
\465\ See supra note 112.
\466\ See supra section III.B.4.a.
---------------------------------------------------------------------------
This amendment may improve the quality of investments' liquidity
classifications. To the extent that valuation using unobservable inputs
that are significant to the overall measurement may have an increased
risk that the fund cannot sell the investment in time to meet
redemptions without dilution, classifying such investments as illiquid
may reduce this risk. To the extent that this risk results in investor
dilution, and to the extent that the overall open-end funds' holdings
of these investments would decrease as a result of this amendment,
investor dilution may be reduced and overall liquidity of funds that
hold such investments may increase as a result.
Although we understand that some funds already have a practice of
classifying these investments as illiquid, this amendment may result in
a one-time switching cost for funds that do not currently follow this
practice. In addition, to the extent that some funds hold a significant
share of their portfolio in such investments and these investments are
not currently classified as illiquid, these funds would have to
rebalance their portfolios and potentially change their investment
strategy.
d. Proposed Minimum for Highly Liquid Investments
Rule 22e-4 currently requires a fund to determine a highly liquid
investment minimum if it does not primarily hold investments that are
highly liquid investments. We propose for open-end funds to have a
highly liquid investment minimum of at least 10% of the fund's net
assets, which is the assumed stressed trade size.\467\ In addition, we
propose to remove the provision allowing funds not to establish a
highly liquid investment minimum if they ``primarily'' hold highly
liquid assets.
---------------------------------------------------------------------------
\467\ See supra note 69 (recognizing that in-kind ETFs would not
be subject to the proposed highly liquid investment minimum
amendments).
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Requiring a highly liquid investment minimum that is equal to or
above the assumed stressed trade size of 10% of net assets may benefit
funds and their investors by creating more standardized liquidity risk
management among funds, thereby increasing their liquidity and helping
all mutual funds to be better prepared to meet investor redemptions
without incurring significant trading costs. A higher amount of liquid
assets may help fund managers to avoid transacting at fire-sale prices
during market stress and, therefore, control trading costs better over
time. This, in turn, may decrease dilution risk for fund
shareholders.\468\ By requiring a minimum of 10% of highly liquid
assets, we set a minimum baseline level of liquidity that would help
reduce dilution risk.
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\468\ Section III.B.3.b analyzes the frequency of large
percentage redemptions from funds. We recognize that if a fund were
to experience a 10% redemption, it could sell primarily its highly
liquid assets (which would then be significantly more than 10% of
each of these holdings), or it could sell a vertical slice of its
portfolio, in which case it would sell 10% of all assets.
---------------------------------------------------------------------------
Funds may experience costs as a result of the proposed requirement.
We recognize that funds that currently have an established highly
liquid investment minimum already have the procedures in place for
ongoing monitoring for meeting the minimum. As such, we do not expect
the direct compliance costs related to meeting the highly liquid
investment minimum, such as monitoring costs and costs related to
shortfall policies and procedures, to increase for these funds.
However, those funds that have an established minimum of less than 10%
may have to rebalance their portfolios in order to meet the proposed
requirement if they do not hold more highly liquid investments than the
proposed requirement. In addition, funds may need to shift their
portfolios away from less liquid holdings, potentially leading to
higher tracking error relative to their benchmarks (if any) \469\ and
lower returns. However, a higher amount of liquid investments may help
fund managers to control trading costs better over time, which may
result in a higher long-term returns for investors. Therefore, the
return loss of holding more liquid investments (relative to less liquid
investments) may be fully or partially offset by the savings on funds'
trading costs.\470\
---------------------------------------------------------------------------
\469\ See supra note 449.
\470\ See supra note 351 and accompanying text.
---------------------------------------------------------------------------
To the extent that some open-end funds' portfolio allocations
change significantly as a result of this proposal, these funds may
experience additional costs related to disclosure of changes to the
fund's allocations and/or strategy and costs related to a potential
change of the fund's name. These costs would be passed on to fund
investors.
Funds that do not currently have an established highly liquid
investment minimum may experience a one-time switching cost related to
establishing shortfall policies and procedures and to reviewing the
highly liquid investment minimum at least annually as a result of the
proposed amendment. Funds may also experience one-time switching costs
related to establishing monitoring procedures related to the highly
liquid investment minimum. To the extent that some funds that do not
currently have an established highly liquid investment minimum are able
to leverage the experience of the funds in the same complex that do
have an established highly liquid investment minimum, these one-time
switching costs may be reduced for these funds.
The proposal to remove the provision allowing funds to not
establish a highly liquid investment minimum if they ``primarily'' hold
highly liquid assets may eliminate compliance costs related to
monitoring whether a fund primarily holds highly liquid assets. Because
funds that hold a substantial amount of highly liquid investments would
generally hold an amount of highly liquid investments that is above the
proposed 10% highly liquid investment minimum, a separate compliance
system that would identify whether a fund ``primarily'' holds highly
liquid assets may be operationally inefficient. We believe that the
``primarily'' determination would become unnecessary in light of the
proposed highly liquid investment minimum that would be applicable to
all funds. We recognize that cost savings from the removal of the
``primarily'' provision would be partially or fully offset by the cost
increase stemming from the proposed highly liquid investment minimum
because funds currently relying on the ``primarily'' provision would
have to build a compliance and monitoring systems around the highly
liquid investment minimum.
e. Amendments to Calculation of the Amount of Assets That Count Toward
the Highly Liquid Investment Minimum or the Limit on Liquid Investments
We also propose to amend how the highly liquid investment minimum
calculation and the calculation of the 15% limit on illiquid
investments
[[Page 77255]]
account for the value of assets that are posted as margin or collateral
for certain derivatives transactions, as well as the value of fund
liabilities in the case of the highly liquid investment minimum.
Specifically, in assessing compliance with the fund's highly liquid
investment minimum, the proposal would require a fund to: (1) subtract
the value of any highly liquid assets that are posted as margin or
collateral in connection with any derivatives transaction that is not
classified as highly liquid; and (2) subtract any fund liabilities. In
addition, the proposal would amend the rule's limitation on illiquid
investments to provide that the value of margin or collateral that a
fund could only receive upon exiting an illiquid derivatives
transaction would itself be treated as illiquid for purposes of that
limit.
The amendments to the highly liquid investment minimum calculation
and the calculation of the 15% illiquid investment limit may benefit
funds and investors. Particularly, these amendments would require funds
to calculate the amount of highly liquid investments and illiquid
investments in a way that more accurately reflects the amount of assets
a fund could sell quickly to meet redemptions without significant
dilution and the amount of assets that could not be sold within seven
days without significant trading costs respectively. This, in turn,
would better prepare funds for periods of increased investor
redemptions and thereby enhance investor-protection benefits of funds'
liquidity risk management programs.
More specifically, we recognize that, although investments used for
collateral are generally classified as highly liquid, the value of
those highly liquid investments cannot be accessed unless the
derivative is exited, which takes a longer time for derivatives
classified as moderately liquid or illiquid. In addition, an unrealized
loss on a derivative or other liability may result in a margin call,
for which highly liquid investments may be used. Moreover, if a fund
may use highly liquid investments to service its liabilities (e.g.,
paying interest on a loan), this fraction of highly liquid investments
would also be unavailable to meet investors' redemptions. While we
recognize that funds generally already subtract investment liabilities
when calculating highly liquid investment minimum,\471\ subtracting all
of the fund's liabilities may further reduce the amount of highly
liquid investments available to satisfy the fund's highly liquid
investment minimum. Therefore, the amendments to the highly liquid
investment minimum calculation would help to ensure that highly liquid
investments used to satisfy the fund's highly liquid investment minimum
actually are available to meet shareholder redemptions.
---------------------------------------------------------------------------
\471\ See supra section II.A.2.b.ii.
---------------------------------------------------------------------------
Similarly, the proposed amendment to add the value of excess
collateral of illiquid derivatives investments to the amount of
illiquid investments for the purposes of determining compliance with
the 15% limit on illiquid investments would limit the extent to which
the fund's assets would be unavailable to meet redemptions because of
the fund's associated illiquid derivatives investments. This amendment
would effectively increase the amount of illiquid investments a fund
holds, potentially pushing these holdings over the 15% limit and
triggering the compliance procedures for going over the limit, which
may impose additional costs on the fund.
The proposed amendments may result in funds rebalancing their
portfolios in order to meet the highly liquid investment minimum and
comply with the limit on illiquid investments. Depending on the value
of highly liquid assets a fund has that are posted as collateral or
margin for non-highly liquid derivatives and the value of the fund's
liabilities relative to the fund's total amount of highly liquid
investments, under the proposed amendment, a fund may have to either
increase its holdings of highly liquid assets or decrease its holdings
of moderately liquid and illiquid derivatives in order to meet the
highly liquid investment minimum. A fund similarly may have to decrease
its holdings of illiquid investments or increase its holdings of highly
liquid or moderately liquid investments as a result of the proposed
amendment to the calculation of the limit on illiquid investments. To
the extent that such portfolio reallocation would significantly change
a fund's strategy, funds may experience additional costs related to
disclosure of changes to the strategy. In addition, the risk-return
profile of the fund's portfolio may change towards more liquid and less
risky investments that may have lower returns. To the extent that some
investors demand higher returns, they may choose to invest in other
investment vehicles that could offer higher returns.
f. Other Amendments Related to Liquidity Categories
We also propose other amendments related to the liquidity
classification categories. First, we propose to amend the term
``convertible to cash'' and its definition to instead refer to
conversion to U.S. dollars, codifying prior Commission statements.
Second, we propose to specify that funds must count the day of
classification when determining the period in which an investment is
reasonably expected to be convertible to cash. Third, we propose to
simplify the definition of moderately liquid investments as those that
are neither a highly liquid investment nor an illiquid investment.
To the extent that, at present, open-end funds use differing
definitions of convertible to cash and may inconsistently include or
exclude the day of liquidity classification when performing the
classifications, the two related proposed amendments would benefit
funds and investors, as these amendments may improve the quality of
liquidity classifications by reducing over- or under-estimation of
investments' liquidity, thereby potentially reducing trading costs
related to investors' redemptions. On the other hand, open-end funds
that do not currently define ``convertible to cash'' as convertible to
U.S. dollars, which may include some funds that invest in foreign
securities, and open-end funds that do not currently count the day of
classification during the classification process may experience a one-
time switching cost. In addition, these funds may have to rebalance
their portfolios, to the extent that their current approach results in
an over-estimation of investments' liquidity.
g. Frequency of Liquidity Classifications
Currently, rule 22e-4 requires that funds review their liquidity
classifications at least monthly and more frequently if changes in
relevant market, trading, and investment-specific considerations are
reasonably expected to materially affect one or more of their
investments' classifications. We propose to require that funds classify
all of their portfolio investments each business day.
To the extent that funds already monitor their classifications on a
daily basis in order to be in compliance with the current highly liquid
investment minimum and 15% limit on illiquid investments requirements,
we believe that this amendment likely will not produce significant
additional benefits or costs. However, to the extent that funds do not
monitor their classifications daily, or to the extent that monitoring
classifications is a less stringent procedure relative to performing
classifications for the funds that do monitor classifications daily,
this amendment may produce benefits and costs.
[[Page 77256]]
On the one hand, requiring daily liquidity classification could
help ensure efficient implementation of funds' liquidity management
programs and enhance their investor protection benefits. Specifically,
daily liquidity classifications may help funds identify changes in
liquidity profiles of their investments in a timelier manner and
monitor potential increases in trading costs for specific investments,
thereby preparing funds for more efficient trading during times of
increased redemptions and increasing their ability to respond more
quickly to rapid changes in liquidity of portfolio investments, which
may decrease investor dilution. In addition, the daily classification
requirement, in combination with the proposed standards for trade size
and value impact, may make the liquidity classification process more
standardized, timely, and efficient.
On the other hand, funds may experience a one-time set-up cost and
increased ongoing costs as a result of this amendment. First, those
funds that generally do not evaluate their classifications more
frequently than monthly would have to change their systems for
performing classifications on a daily basis. In addition, these funds
would experience increased ongoing costs due to increased frequency of
classifications.\472\ Second, those funds that already monitor their
classifications on a daily basis would have to change their systems, to
the extent that monitoring classifications on a daily basis is a
different procedure compared to the proposed requirement to perform
classifications.
---------------------------------------------------------------------------
\472\ Under the proposed amendments, a more frequent
classification may not necessarily result in more frequent portfolio
rebalancing. For example, if a fund exceeds the 15% illiquid
threshold, it would not have to sell its illiquid investments,
rather it would not be able to acquire more. In addition, if a fund
falls below the highly liquid investment minimum, it would still be
able to purchase and sell highly liquid investments. However, both
of these events would trigger filing of Form N-RN.
---------------------------------------------------------------------------
In addition, in times of market stress some highly liquid
investments may become less liquid due to unusual selling pressure
(e.g., Treasuries during March 2020), and more frequent classification
may move these investments to less liquid buckets. In such instances
where funds do not typically expect highly liquid investments to
decrease in liquidity, more frequent reclassification of these
investments may not help funds better accommodate increased redemptions
compared to the baseline.\473\ However, to the extent funds would
prefer to avoid triggering events that would cause additional
compliance requirements such as Form N-RN filings, the potential for
some investments to become less liquid in times of market stress could
incentivize funds to be more conservative, ex-ante, in how they
classify holdings and manage liquidity risk. This, in turn, may result
in funds investing in more liquid assets, thereby decreasing the
dilution risk in the mutual fund sector.
---------------------------------------------------------------------------
\473\ For example, during Mar. 2020 the liquidity of U.S.
government securities unexpectedly decreased. Under the proposal,
this event would trigger more rapid re-classification into a lower
liquidity category. However, because of the unexpected nature of
this event, a fund would still not be prepared to immediately meet
an increased level of redemptions.
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2. Swing Pricing
The proposed amendments would make several changes to the swing
pricing framework adopted by the Commission in 2016. In particular, the
proposed amendments would (1) require funds to implement swing pricing
for each pricing period when a fund has any amount of net redemptions
or when net subscriptions exceed 2% of the fund's NAV; (2) establish
specific thresholds that determine when a fund is required to adjust
its NAV and the factors a fund needs to incorporate into its swing
factor; (3) require that swing factors are calculated assuming a
vertical slice of the fund's portfolio; and (4) remove the upper limit
on the swing factor of 2%. By requiring all funds to implement swing
pricing, the proposed amendments would impose the estimated trading
costs associated with redemptions and subscriptions onto investors
whose transactions generate these costs, reducing the dilution of non-
transacting fund shareholders. As such, the proposed amendments are
also intended to reduce the first-mover advantage that stems from the
dilution of non-transacting shareholders, particularly during stressed
market conditions.
The proposed swing pricing framework would impose costs on mutual
funds that would be passed on to their investors. We estimate, for
Paperwork Reduction Act purposes, that the modification of existing
collection of information requirements of rule 22c-1 associated with
establishing and implementing swing pricing policies and procedures,
board reporting, and recordkeeping will result in an annual cost
increase of $7,775 per fund.\474\ Funds would also incur additional
operational costs associated with establishing and implementing swing
pricing policies and procedures, including the periodic calculation of
swing factors associated with the swing pricing framework's
thresholds.\475\ In addition, the economic benefits of swing pricing
would be offset by the costs associated with the proposed hard close
requirement.\476\ Finally, to the extent that the proposed swing
pricing framework would make mutual funds less attractive to investors,
mutual funds may experience investor outflows and/or reduced inflows.
---------------------------------------------------------------------------
\474\ See infra section IV.C.
\475\ Note that the swing factor itself in theory does not
impose a net cost across all types of shareholders. Instead, swing
pricing affects a zero-sum distribution of estimated future trading
costs among transacting and non-transacting shareholders. The
dilution that different types of fund shareholders ultimately
experience will reflect this distribution in addition to the actual
trading costs incurred by the fund from transactions that
accommodate investor subscriptions or redemptions. Beyond the
economic effects of the swing factor itself, the processes for
calculating and applying the factor as well as the hard close will
impose additional costs on all shareholders and intermediaries,
which are discussed below.
\476\ See infra section III.C.3 for a detailed discussion of
benefits and costs of the proposed hard close requirement.
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We are not able to quantify many of the costs associated with the
proposed swing pricing framework for several reasons. First, we do not
have granular data on the current practices and operating costs for all
funds, which might allow us to estimate how their systems would change
as a result of the proposed swing pricing requirement. Second, we
cannot predict the number of investors that would choose to keep their
investments in the mutual fund sector nor the number of investors that
would exit mutual funds and instead invest in other fund structures
such as ETFs, closed-end funds, or CITs. We also cannot estimate how
many funds would choose to upgrade their systems and processes in order
to comply with the proposed swing pricing requirement versus how many
funds would instead convert to an ETF or a closed-end structure. We
request comment on the full costs of the swing pricing requirement,
particularly any dollar estimates of the costs that funds and other
affected parties will incur as a result of the rule.
a. Mandatory Swing Pricing
At present, rule 22c-1 permits mutual funds to use swing pricing,
and yet no U.S. open-end fund has chosen to use it as an anti-dilution
tool. We propose to require all affected mutual funds to use swing
pricing. In particular, we propose to require every fund to establish
and implement swing pricing policies and procedures that would adjust
the fund's NAV per share by a swing factor either if the fund has net
redemptions of any amount or if the fund has net
[[Page 77257]]
subscriptions that exceed an identified threshold.
We expect the proposed mandatory swing pricing requirement to
benefit investors. First, swing pricing would protect non-transacting
mutual fund investors because it would require transacting fund
shareholders to bear the estimated trading costs that arise due to
their trading activity. In contrast, currently, investors transacting
in fund shares generally do not bear the costs associated with their
trading activity, imposing dilution on non-transacting
shareholders.\477\ For example, an industry study on the use of swing
pricing in other jurisdictions estimates that dilution effects can be
significant, with effects on annual returns of selected funds in one
complex ranging from 10 to 66 basis points in 2019.\478\ While these
estimates from other jurisdictions may be based on fund transaction
cost components that differ from the U.S., such as those associated
with government taxes and levies, to the extent that dilution effects
are comparably significant in the U.S., the proposed mandatory swing
pricing requirement would reduce the dilution of non-transacting fund
shareholders.\479\ Second, mandatory swing pricing could benefit
markets overall because it may reduce the first-mover advantage that
arises from dilution associated with trading costs. As a result, the
proposed amendment may mitigate the risk of runs on mutual funds and
may decrease the risk of fire-sales for the funds' underlying
investments.
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\477\ In this section when we discuss trading costs, we refer to
both direct (e.g., spread costs) and indirect trading costs (e.g.,
market impact costs).
\478\ See BlackRock, Swing Pricing: The Dilution Effects of
Investor Trading Activity on Mutual Funds (white paper, Oct. 2020),
available at https://www.blackrock.com/corporate/literature/whitepaper/swing-pricing-dilution-effects-of-trading-activity-on-mutual-funds-october-2020.pdf. To our knowledge, such data on fund
dilution are not available for the U.S. and we solicit data that
could enable quantification of the benefits of swing pricing. See
also supra section I.B and supra notes 59, 60, 61, and 161 for
additional discussion of swing pricing experience in other
jurisdictions.
\479\ See supra section III.B.3 for a discussion of other
sources that may contribute to dilution. We solicit comment on the
relative impact of these sources on dilution. While the proposed
swing pricing requirement is unlikely to reduce dilution associated
with stale valuations directly, the proposed requirements would
nevertheless help mitigate dilution resulting from trading costs
associated with strategic trading behavior that may seek to take
advantage of stale valuations.
---------------------------------------------------------------------------
We believe that these benefits may be more pronounced in the case
of net redemptions because dilution may be more severe when net
redemptions occur. One reason for this asymmetry is that investor
redemptions are required to be met within seven days, whereas the money
a fund receives from new subscriptions is not required to be invested
within a specific timeframe. Therefore, funds must incur the trading
costs that exist during the seven days following investor redemptions,
regardless of how large or small these costs are. On the other hand,
while fund managers may generally accommodate new subscriptions by
investing promptly to increase fund returns and reduce tracking error,
they may also elect to wait to purchase investments at more
advantageous prices or lower trading costs, resulting in lower dilution
of non-transacting fund shareholders. Another reason for asymmetry in
dilution from redemptions and subscriptions is that large redemptions
can have a greater correlation across funds exposed to the same asset
class in times of market stress, which in turn may induce more
redemptions and further increase trading costs and associated
dilution.\480\ Therefore, while swing pricing would reduce dilution
from trading costs associated with both net subscriptions and
redemptions, we believe that the magnitude of this anti-dilution
benefit would be greater in the case of net redemptions.
---------------------------------------------------------------------------
\480\ See, e.g., Dunhong Jin et. al., Swing Pricing and
Fragility in Open-End Mutual Funds (working paper, revised Jan. 7,
2021) available at https://ssrn.com/abstract=3280890 (retrieved from
SSRN Elsevier database). Also see section III.B.3 and note 395 for
additional research references.
---------------------------------------------------------------------------
Another potential benefit of the mandatory swing pricing approach
is that it would help overcome the collective action problem that may
exist under the current optional framework and may have prevented
voluntary swing pricing implementation due to the stigma that could be
attached to being the first fund to implement swing pricing. To the
extent that such a stigma effect is present in relation to swing
pricing, it may deter investors from choosing funds that could
implement swing pricing under the optional approach, and that could be
a reason why no U.S. fund currently chooses to implement swing
pricing.\481\ We also recognize that U.S. mutual funds are currently
also allowed to implement certain purchase and redemption fee
approaches (which do not necessarily require substantial operational
changes in contrast to swing pricing), yet these funds do not widely
use redemption fees as an anti-dilution tool, possibly because of any
stigma attached to anti-dilution tools generally.\482\
---------------------------------------------------------------------------
\481\ While we recognize that swing pricing has been
successfully implemented in other jurisdictions, these other
jurisdictions do not have the same regulatory frameworks and
investor base, which may influence investors' sentiment towards
anti-dilution tools and the extent of the potential stigma effects.
In addition, other jurisdictions do not have the same intermediary
structures between funds and their investors as in the U.S. See
supra section III.B.2.
\482\ See supra note 67 (stating that, based on staff review of
fund prospectuses, fewer than 5% of funds impose a redemption fee on
at least one share class).
---------------------------------------------------------------------------
The mandatory swing pricing requirement would impose costs on
mutual funds, investors, their intermediaries, and other market
participants. In addition to the costs associated with the proposed
hard close requirement discussed below, mutual funds would experience
initial and ongoing operational costs associated with developing and
administering swing pricing policies and procedures, changing their
systems to accommodate swing pricing, updating fund prospectuses, as
well as any costs associated with educating investors about swing
pricing procedures. These costs would ultimately be passed on to fund
investors.
To the extent that investors expect an increase in the costs of
investing in mutual funds as a result of the proposed mandatory swing
pricing, they may choose to divest from the mutual fund sector. To the
extent that such investor outflows would be substantial, funds may
experience a reduction in their economies of scale, which may lead to a
further increase in fund fees. In addition, the mandatory swing pricing
approach would reduce the set of investment choices available to
investors, relative to the optional approach, where investors can
choose to invest in funds that use swing pricing or funds that do not
use swing pricing.
The determination and application of a fund's swing factor could
delay the publication and dissemination of the fund's NAV relative to
current practices. To the extent that intermediaries require NAVs for
purposes such as updating and publishing client account statements,
they would incur costs updating their operations and systems to adapt
to later NAV publication times. In addition, any other market
participants, such as financial data aggregators, that depend on fund
NAV publication would also incur costs updating their operations and
systems to adapt to later NAV publication times.
b. Swing Threshold Framework
The current rule permits a fund to determine its own swing
threshold for net purchases and net redemptions, based on a
consideration of certain factors the rule identifies.\483\ For a fund
[[Page 77258]]
experiencing net redemptions, the proposal would require the fund to
apply a swing factor for any level of net redemptions. In addition, the
proposed rule would establish a threshold for inclusion of market
impact costs in its swing factor when net redemptions exceed 1% of the
fund's net assets (the ``market impact threshold''). For funds
experiencing net subscriptions, the proposal would require funds to
apply a swing factor that accounts for all trading costs (i.e.,
including market impact costs) when net purchases exceed the threshold
of 2% (the ``inflow swing threshold'').
---------------------------------------------------------------------------
\483\ The factors a fund currently must consider in determining
the size of its swing threshold are: (1) the size, frequency, and
volatility of historical net purchases or net redemptions of fund
shares during normal and stressed periods; (2) the fund's investment
strategy and the liquidity of the fund's portfolio investments; (3)
the fund's holdings of cash and cash equivalents, and borrowing
arrangements and other funding sources; and (4) the costs associated
with transactions in the markets in which the fund invests. See rule
22c-1(a)(3)(i)(B).
---------------------------------------------------------------------------
Under the current rule, funds are able to tailor their swing
pricing thresholds to their size, the characteristics of their
underlying portfolio holdings, and the characteristics of their
investor base. While this principles-based approach may be less
burdensome for funds, some funds may find it suboptimal to implement
swing pricing routinely due to the operational costs of doing so
frequently. As a result, they may choose thresholds that reduce the
frequency and impact of swing pricing on transaction prices for fund
shares. This, in turn, could reduce the benefits of the proposed swing
pricing requirement, including protecting non-transacting investors
from dilution due to trading costs and reducing the first-mover
advantage associated with such costs. Therefore, we believe that a
uniform approach to swing thresholds would better protect non-
transacting investors in the mutual fund sector by ensuring that
trading costs are passed on to transacting investors, regardless of
which fund's shares investors hold in their portfolios.
Trading costs incurred by a fund can be dilutive when a fund
experiences either redemptions or subscriptions. However, as discussed
above, subscriptions are likely to be less dilutive than redemptions.
To the extent that determining the swing factor is costly, as discussed
below, only requiring funds to do so when net subscriptions exceed 2%
would limit the frequency with which funds incur such costs. Based on
the analysis of historical daily fund flows in Table 3, a random fund
on a random day has approximately a 1% chance of exceeding the inflow
swing threshold. In addition, there were only 0.2% of days where more
than 5% of funds in the sample experienced net subscriptions exceeding
the inflow swing threshold.\484\ Therefore, we do not expect most funds
to experience the costs of applying a swing factor in the case of net
subscriptions frequently. The anti-dilutive benefits of swing pricing
in response to net redemptions are likely to be more than those
associated with net subscriptions, as discussed above. Therefore, we
believe that applying swing factor on any day with net redemptions may
benefit non-transacting investors compared to applying swing factor
only when a certain threshold is crossed. However, to the extent that
applying the swing factor more frequently is costly, these benefits may
be offset by such costs.
---------------------------------------------------------------------------
\484\ The analysis also shows that if the 99th percentile net
fund flow is computed on each date, it exceeds the inflow swing
threshold on approximately 34% of days.
---------------------------------------------------------------------------
The proposed market impact threshold of 1% may result in varying
costs and benefits for funds and their investors. For example, two
funds that invest in underlying assets with similar liquidity
characteristics may experience market impact at significantly different
levels of redemptions, as measured in percentage, if they are
significantly different in size. A 1% redemption from a fund with low
AUM may not result in sales of assets that result in market impact,
whereas a 1% redemption from an otherwise similar fund with
significantly larger AUM might. Similarly, two funds with comparable
levels of AUM holding investments with different liquidity
characteristics may experience market impact at different levels of
redemptions. For example, a large cap equity fund may not experience
market impact at the 1% threshold, whereas a fixed income fund with
comparable AUM might. As such, the extent to which a given fund and its
investors benefit from evaluating market impact at the 1% threshold
will vary based on factors such as the fund's size and the liquidity of
its underlying investments. For funds that may experience market impact
even when redemptions are below the 1% threshold, we note that funds
can choose to incorporate market impact into their swing factor at a
lower threshold than 1%. To the extent that calculating market impact
may be costly, only requiring funds to do so when net redemptions
exceed 1% would limit the frequency with which funds incur such costs.
We estimate that a random fund on a random date has approximately a
1.6% chance of exceeding the market impact threshold, and there were
2.3% of dates where more than 5% of funds experienced net redemptions
exceeding the market impact threshold.\485\
---------------------------------------------------------------------------
\485\ An analysis of historical Morningstar daily fund flow data
for equity and fixed income funds from 2009 through 2021 shows that
the 1st percentile flow is approximately -1.6% while the 5th
percentile flow is approximately -0.3%. The same analysis shows that
the 1% market impact threshold corresponds to approximately the
0.016 percentile of pooled daily net fund flows. The same analysis
shows that if the 1st percentile fund flow is computed on each date,
it exceeds the market impact threshold on approximately 84.6% of
dates.
---------------------------------------------------------------------------
c. Calculation of the Swing Factor
The current swing pricing framework provides an upper limit of 2%
for the swing factor and requires that the swing factor take into
account only the near-term costs expected to be incurred by the fund as
a result of net purchases or net redemptions that occur on the day the
swing factor is used,\486\ as well as borrowing-related costs
associated with satisfying redemptions; however, it does not specify
how a fund should select investments for the purposes of estimating the
trading costs and it does not require a fund to include market impact
costs in the swing factor.\487\ We propose removing the current upper
limit of 2% for the swing factor and requiring a fund's swing pricing
administrator to make good faith estimates, supported by data, of the
overall costs, including market impact costs under certain conditions,
that the fund would incur if it purchased or sold a pro rata amount of
each investment in its portfolio equal to the amount of net purchases
or net redemptions (i.e., a vertical slice).\488\ Because a fund would
need to calculate its costs based on the purchase or sale of a vertical
slice of its portfolio, rather than selecting specific investments to
be sold/purchased and estimating the cost of selling/purchasing those
specific investments, we propose removing borrowing costs from the
swing factor calculation.
---------------------------------------------------------------------------
\486\ These near-term costs include spread costs, transaction
fees, and charges arising from asset purchases or asset sales
resulting from those purchases or redemptions.
\487\ See rule 22c-1(a)(3)(i)(C).
\488\ See proposed rule 22c-1(b)(2).
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i. Vertical Slice Assumption
The vertical slice assumption may benefit investors of the affected
funds. Specifically, the vertical slice assumption is designed to
recognize the potential longer-term costs of reducing a fund's
liquidity and would more fairly reflect the costs imposed by redeeming
or purchasing investors than an approach that focuses solely on the
costs associated with the instruments that a fund expects to buy or
sell (or
[[Page 77259]]
expected borrowing costs, in the case of redemptions). For example, if
investor redemptions continue for multiple days, a fund that sells its
most liquid investments on the first day could experience increased
trading costs on subsequent days because it has to sell a bigger
fraction (relative to a vertical slice) of its less liquid assets. As a
result, redeeming investors on subsequent days would be charged more
than investors who redeemed on the earlier date via a higher swing
factor. In addition, the future costs associated with rebalancing the
fund portfolio to its pre-redemption level of highly liquid investments
are not currently permitted to be incorporated into the swing factor
because they are not near-term costs that may be considered under the
current rule. Therefore, the proposed vertical slice assumption would
help to ensure that redeeming investors bear not just the immediate
trading costs they impose on the fund, but also, in cases where a fund
sells its most liquid investments to meet redemptions first, the
estimated transaction costs associated with rebalancing the fund's
portfolio to its pre-redemption level of highly liquid investments,
such that subsequent redeeming investors are not charged for the costs
associated with past redemptions.
We recognize that selling a vertical slice of a portfolio in order
to meet investor redemptions may not be a practice used by all mutual
funds during all times. For example, recent research documents that
during tranquil market conditions, corporate bond funds tend to reduce
liquid asset holdings to meet redemptions; however, when aggregate
uncertainty rises these funds tend to scale down their liquid and
illiquid assets proportionally to preserve portfolio liquidity.\489\
Another paper finds that some funds holding less liquid assets reacted
to redemptions in March 2020 by adding to their cash buffers even after
meeting investor redemptions, rather than selling their most liquid
assets first or selling a vertical slice of their portfolio.\490\
Therefore, we recognize that the vertical slice assumption could result
in using estimates of transaction costs in the calculation of the swing
factor that differ from the estimated trading costs tailored to a
different asset liquidation approach. As a consequence, to the extent
that the trading costs estimated based on the vertical slice assumption
are higher or lower than estimated trading costs of the fund's
portfolio liquidation strategy, redeeming investors may be over- or
under-charged relative to the immediate trading costs of a fund's
actual liquidation strategy.
---------------------------------------------------------------------------
\489\ See Hao Jiang, et al., Dynamic Liquidity Management by
Corporate Bond Mutual Funds, J. Fin. & Quantitative Analysis 1622,
no. 5 (Aug. 2021).
\490\ See Andreas Schrimpf, et. al., Liquidity Management and
Asset Sales by Bond Funds in the Face of Investor Redemptions in
March 2020 (Mar. 17, 2021) available at https://ssrn.com/abstract=3799868 (retrieved from SSRN Elsevier database).
---------------------------------------------------------------------------
ii. Market Impact Costs
We propose requiring funds to include a good faith estimate of
market impact costs in the calculation of their swing factors when (1)
net subscriptions are above the inflow swing threshold or (2) when net
redemptions exceed the market impact threshold of 1%. To the extent
that funds are able to forecast market impact costs accurately, this
requirement would ensure that transacting investors bear, in addition
to direct transaction costs, the estimated impact of their transactions
on the ultimate price a fund pays or receives for any investments it
buys or sells. This may allow non-transacting shareholders to recapture
more of the dilution imposed on the fund by transacting fund investors.
As a result, the proposed market impact inclusion may also help reduce
first-mover advantage.
Several factors may limit the anti-dilution benefits of including
market impact costs in the swing factor. First, funds may incur costs
in obtaining reasonable ex-ante estimates of market impact costs,
either because they need to pay vendors for such estimates or because
they need to exert costly effort to develop such estimates internally.
These costs may ultimately be passed on to investors. Second, it may be
difficult and sometimes not feasible to develop objective estimates of
market impact for some of the investments that mutual funds hold, such
as those that generally lack a robust and liquid secondary market
(e.g., municipal securities and small-cap equities). In addition,
market impact may be more difficult to estimate during periods of
stress when trading in certain markets may be limited or stop.
Therefore, funds may need to use subjective discretion to determine
market impact estimates in certain circumstances, which may result in
funds over- or under-estimating the true ultimate market impact costs
associated with a given day's orders. This, in turn, would result in
over- or under-charging transacting investors, exposing them to
additional risk regarding the price at which they will ultimately
transact their shares.\491\
---------------------------------------------------------------------------
\491\ Transacting investors already face market risk when
submitting an order to buy or sell fund shares because these orders
must be submitted prior to the time at which a fund determines its
NAV.
---------------------------------------------------------------------------
Third, because funds would still have some discretion in
determining their swing factors, such as discretion over which price
impact model is used to estimate market impact, some funds may have an
incentive to under- or overestimate their swing factors, depending on
the circumstances. For example, a fund may choose to underestimate
market impact, biasing the swing factor estimate downwards, in order to
attract investors that prefer less volatile transaction prices for fund
shares. On the other hand, funds may have an incentive to overestimate
market impact and overcharge transacting investors relative to the
trading costs they are expected to impose on the fund, because doing so
may increase the performance of the fund.\492\ However, the proposed
requirement that funds report each swing factor on Form N-PORT may
mitigate any incentive funds have to under- or overestimate their swing
factors, as it will provide public transparency regarding the size of
these NAV adjustments.\493\
---------------------------------------------------------------------------
\492\ When a fund overcharges transacting investors, the fund
increases its assets and hence the performance of the fund.
\493\ See supra section III.B.4.
---------------------------------------------------------------------------
iii. Removal of the Upper Limit on the Swing Factor
The proposed removal of the upper limit on the swing factor may
benefit fund investors by permitting swing pricing to address the
dilution that transacting investors impose on a fund more fully. The
magnitude of this benefit would depend on how often funds' trading
costs exceed the current 2% swing factor. To the extent that trading
costs are more likely to exceed this threshold during stressed periods,
we expect this amendment to benefit non-transacting fund investors
during such periods when dilution may be increasing, which may further
address the first-mover advantage related to dilution from trading
costs. In addition, to the extent that trading costs for certain types
of funds are more likely to exceed the current 2% swing factor, the
proposed amendment would ensure that investors in these funds are as
protected from dilution as investors in funds for which trading costs
generally correspond to a swing factor lower than 2%. These benefits
may be partially offset because the removal of the upper limit for the
swing factor may also have a destabilizing effect during periods of
stress. For example, if investors expect that trading costs will
continuously increase, and that the swing factor will
[[Page 77260]]
increase accordingly, they may be incentivized to redeem their shares
at the onset of market stress, when the swing factor is lower.
iv. Removal of Borrowing Costs From the Swing Factor
We propose removing borrowing costs from the costs that should be
included in the swing factor. To the extent that the vertical slice
assumption would result in higher magnitude swing factors, any decrease
in swing factor magnitude due to the proposed removal of borrowing
costs from the swing factor calculation may be fully or partially
offset. Therefore, we do not expect this aspect of proposal to have
substantial effects. Although affected funds would still be allowed to
engage in bank or inter-fund borrowing in order to fund investor
redemptions, the proposed swing factor calculation will not reflect
potential borrowing costs for funds that do use borrowing to fund
redemptions.\494\ To the extent that these costs are higher than the
estimated costs of buying or selling a vertical slice of a fund's
portfolio, they would be borne by investors remaining in the fund,
limiting the anti-dilution benefits of the proposal.
---------------------------------------------------------------------------
\494\ Fund borrowing may defer but not always eliminate the need
for a fund to sell portfolio investments, as a fund will eventually
have to re-pay the loan. As a result, a fund may incur borrowing
costs in addition to trading costs, but only the latter would be
captured by the adjustment of NAV by the swing factor under the
proposal.
---------------------------------------------------------------------------
3. Hard Close Requirement
With respect to putting swing pricing into practice, requiring a
hard close would ensure that funds receive more timely flow
information. Because swing pricing requires both fund flows and
estimates of trading costs, requiring a hard close should reduce any
flow estimation error that would otherwise occur if funds had to rely
heavily on estimated fund flows in adjusting their NAV. In addition, by
providing funds with more complete flow information, the hard close
requirement could have auxiliary benefits unrelated to swing pricing,
including settlement modernization, and order processing
improvements.\495\ Also, a fund that knows its flows sooner may be able
to plan and implement trading strategies to meet those flows in a more
cost effective manner.
---------------------------------------------------------------------------
\495\ See supra section II.C.3.a for additional discussion.
---------------------------------------------------------------------------
The hard close requirement may change operational burdens for
mutual funds and other parties related to mutual fund order processing.
Currently, because mutual fund flows from different intermediaries and
investors are received by funds at different times, fund transfer
agents may have to process the orders in multiple batches that may span
until the next day. On the one hand, if doing so is costly in terms of
labor and/or strain on the processing systems and to the extent that
these costs are non-negligible, the hard close requirement may decrease
operational burden by allowing all orders to be processed within a
shorter time frame. On the other hand, to the extent that processing
all orders in a short amount of time, as it would be implied under the
proposal, requires more manpower and/or more processing capabilities,
the hard close requirement may increase operational burden of open-end
fund transfer agents. This effect may be more pronounced for smaller
transfer agents that do not enjoy economies of scale.
In addition, the hard close requirement may allow funds to plan
next-day and future activity related to today's redemptions or
subscriptions more efficiently. For example, the hard close would in
some cases improve the reliability of the flow information fund
portfolio managers use by eliminating cancellations and corrections. In
addition, if a portfolio manager uses flow information posted at the
custodian, the hard close generally would provide timelier flow
information. To the extent that these effects are present, the hard
close requirement would allow funds to have timelier information that
would permit them to plan and execute their trades in a more efficient
manner. This, in turn, may reduce funds' tracking errors and may help
prevent any error corrections or trade cancellations after the pricing
time.
However, requiring a hard close may impose significant switching
costs (e.g., changing business practices, computer systems, integrating
new technologies, etc.) on funds, their intermediaries, and service
providers that could ultimately be passed on to investors. We recognize
that these switching costs could be larger for certain types of
intermediaries. For example, some intermediaries may have more layers
of intermediation than others, and, therefore, would have to update
more systems and processes. As another example, some intermediaries may
have more reporting and recordkeeping requirements than others, and
would have to update more systems and processes to comply with the hard
close requirement. In addition, some intermediaries have their
processes and systems set up such that the daily price information is
required before any orders can be processed. For example, retirement
plan recordkeepers and any affiliated brokers and trust companies, as
well as DCS&S, would have to modify their processes and systems
substantially, as these processes currently require daily price
information for all investments prior to processing of any investment
instructions from the plan participants. In addition, retirement plans
may have to modify their provisions, and employers sponsoring these
plans may need to modify payroll systems, as well as change the
information (e.g., websites, manuals, and training materials) they
provide to employees regarding how to submit orders, as a result of the
hard close requirement.
A substantial number of affected retirement plans are small in size
as shown in Table 5. Therefore, a large number of small plans may be
disproportionally affected by the implementation costs related to the
proposed hard close because they may not enjoy economies of scale. To
the extent that these costs are too large relative to the size of
assets under management, some of the plans may cease to exist or choose
to offer other investment vehicles such as ETFs or CITs. For example,
in 2003, one commenter stated that one cost related to a hard close
that was substantially similar to what we are proposing would be
requiring submission of trades on sub-account levels rather than on an
omnibus level, which would result in an incremental cost increase of
$4.1 million per year for this commenter with 1.3 million of omnibus
trades per year.\496\ To the extent that not all investors have a
choice of intermediary, such as participants in employee-provided
retirement plans, the costs stemming from the proposed hard close
requirement may be borne by either investors (i.e., plan participants)
or their employers that sponsor the plan.
---------------------------------------------------------------------------
\496\ Comment Letter of Charles Schwab (Oct. 27, 2003) on 2003
Hard Close Proposing Release, File No. S7-27-03, available at
https://www.sec.gov/rules/proposed/s72703/s72703-2.pdf.
---------------------------------------------------------------------------
In addition, to the extent that not all intermediaries may be able
to comply with the hard close requirement, the investors that use these
intermediaries may face a decreased ability to invest in mutual funds
via certain intermediaries. To the extent that the strategies that
open-end funds subjected to the proposed requirement cannot be
replicated or to the extent that such replication would be more costly
outside of the mutual fund sector (e.g., via a separately managed
account), investors may end up with either less
[[Page 77261]]
diversified portfolios, or experience higher costs of investing.
The hard close requirement may disadvantage certain investors that
do not have a choice in their intermediary, if it precludes them from
responding to market events after a specific cut-off time that is
earlier than 4 p.m. ET or lengthens the amount of time for completing
certain types of transactions \497\ compared to investors that submit
orders directly to funds. For example, if an intermediary sets up a
cut-off time for transactions that is earlier than the fund cut-off
time (4 p.m.), investors in mutual funds that use these intermediaries
will not be able to react to market events that take place between an
intermediary cut-off and the fund cut-off time, thereby increasing a
market risk for investors that trade via intermediaries with earlier
cut-off times. However, investors that trade directly with a fund or
use intermediaries with later cut-off times would have an advantage and
still be able to respond to some or all market events during this time
frame (depending on the applicable cut-off time), allowing them to
decrease their market risk relative to investors that would be pushed
to next-day pricing.
---------------------------------------------------------------------------
\497\ See supra section II.C.3.d.
---------------------------------------------------------------------------
In addition, to the extent that investors designate their employers
to make retirement contributions to intermediaries via payroll
procedures, and to the extent that payroll procedures have to be
performed during a specific time frame in order for transaction to
receive that day's price, the employers may experience a cost of
switching the system to accommodate an earlier cut-off time for orders.
These effects may be more pronounced for employers and investors in the
western regions of the U.S. who may not have a sufficient time window
to process contributions and/or (re)allocate their portfolios. In
addition, to the extent that some intermediaries already impose an
earlier cut-off time for investors' orders, the hard close may entail
an even earlier cut-off time, which may further disadvantage investors.
In addition, the proposed hard close might affect current order
processing for funds of funds. We understand that an upper-tier fund in
a fund of funds structure may not submit its purchase or redemption
orders for lower-tier funds' shares until after 4 p.m. Under the
proposed rule, the upper-tier fund would have to submit purchase or
redemption orders for lower-tier funds' shares before the lower-tier
funds' designated pricing time in order to receive that day's price for
the orders.
We are not able to quantify many of the costs of the hard close
requirement for several reasons. First, we cannot predict how the costs
would be allocated between funds and their intermediaries because we do
not have detailed information about the number of intermediate steps
required to be completed between the time an investor places an order
and the time a fund receives this order for each type of an
intermediary and which party currently bears the costs of each
intermediate step. Second, we do not have granular data related to the
current practices and operating costs for each intermediary type, both
those that are regulated by the Commission and those that are not.
Therefore, we cannot predict how their systems and practices would
change in response to the hard close requirement and estimate the
associated costs of these changes. Third, we cannot predict how many
intermediaries will choose to upgrade their systems and processes in
order to maintain their ability to offer mutual funds to the client,
how many intermediaries will choose to impose an earlier cut-off time
for investor orders, and the number of intermediaries that will retain
their existing systems and order cut-off times and offer products that
would not be subject to the proposed hard close requirement, such as
CITs, ETFs, or closed-end funds in place of mutual funds. Finally, we
cannot predict how many investors will respond to changes that
intermediaries may implement in response to the hard close requirement
by divesting from the mutual fund sector. We request comment on these
costs of the hard close requirement, particularly any dollar estimates
of the costs that funds, intermediaries, and other affected parties
will incur as a result of the rule.
4. Commission Reporting and Public Disclosure
The Commission is proposing to change reporting frequency of Form
N-PORT, to change public availability of certain items on Form N-PORT,
and to amend Forms N-PORT, N-CEN, and N-1A. The proposed amendments are
intended to increase transparency around funds' activities related to
liquidity management and anti-dilution tools and to make information
more usable by filers, regulators, investors, and other potential data
users. The proposed amendments would also provide more information
about a fund's portfolio and its liquidity risk profile to investors,
thereby improving their portfolio allocation decisions.
Open-end funds will experience costs as a result of the proposed
changes to the three forms. In connection with the proposed information
collection requirements under the Paperwork Reduction Act, we estimate
that the proposed changes to Form N-PORT would result in an internal
cost increase of $2,472,356 and an external cost increase of
$5,613,175, the proposed changes to Form N-1A would result in internal
cost increase of $10,609,390; and the proposed changes to Form N-CEN
would not on aggregate result in an increase of ongoing costs.\498\
---------------------------------------------------------------------------
\498\ See infra sections IV.D, IV.E, and IV.F. These annual
direct costs include ongoing as well as initial costs, with the
latter being amortized over three years.
---------------------------------------------------------------------------
a. Commission Reporting Frequency
Currently funds file Form N-PORT reports for the first, second, and
third months of each fiscal quarter with the Commission 60 days after
the end of the third month of the quarter. We are proposing to require
funds to file Form N-PORT reports with the Commission within 30 days
after the end of each month. We believe that this amendment would help
the Commission to oversee funds' activities on a timelier basis. We do
not expect this part of proposal to have substantial economic effects
on funds, as funds already are required to maintain records of the
information that Form N-PORT requires no later than 30 days after the
end of each month and many funds report monthly information about their
portfolio holdings on a voluntary basis to third party data
aggregators, generally with a lag of 30 to 90 days, which in turn make
them available to investors and other data users for a fee.\499\ To the
extent it is less efficient for fund groups to submit on a more
frequent monthly basis instead of in one batch after quarter-end, the
costs borne by fund groups may marginally increase under the proposal.
---------------------------------------------------------------------------
\499\ See rule 30b1-9. Also see section II.E.1.b. and note 287.
---------------------------------------------------------------------------
The data the Commission would receive on Form N-PORT reports within
30 days of month-end would include portfolio information which,
depending on the fund, may not currently be public. To the extent this
nonpublic information was subject to a data breach before its scheduled
publication 60 days after month-end, unauthorized access could harm
shareholders by expanding the opportunities for professional traders or
others to exploit the information. However, the Commission has controls
and systems for the use and handling of the proposed modified and new
data in a manner that reflects the sensitivity of the data and is
consistent with the maintenance of its confidentiality. In addition, as
discussed below, many funds already
[[Page 77262]]
publicize their monthly holdings, which reduces the sensitivity of the
information the Commission would store confidentially, and Form N-PORT
reports would become publicly available 60 days after month-end.
b. Public Availability of Form N-PORT Data and Aggregate Liquidity
Disclosure
Currently, funds are required to make the report for the third
month of every quarter available to the public. We are proposing to
make funds' monthly reports on Form N-PORT public 60 days after the end
of each monthly reporting period. We are also proposing to require an
open-end fund to provide information regarding the aggregate percentage
of its portfolio in each of the three proposed liquidity classification
categories, which would become public on the same time frame.
Public disclosure of aggregate liquidity classifications would help
investors to assess the liquidity profile of the funds in which they
are investing, and may be more useful to investors than the narrative
liquidity disclosure the Commission adopted in 2018. The proposed
disclosure may provide more information about a fund's liquidity risk
profile to investors, thereby improving their portfolio allocation
decisions. In addition, observing other funds' aggregate liquidity
profiles might provide some information that is useful in a fund's own
liquidity classification process. These benefits may be offset to the
extent that liquidity classifications are not directly comparable
across mutual funds, although the proposal would establish minimum
standards that reduce the amount of discretion funds currently have in
classifying their investments. We expect that funds will incur one-time
and ongoing costs associated with preparing the portion of Form N-PORT
associated with the aggregate liquidity profile, as discussed in
section IV.
The proposal would triple the amount of data made available to
investors and other potential users on Form N-PORT in a given year. To
the extent that investors currently are not able to obtain monthly
portfolio data from other sources, such as fund websites or third-party
data aggregators the proposed requirement would enhance the ability of
investors to monitor funds' portfolios, which in turn may help
investors to make more efficient investment decisions.\500\ Many funds
report their monthly portfolios to third party data aggregators.
Because the data made available to data aggregators is inconsistent
across funds and time, the proposed amendment would increase
consistency of portfolio data available to investors and other data
users. To the extent that 60 days is not a long enough delay in
disclosure of portfolio data, funds may be subject to predatory trading
or ``copycatting activities'' that could potentially affect portfolio
returns.\501\ This effect may be more pronounced for funds with more
proprietary trading strategies.
---------------------------------------------------------------------------
\500\ See e.g., Ji-Woong Chung et. al., Intended Consequences of
More Frequent Portfolio Disclosure (working paper, Apr. 17, 2022),
available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4086186 (retrieved from SSRN Elsevier
database).
\501\ A recent working paper examines the costs of Form 13F
disclosure and finds that additional disclosure may harm portfolio
returns over time. See David Kwon, The Differential Effects of the
13f Disclosure Rule on Institutional Investors (working paper, May
5, 2022), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4095482 (retrieved from SSRN Elsevier
database).
---------------------------------------------------------------------------
c. Other Amendments to Forms N-PORT, N-CEN, and N-1A
We are proposing to remove the reporting requirement for swing
pricing on Form N-CEN and replace it with a new reporting requirement
on Form N-PORT that would require information about the number of times
the fund applied a swing factor during the month and the amount of each
swing factor applied. We are also proposing amendments to Form N-CEN to
identify and provide certain information about service providers a fund
uses to fulfill the requirements of rule 22e-4. In addition, instead of
classifying an RSSD ID as an LEI, we propose to provide separate line
items where a fund would report an RSSD ID, if available, in the event
that an LEI is not available for an entity. We also propose to amend
certain items and definitions on Form N-PORT to conform them to the
proposed amendments. Finally, we propose to amend Item 11(a) of Form N-
1A to require, if applicable, that funds disclose that if an investor
places an order with a financial intermediary, the financial
intermediary may require the investor to submit its order earlier to
receive the next calculated NAV. In addition, as a result of the
proposed swing pricing requirement, funds would be required to disclose
information about swing pricing in response to certain existing items
in the form.\502\
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\502\ See Items 6(d), 4(b)(2)(ii), 4(b)(2)(iv)(E), and 13(a) of
Form N-1A.
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The proposed amendments would increase transparency around funds'
activities in several ways. First, additional information about funds'
service providers would enable investors and other data users to assess
fund liquidity management practices and help the Commission oversee the
industry better. Second, information about swing pricing application
can help the Commission and investors understand swing factor
adjustments a given fund makes and evaluate how often a fund has any
net redemptions or has net subscriptions of more than 2% and the amount
of the swing factor adjustment.
The proposed amendments would impose PRA costs, as discussed in
above. Some funds may already maintain some of the information they
would be required to report under the proposal in the ordinary course
of business. However, we recognize that funds would incur some costs in
reporting the information. We recognize that, due to economies of
scale, such costs may be more easily borne by larger fund families, and
that costs borne by funds would be passed along to investors in the
form of higher fees and expenses. In addition, the proposed disclosures
of each swing factor and the number of times a swing factor was applied
may create incentives for funds to compete on this dimension.
Specifically, investors who prefer lower variability in the value of
their investments may move capital from funds that had high historical
swing factors to funds with lower swing factors. However, while NAV
swings penalize redeemers or subscribers under certain circumstances,
they benefit investors remaining in the fund, which may make funds
actively using swing pricing more attractive to longer term investors.
The proposed amendments related to entity identifying information
would help the Commission and market participants to identify entities
related to funds' businesses more efficiently.
D. Effects on Efficiency, Competition, and Capital Formation
1. Efficiency
The proposed amendments may affect allocative efficiency in several
ways. First, the proposed changes to the liquidity classification
methodology, proposed public disclosure of funds' aggregate liquidity
classifications, and swing pricing disclosures are expected to benefit
investors by reducing information asymmetries between funds and
investors. To the degree that some investors may currently be
uninformed about liquidity risks of funds' investments, the proposed
disclosure requirements may increase transparency about liquidity costs
transacting investors impose on remaining fund investors and liquidity
risks in open-end funds. To the degree that greater
[[Page 77263]]
transparency about liquidity risk of mutual funds may lead some risk
averse investors to use other instruments, in lieu of mutual funds for
long-term investment, allocative efficiency may increase.\503\ In
addition, the increased transparency may result in greater allocative
efficiency as investors with low tolerance of liquidity risk and costs
may choose to reallocate capital to funds that have lower liquidity
risk and costs. Further, to the degree that uncertainty about the
proposed swing pricing requirement may reduce the attractiveness of
affected funds to investors, transparency about historical swing
factors may reduce those adverse effects.
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\503\ See, e.g., Jennifer Huang et. al., Shifting and Mutual
Fund Performance, 24 Rev. Fin. Stud. 2575, no. 8 (2011). The paper
argues that if investors are not fully aware of risk-shifting
behavior or if the changing risk level hampers their ability to
assess fund performance, then individual portfolios are less likely
to be efficient.
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Second, market efficiency for funds' underlying investments may
increase, to the extent that the proposed amendments mitigate the risk
of runs on open-end funds and decrease fire-sales for the funds'
underlying investments. In addition, a potential shift in demand from
illiquid to liquid investments may encourage the development of market
structures that increase the liquidity of investments that are
currently less liquid. For example, currently, only a fraction of
traded bank loan interests has a standardized settlement process and
transparent prices and quotations. To the extent that the proposed
amendments would lead market participants to standardize and shorten
the settlement process for bank loan interests, the prices and spreads
for bank loans may become more transparent at a sector level,
increasing the efficiency in this market. On the other hand, the
proposed liquidity requirements may lead funds to allocate less to
these investments. Absent other frictions, the difference in demand for
these investments could be made up for by other investors or other the
same investors through other structures (such as more direct
investment). However, if this difference in demand is not fully
absorbed by other market participants, the efficiency in this market
may decrease.
Third, the hard close requirement may make portfolio allocation
less efficient for investors, to the extent that intermediaries used by
these investors would impose an earlier cut-off time for orders and
investors would not be able to reflect the entire day's market
information into their allocation decisions. In addition, to the extent
that certain types of orders would no longer be executed at today's
prices and rather would be sent to funds the next day, investors may be
exposed to additional market risk as well as potentially decreased
portfolio returns because an intermediary may hold the cash from
investors' orders submitted after the cut-off time (but before 4p.m.
ET) until it could submit these orders at the end of the next day.
The proposed amendments may affect funds' portfolio efficiency. For
example, funds may start considering the liquidity of investments and
their overall portfolios to a higher degree when making portfolio
allocation decisions and considering other factors, such as an
investment's risk and expected return, to a relatively lower degree.
This may reflect an optimal choice, to the extent that funds' investors
believe that illiquidity of a fund's portfolio is more costly relative
to the cost of foregoing less liquid portfolio investments that may
offer higher returns. On the other hand, if liquidity considerations
lead to deviations from the fund's investment strategy or benchmark
return, the proposed amendments may decrease the efficiency of funds'
portfolios.
The proposed daily classifications may also affect funds' portfolio
efficiency. On the one hand, if daily fluctuations in market values of
a fund's portfolio investments are large (and therefore the daily
changes in the dollar value of the stressed trade size is also large)
but revert to the mean within several days, liquidity classification
for the same portfolio position may also fluctuate daily while
eventually reverting to the mean. In this scenario, funds may start
managing the portfolio positions inefficiently in order to be in
compliance with the highly liquid investment minimum and the 15% limit
on illiquid investments. On the other hand, daily classifications may
increase informational efficiency of the funds' investments, to the
extent that funds' demand for daily information results in increased
availability of such information offered by third-party providers. As a
result, funds' portfolio allocation decisions may become more
efficient.
The proposed amendments may also affect operational efficiency of
funds and intermediaries. First, to the extent that the proposed
removal of the less liquid category results in an increased
standardization of settlement practices and a reduction of settlements
times for bank loan interests and other investments that are currently
classified as less liquid, a reduction in allowed settlement time for
investments in order to qualify as moderately liquid investments may
facilitate operational efficiency of funds that trade these
investments. Second, the proposed removal of the less liquid category
may facilitate operationalizing funds' swing pricing by reducing
uncertainty related to trading costs for investments that are currently
classified as less liquid. In particular, to the extent that open-end
funds will become more certain about trades' settlement dates, it may
allow them to more accurately estimate trading costs and, therefore,
more accurately estimate the swing factor. Third, intermediaries may
improve their order-processing systems as a result of the proposed hard
close requirement, improving ongoing operational efficiency for both
intermediaries and funds.\504\
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\504\ See supra section II.C.3 for additional discussion.
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2. Competition
The proposed amendments may affect the competitive landscape for
open-end funds. There are two main economic effects discussed above
that may cause the change in the competitive landscape for open-end
funds: (1) cost increases for funds, fund managers, and fund
administrators stemming from proposed changes in the liquidity risk
management program, proposed mandatory swing pricing, and the hard
close; and (2) additional constraints on funds' holdings of certain
investments that could limit these funds' investment strategies due to
proposed changes to funds' liquidity classifications, the proposed
definition of illiquid investments, and proposed changes to the highly
liquid investment minimum.
Competition within the open-end fund sector may evolve as a result
of the two effects stated above in several ways. First, to the extent
that certain funds substantially change their investment strategies
towards more liquid investments, the number of open-end funds that hold
more liquid investments may increase, and competition among those funds
for investors may increase. Conversely, competition among funds that
hold less liquid investments may decrease. These effects depend also
upon how investor demand for funds with liquid and illiquid investments
may change with the proposed amendments. Second, to the extent that
smaller open-end funds would experience a more substantial operational
burden compared to larger fund complexes that exhibit economies of
scale and may be able to set up their trading desks in a more efficient
[[Page 77264]]
manner,\505\ smaller funds may become less competitive than larger
funds. As a result, smaller funds may decide to liquidate or to convert
to other fund structures, such as ETF or closed-end structures, to the
extent such conversion would be less costly compared to remaining a
mutual fund. Third, to the extent that some open-end funds may
currently deliver higher returns because they set a lower highly liquid
investment minimum and reasonably anticipated trade size compared to
other funds with similar investment strategies but higher highly liquid
investment minimums and reasonably anticipated trade sizes, the
proposed amendments to apply uniform minimum for the stressed trade
size and highly liquid investment minimum may minimize such a
competitive advantage in performance and level the field among open-end
funds. Finally, to the extent that investors would prefer funds with
less volatile transaction prices for fund shares under the proposed
swing pricing requirement, funds with larger trading costs may become
less competitive relative to the funds with smaller trading costs.
---------------------------------------------------------------------------
\505\ See e.g., Gjergii Cici et. al., Trading Efficiency of Fund
Families: Impact on Fund Performance and Investment Behavior, 88 J.
Banking & Fin.1 (Dec. 22, 2015, rev. Jan. 12, 2016), available at
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2514203. The
authors find that by operating more efficient trading desks that
help reduce trading costs, fund families improve the performance of
their funds significantly relative to fund families with less
efficient trading desks.
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Competition for investment flows between open-end funds and other
collective investment vehicles within retail and institutional non-
retirement space may also be affected. To the extent that the proposed
amendments reduce investor dilution and the liquidity risk of open-end
funds, some investors may increase their holdings of open-end funds
relative to other investment vehicles. That said, we also recognize
that some investors may attach more importance to investing in less
liquid investments through a pooled vehicle with the ability to redeem
on a daily basis and may view potential costs of dilution as the price
of shareholder liquidity.
In addition, there are three reasons why investors may reduce their
investment in open-end funds, making open-end funds less competitive
with other types of investment vehicles, such as closed-end funds
(e.g., interval funds), ETFs, or CITs. First, holding open-end funds
may become relatively more costly compared to these other collective
investment vehicles. Second, some investors may prefer to have holdings
of less liquid investments, such as bank loan interests or investments
that are valued using unobservable inputs that are significant to the
overall measurement, such as long-dated currency swaps and three-year
options on exchange-traded shares, within a collective investment
vehicle structure. Third, some investors may be averse to the potential
effects of the proposed swing pricing requirements, such as redeeming
investors that may be charged for more than the dilutive costs they
impose on the fund, as well as any investor averse to the increased
uncertainty regarding the price at which the investor's fund
transactions will ultimately execute.
For these reasons, some open-end funds may decide to offer their
existing strategies in alternative fund structures, such as ETF or
closed-end fund structures instead of maintaining these strategies
within open-end funds under the proposed rule.\506\ Funds may make such
a determination if doing so would be more cost-efficient, if they
anticipate that investors would prefer to invest in their strategies
via these alternative structures, or if their existing strategies would
no longer be viable under the proposed amendments that call for an
increased share of more liquid investments in funds' portfolios. This
may give fund complexes or other financial institutions that have more
experience in these alternative structures a competitive advantage over
those that do not. In addition, some open-end fund strategies may be
more amenable to being migrated to other structures than others. For
example, a passive open-end fund that does not rely on specialized
skills or knowledge of a fund manager may be relatively easy to offer
as an ETF. On other hand, while some active investment strategies are
available as ETFs, funds may consider the structure less attractive if
they consider the daily revelation of their holdings undesirable and
they determine that obtaining the exemptive relief that would enable
them to structure the fund as a non-transparent ETF would be too
costly.\507\ Such funds may end up at a competitive disadvantage to
those that can more easily offer their strategies in other structures
under the proposal.
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\506\ To the extent existing mutual funds convert to ETFs,
certain investors in these funds may incur long-term capital gains
taxes as a result of such conversions.
\507\ See Precidian ETFs Trust, et al., Investment Company Act
Release Nos. 33440 (Apr. 8, 2019) [84 FR 14690 (Apr. 11, 2019)]
(notice) and 33477 (May 20, 2019) (order) and related application
(``2019 Precidian'') for an example of exemptive relief pertaining
to non-transparent ETFs.
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Competition between open-end funds and other collective investment
vehicles, such as ETFs, and CITs,\508\ as well as separately managed
accounts, within the retirement space may also be affected. As
discussed in section III.B.2, processes and systems related to
executing investors' orders within their retirement plans require
knowledge of NAVs prior to sending investors' trades to funds, and it
may be costly to change these processes. To the extent that retirement
plans can offer collective investment vehicles or ETFs that are not
open-end funds but have similar investment strategies to open-end funds
at a lower cost, open-end funds would become less competitive within
the retirement sector. One type of a vehicle that offers similar
investment strategies to open-end funds at a lower cost is CITs. CITs
differ in certain respects, however. For instance, CIT fees are bespoke
for each plan, meaning that fees are individually negotiated and a plan
participant cannot roll a CIT investment to an IRA when leaving the
plan. Recent analysis from ICI demonstrates that, as of 2018, among all
assets held in 401(k) plans, mutual funds comprise 43% while CITs
amount to 33%.\509\ To the extent that the proposed hard close
requirement would make mutual funds more costly or difficult to trade
relative to CITs, the share of CITs among retirement assets may further
grow making open-end funds less competitive.
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\508\ CITs are an alternative to mutual funds for defined
contribution plans. Like mutual funds, CITs pool the assets of
investors and invest those assets according to a particular
strategy. Unlike mutual funds, which are regulated under the
Investment Company Act of 1940, CITs are regulated under banking
laws and are not marketed as widely as mutual funds; which reduces
their operational and compliance costs compared with mutual funds.
\509\ See BrightScope/ICI working paper at 2.
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The proposed hard close requirement may have effects on competition
among intermediaries. First, to the extent that intermediaries that are
affiliated with fund complexes have an advantage in processing fund
orders more swiftly compared to intermediaries that are not affiliated
with the funds they offer, the former may not have to impose earlier
order deadlines on investors, which would result in competitive
advantage over intermediaries that are not affiliated with the funds
they offer. Second, to the extent that larger intermediaries enjoy
economies of scale and would be able to implement the hard close in a
more cost-effective way relative to smaller intermediaries, smaller
intermediaries may become less competitive as they may have to pass
[[Page 77265]]
the implementation costs on to their investors.
To the extent that daily classifications would require a more
frequent use of liquidity classification providers, demand for
liquidity classification providers may increase. To the extent that
funds would expand their outsourcing of liquidity classifications,
competition among outside liquidity classification providers may
increase. However, to the extent that some liquidity classification
providers currently used by funds have operational capacity only for
less frequent than daily provision of services, they may become less
competitive compared to those that can provide the service on a daily
basis.
The proposed amendments may also affect competition in markets for
funds' underlying investments. To the extent that open-end funds would
change their overall portfolio towards more liquid investments as a
result of the proposed amendments, and to the degree that such
reallocation would be correlated across funds, competition in the
markets for more liquid investments may increase, while competition in
market for less liquid investments may decrease, which may further
decrease the liquidity of these investments. For example, the proposed
removal of the less liquid category may affect competition in the
secondary market for bank loan interests. To the extent that open-end
funds would demand bank loan interests that are more liquid and
standardized in terms of the settlement process, competition in the
bank loan market may be affected--both among the loan issuers and loan
administrators. Specifically, increased demand for shorter settlement
may drive bank loan market participants to compete with each other via
offering shorter settlement for their trades, including among
counterparties who are willing to contract for expedited settlement, to
the extent that 15% of bank loan interests held by open-end funds \510\
is a substantial enough share of the bank loan market for funds to have
bargaining power in this market. To the extent that settlement times do
not improve as a result of this amendment, bank loan interests with
longer settlement times may become less competitive with loan interests
that have shorter settlement times. Third, to the extent that open-end
fund investors would substitute funds that hold bank loans for funds
that hold close alternatives, such as high-yield bond funds, as a
result of the proposal, demand for funds holding these instruments may
increase. In addition, to the extent that open-end funds become more
limited in how much of bank loan interests they can hold directly,
open-end funds may increase their holdings of CLOs, which in turn could
increase demand for CLOs and competition among CLOs. Finally, to the
extent that the demand for bank loan interests decreases as a result of
the proposal, these instruments would become less competitive overall.
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\510\ See note 422 and accompanying text.
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3. Capital Formation
The proposed amendments may affect capital formation. First, to the
extent that the above efficiency and competition effects result in
investor outflows from the mutual fund sector, capital formation within
the sector may be reduced, while capital formation via banks and trust
companies, ETFs, or other vehicles may increase. Second, to the extent
that open-end funds would demand more liquid investments, the capital
formation for issuers of these investments may increase. On the other
hand, to the extent that funds would become more limited in the amount
of investments with lower liquidity profiles they are able to make
(such as investments that are valued using unobservable inputs that are
significant to the overall measurement and investments that are
currently classified as less liquid and illiquid), the capital
formation for issuers of investments that are currently classified in
less liquid categories may decrease.
For example, a recent paper \511\ shows that, although CLOs (the
largest lender of leveraged loans) increase their purchases of
outstanding bank loan interests in the secondary market at times when
bank loan funds face outflows, they reduce their lending in primary
market at the same time; which highlights the externality imposed by
bank loan fund redemptions on capital formation for non-investment
grade firms. Therefore, to the extent that open-end funds would hold
fewer bank loans in their portfolios as a result of this amendment, the
externality discussed above may be reduced and capital formation for
non-investment grade firms could improve. On the other hand, to the
extent that market settlement processes do not change, and to the
extent that open-end bank loan funds are not converted to closed-end
funds, the demand for bank loan interests may decrease, reducing
capital formation for non-investment grade firms. This effect may be
more pronounced for smaller issuers, to the extent that their
securities are classified into less liquid categories more frequently
compared to larger issuers.
---------------------------------------------------------------------------
\511\ Thomas M[auml]hlmann, Negative Externalities of Mutual
Fund Instability: Evidence from Leveraged Loan Funds, 134 J. Banking
& Fin. (2022).
---------------------------------------------------------------------------
Finally, the proposed amendments are expected to decrease the risk
of fire sales of funds' underlying investments that may occur as a
result of an increased selling pressure experienced by open-end funds
during periods of high redemptions. This, in turn may increase
confidence in markets for investments held in open-end funds'
portfolios, thereby aiding capital formation for these investments.
E. Alternatives
1. Liquidity Risk Management
a. Stressed Trade Size and Significant Changes in Market Value
Although tightening of inputs would reduce fund discretion in the
methodology for liquidity classification relative to the baseline,
funds would still have discretion in the use of models to calculate
price impact under the proposal. One alternative that could alleviate
this concern would be to define a list of investments that qualify as
highly liquid investments explicitly, as well as the list of illiquid
investments or to define liquidity of each security, regardless of its
amount held by a fund. For example, we could define highly liquid
investments similarly to the way Federal banking agencies define high
quality liquid assets (``HQLA'') for the purposes of liquidity coverage
ratio rules.\512\ This approach would simplify funds' compliance and
may eliminate the need to calculate reasonably anticipated trade size
or stressed trade size. As a result, an investment would be more
consistently classified across funds, regardless of the amounts of this
investment held by each fund. However, this approach would put the
Commission in the position of determining the liquidity of each
investment or investment type in the market, which may be difficult to
[[Page 77266]]
maintain over time and may over- or under-include securities that may
demonstrate equal liquidity characteristics, as this alternative regime
only covers HQLA and not all investments that could be held by a fund.
---------------------------------------------------------------------------
\512\ See 12 CFR 50.20 (Office of the Comptroller of the
Currency); 12 CFR 249.20 (Federal Reserve Board); 12 CFR 329.20
(Federal Deposit Insurance Corporation). HQLA are composed of Level
1 and Level 2 assets. Level 1 assets generally include cash, central
bank reserves, Treasuries, certain agency securities, and certain
marketable securities backed by sovereigns and central banks, among
others. Level 2 assets are composed of Level 2A and Level 2B assets.
Level 2A assets include, for example, certain debt guaranteed by a
government sponsored entity or by a sovereign entity. Level 2B
assets include, for example, investment grade corporate bonds, and
publicly traded common equities that meet certain conditions, and
investment grade municipal obligations. See also Bank for
International Settlements (BIS), Basel Committee on Banking
Supervision, LCR30 High-Quality Liquid Assets (final report, Dec.
31, 2019), available at https://www.bis.org/basel_framework/chapter/LCR/30.htm?tldate=20191231&inforce=20191215.
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As an alternative, we could have proposed a higher level of STS.
For example, an STS that is equal to 100% would assume a full
liquidation of a position. Under this alternative, the classification
of an investment would depend on the absolute value of the whole
position rather than a percentage of a position. This approach may more
accurately reflect liquidity needs during the times of increased
redemptions, to the extent that funds sell their most liquid holdings
first in order to meet redemptions.\513\ An STS that is higher than 10%
but lower than 100% would have the effect that is similar but lower in
magnitude. While a higher STS might better reflect that funds may need
to sell a higher fraction of a particular investment than 10%, it
nonetheless could be the case that a 10% STS is a better measure for
determining liquidity under the proposed requirement for vertical slice
assumption.
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\513\ For example, if a fund experiences net outflows equal to
10% of its net assets, and the fund's highly liquid assets comprise
20% of its portfolio, the fund would be able to fund all outflows
with the proceeds from highly liquid assets. On the other hand, a
10% STS would test whether 10% x 20% = 2% of the fund's holdings
could be sold without significantly changing the price of these
holdings in order to meet redemptions. In this scenario, the fund
may need to sell additional holdings that may be more costly to
trade due to their lower liquidity classification.
---------------------------------------------------------------------------
As another alternative, we could have proposed a lower level of
STS. To the extent that some funds currently set their reasonably
anticipated trade size lower than 10%, these funds may experience less
changes in the classifications of their investments, which may result
in less portfolio adjustments in order to comply with the 15% limit on
illiquid investments and the highly liquid investments minimum.
However, we believe that the 10% STS has the advantage of simulating a
stress event and would better prepare funds to accommodate redemptions
during such events. We seek comment on whether a level of STS lower
than 10% would be a more appropriate STS that would ensure funds
classify their investments in a way that would safeguard the fund and
its shareholders during stressed times.
As another alternative, we could have proposed an STS that would
depend on an individual fund's flows. For example, each fund could be
required to use an STS that is equal to a certain percentile (e.g.,
99th percentile) of the fund's highest week of absolute flows or net
outflows over a specified period of time (e.g., 3, 5, or 10
years).\514\ Under this alternative, funds would have a liquidity
classification approach that is more tailored to their strategy and
investor base. This approach would be less discretionary compared to
the baseline but more discretionary compared to the proposal. To the
extent that some funds may never experience net outflows that amount to
10% of their net assets, this alternative could be more appropriate for
such funds. However, this alternative may result in inconsistent
classifications among funds that have similar holdings. For example, if
an established fund and a new fund have identical portfolios, the new
fund would not have the same level of historical flows as the
established fund, to the extent that the established fund existed
during periods of stress and the new fund did not. This would result in
two different STSs for identical funds.
---------------------------------------------------------------------------
\514\ Basing the calculation on absolute, rather than net, flows
would be designed to reflect that large inflows have the possibility
of translating to similarly large outflows.
---------------------------------------------------------------------------
As another alternative, we could have proposed an STS that would
differ for funds with different investment strategies. For example,
because during times of stress certain investments generally remain
relatively liquid, we could have proposed a lower STS for funds with
strategies that generally invest in more liquid assets, such as certain
equities or government securities. However, under certain
circumstances, large concentrations of any asset type (including those
assets that are generally very liquid) held by a fund may weaken the
fund's ability to dispose of such assets without a significant cost
imposed on the fund's investors.\515\ Therefore, we believe that
requiring funds with different types of strategies to have the same STS
would appropriately prepare all funds for stress events. In addition,
although this approach would be more tailored to net flows trends
specific to particular types of funds, this alternative may result in
inconsistent application of the STS because there is no single taxonomy
of fund types and there would be limited utility in proposing a new
taxonomy given the previously noted concerns about an approach that
differs by fund type.
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\515\ For example, during Mar. 2020, the U.S. Treasury market
became less liquid than usual.
---------------------------------------------------------------------------
For determining whether a sale or disposition would significantly
change the market value of an investment, we could have proposed a
higher or lower value impact standard. For example, we could have
proposed that a sale or disposition of less than or more than 20% of a
security listed on a national securities exchange or foreign exchange,
or a decrease in sale price of less than or more than 1% for other
investments, would result in a significant change in market value.
Setting a stricter test for what would constitute a significant change
in market value may lead funds to classify investments as less liquid
than under the proposed rule, and correspondingly, setting a more
lenient test would lead to more liquid classifications. Because funds
currently use different value impact standards today, increasing or
reducing the thresholds in the rule may align with some funds' current
practices, while the proposed rule may align with other funds' current
practices. Therefore, any approach to defining the value impact
standard would require some funds to change their current
methodologies.
b. Amendments to Liquidity Classification Categories and Definitions
As an alternative, we could have proposed an approach that provides
additional time, beyond seven calendar days, for a sale to settle and
convert to U.S. dollars before a fund must classify the investment as
illiquid. For example, we could have proposed to define moderately
liquid investments as those that a fund reasonably expects to be able
to sell within seven days without a significant change in market value
and to be convertible to U.S. dollars within an additional seven days.
Under this alternative, all the economic effects of removing the less
liquid investment category discussed above would still be present,
however, their magnitude may be reduced. As a result, not as many bank
loan funds would have to rebalance their portfolios towards shorter-
settlement loans and other investments, contract for expedited
settlement, or restructure as a different investment vehicle. At the
same time, the potential need to arrange expedited settlement to meet
redemptions in the midst of market stress, as well as the potential
borrowing costs a fund incurs to meet redemptions and the resulting
dilution of fund investors, would not be reduced by as much as it would
under the proposal. Therefore, we believe that aligning the time it
takes to receive proceeds from the trade with the statutory requirement
to meet investor redemptions within seven days would be a more
economically sound step towards helping to ensure funds can meet
redemptions within seven days and reducing investor dilution.
We could have proposed that a fund start measuring the number of
days in
[[Page 77267]]
which it reasonably expects a stressed trade size would be convertible
to U.S. dollars without significantly changing its market value after
the date of classification, instead of on the date of classification as
proposed. Under this alternative, funds' liquidity classifications
would be marginally less liquid. We understand some funds are using
this method of counting the number of days currently and would not have
to make any changes to their methodology; however, those funds that
begin counting on the date after classification would need to make
changes and their classifications would be more liquid than they are
currently. We believe that funds should measure days consistently in
order to help funds meet redemptions within seven days without
significant trading costs.
c. Frequency of Liquidity Classifications
As an alternative, we could have proposed to require classification
on a less frequent basis, for example, weekly. Under this alternative,
funds would have less operational burden relative to the proposed daily
classification requirement. In addition, to the extent that portfolio
allocations of funds are noisy on a daily basis due to, for example,
trading related to tracking errors or inability to invest newly
incoming cash from investors immediately, weekly classifications may be
more appropriate from an operational perspective. However, weekly
classifications could reduce the effectiveness of the rule by delaying
the identification of significant liquidity issues, such as a rise in
illiquid investments or a drop in highly liquid investments,
particularly at the onset of market stress when a fund might begin to
face increasing levels of redemptions. Therefore, we believe daily
classifications would promote better monitoring of a fund's liquidity
and ability to more rapidly understand and respond to changes that
affect the liquidity of the fund's portfolio.
d. Definition and Calculation of Highly Liquid Investment Minimum and
Proposed Limit on Illiquid Investments
As an alternative, we could have proposed different highly liquid
investment minimums for different type of funds, with lower highly
liquid investment minimums for funds with strategies that generally
invest in more liquid assets, such as equities or government
securities. However, under certain circumstances, large concentrations
of any asset type (including those assets that are generally very
liquid) held by a fund may weaken the fund's ability to dispose of such
assets without a significant cost imposed on the fund's investors.\516\
Therefore, we believe that requiring funds with different types of
strategies to have a highly liquid investment minimum of at least 10%
would appropriately prepare all funds for stress events. In addition,
although this approach would be more tailored to net flows trends
specific to particular types of funds, this alternative may result in
the inconsistent application of highly liquid investment minimums
because there is no single taxonomy of fund types and there would be
limited utility in proposing a new taxonomy given the previously noted
concerns about an approach that differs by fund type.
---------------------------------------------------------------------------
\516\ See note 515.
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As another alternative, we could have proposed to require funds to
maintain a highly liquid investment minimum that is lower or higher
than the proposed 10% minimum, such as a minimum of at least 5% or 15%.
A lower required threshold would require fewer changes to some funds'
portfolios and would be less likely to affect performance. However, a
lower minimum would result in funds being less prepared to meet
redemptions in stressed periods. A higher highly liquid investment
minimum would better ensure that a fund can meet redemptions in
stressed periods, but would require more significant changes to some
funds' portfolios and would likely have a larger effect on fund
performance. Further, to the extent that certain funds would benefit
from a highly liquid investment minimum that is greater than 10%
because, for example, they have a concentrated shareholder base, such
funds could establish a higher minimum under the proposal. Similarly,
we considered a lower limit on a fund's illiquid investments, such as a
5% or 10% limit. The alternatives would further limit a fund's ability
to acquire illiquid investments, which would limit the mismatch between
the time a fund must pay redemptions and the time it can sell its
investments without significant dilution. However, lowering the limit
on illiquid investments while also expanding the definition of illiquid
investment would more significantly affect funds that currently invest
in less liquid investments.
As another alternative, we could have proposed to define
investments used for collateral and margin purposes of moderately
liquid and illiquid investments as moderately liquid and illiquid
respectively. However, by reducing the fund's highly liquid investments
by the value of amounts posted as margin or collateral, the proposed
approach would avoid burdens associated with tracking specific
securities posted as margin or collateral and reclassifying investments
as they are posted as margin or collateral and recalled. The proposed
approach also would not understate the liquidity of securities that are
posted as margin or collateral because each security would continue to
be classified based on its own characteristics rather than based on the
characteristics of the derivative it is tied to, and instead the
adjustments would only be made at the aggregate level.
2. Swing Pricing
This section discusses alternatives to the proposed swing pricing
requirements. These alternatives include variations on the swing
pricing requirements, variations on the thresholds used to determine
the swing factor, and tools other than swing pricing that may achieve
some of the same anti-dilutive goals of the proposed rule. These
alternatives could be used independently or in combination with each
other, and also could be paired with a hard close or the alternatives
to the hard close we discuss in the next section, depending on the
degree to which a given alternative does or does not require a fund to
have complete order flow information at the time a fund strikes its
NAV.
a. Alternative Approaches Within the Swing Pricing Framework
As an alternative, we could have proposed different thresholds for
net redemptions, net subscriptions, and inclusion of market impact. For
example, we could have required funds to adjust the NAV only when net
redemptions exceed a specified swing threshold, allowing funds to not
adjust the NAV at all when redemptions are low in magnitude, as the
proposal does for net subscriptions. To the extent that determining a
swing factor is costly, only requiring funds to do so when net
redemptions exceeded a threshold would limit the frequency with which
funds incur such costs. However, because net redemptions are likely to
dilute fund shareholders by a larger magnitude compared to net
subscriptions, such an alternative may forego some of the benefits non-
transacting fund shareholders would be expected to receive under the
proposal.
The proposal also could have used a different market impact
threshold, or no threshold, requiring that funds always include market
impact in their swing factor calculations. A higher (lower) market
impact threshold would reduce (increase) the number of days for which
[[Page 77268]]
affected funds must calculate market impact costs for their portfolio
investments, reducing (increasing) any related costs and operational
challenges. However, a higher (lower) market impact threshold would
also reduce (increase) the amount of dilution from redemptions that is
recaptured by funds and accrued to non-transacting shareholders,
assuming some funds do not opt to set lower market impact thresholds,
as permitted under the proposal.
Similarly, the proposal could have used a different swing threshold
for net subscriptions, or no threshold, requiring that funds always
adjust their NAV in response to net subscriptions. A higher (lower)
threshold for net subscriptions would reduce (increase) the number of
days for which affected funds must calculate swing factors, reducing
(increasing) any related costs and operational challenges. However, a
higher (lower) threshold for net subscriptions would also reduce
(increase) the amount of dilution from subscriptions that is recaptured
by open-end funds and accrue to non-transacting shareholders, assuming
some funds do not opt to set lower threshold for net subscriptions, as
permitted under the proposal.
As another alternative, we could have required that funds only
apply a swing factor when they experience net redemptions rather than
requiring that they also apply a swing factor when net subscriptions
exceed 2%. Removing the requirement that funds apply a swing factor for
net subscriptions would remove any operational costs funds may incur in
implementing swing pricing for net subscriptions and may reduce the
uncertainty that subscribing investors face regarding the share price
at which their subscription orders will ultimately transact. However,
while we recognize that subscriptions tend to be less dilutive than
redemptions, the trading costs incurred by funds to accommodate
subscriptions can still be dilutive. Therefore, non-transacting
investors would be exposed to more dilution risk under this
alternative.
As an alternative, the proposal could have also permitted funds to
use a default swing factor (e.g., 2% or 3%) when estimating trading
costs accurately may be more difficult, such as in times of market
stress. A fund's swing pricing administrator, adviser, or a majority of
the fund's independent directors could be permitted to determine
whether market conditions are sufficiently stressed to invoke this
default swing factor. This alternative could benefit investors by
mitigating shareholder dilution during periods of increased market
uncertainty when standard analyses that funds use to estimate trading
costs may fail to capture these costs accurately, to the extent that
the standard analyses result in underestimation of trading costs.
However, this alternative would provide funds with more discretion in
determining when their swing factor applies in a way that is less
transparent and consistent for fund shareholders, which increases the
chance that funds may take advantage of such discretion in order to
boost the performance of a fund. In addition, a default swing factor
may not be a good approximation of the actual trading costs a fund will
incur during the periods it is applied, which could either overcharge
transacting investors relative to the trading costs they impost on a
fund or undercharge transacting investors, limiting the extent to which
non-transacting shareholder dilution is mitigated.
As another alternative, the proposal could have defined the market
impact threshold or inflow swing threshold on a fund-by-fund basis,
with a reference to a fund's historical flows. For example, each fund
could have been required to determine the trading days for which it had
its highest outflows over a set time period, and set its market impact
threshold based on the 1-5% of trading days with the highest
redemptions. Similarly, each fund could have been required to determine
the trading days for which it had its highest inflows or outflows over
a set time period, and set its inflow or outflow swing threshold based
on the 1-5% of trading days with the highest redemptions or
subscriptions. While this alternative could allow funds to customize
their swing thresholds to their historical flows, such an alternative
may create strategic incentives for fund complexes to open and close
funds depending on historical transaction activity. For example, to the
degree that the estimation of market impact factors or other trading
costs may be costly, or to the extent that investors prefer funds that
do not apply swing factors as frequently, fund families may choose to
close funds that experienced high redemptions to avoid the application
of market impact factors. In addition, allowing funds to determine
their own thresholds based on historical data may lead to less
comparability across funds with respect to when investors expect funds
to incorporate market impact or swing their NAV in response to net
subscriptions or net redemptions.
b. Alternatives to Swing Pricing
i. Liquidity Fees \517\
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\517\ See also section II.D.1.a for additional discussion of
liquidity fee alternatives.
---------------------------------------------------------------------------
As an alternative to the proposed swing pricing requirement, we
could have proposed to require funds to charge liquidity fees to
transacting investors. There are various types of fees that we
considered, which are discussed below.
(a) Dynamic Liquidity Fee
As an alternative, we could have proposed a dynamic liquidity fee
that could, in principle, be equivalent to swing pricing from the point
of view of the transacting investor. For example, this alternative
could charge transacting investors the estimated trading, spread, and,
in some cases, market impact costs associated with their subscription
or redemption activity, allowing remaining shareholders to recoup these
costs and mitigate dilution. Under this alternative, like under the
proposed swing pricing framework, a fund would be required to determine
a given day's liquidity fee for subscribers or redeemers based on the
fund's net flows. Specifically, on a day with net redemptions
(subscriptions), the fund would determine a liquidity fee that reflects
the costs redeeming (subscribing) investors are expected to impose on
the fund and would only charge redeeming (subscribing) investors the
fee.
From an economic (namely non-operational) perspective, the
difference between a liquidity fee and swing pricing is the effect on
subscribing (redeeming) investors when a fund experiences net
redemptions (subscriptions) and how the anti-dilution benefit is shared
among transacting and non-transacting fund investors. Specifically,
under swing pricing, in the case of net redemptions, subscribing
investors would purchase fund shares at a discount relative to the NAV
because there will be only one transaction price for fund shares
determined by swing pricing. Similarly, in the case of net
subscriptions, redeeming investors would receive a premium for their
redeemed shares because the transaction price for fund shares would be
adjusted above the NAV. As a result, some of the recouped dilution
costs from net redemptions (subscriptions) are diverted to other
transacting investors--subscribers (redeemers)--rather than to non-
transacting fund investors.\518\ If the fund
[[Page 77269]]
charges a liquidity fee, on the other hand, subscribing (redeeming)
investors would not be purchasing (selling) fund shares at a discount
(premium) in the case of net redemptions (subscriptions). Instead, the
fee would be borne by redeemers (subscribers) without the commensurate
benefit to subscribers (redeemers) and would fully accrue to the fund
instead.\519\ From this perspective, a liquidity fee may be fairer to
redeeming (subscribing) fund investors in the case of net redemptions
(subscriptions) compared to swing pricing. In addition, relative to
swing pricing, liquidity fees would be more transparent regarding the
liquidity costs transacting investors are charged and would not change
day-to day fund returns that investors observe.\520\
---------------------------------------------------------------------------
\518\ Under the proposed swing pricing requirement, a fund would
still recoup the full dilution costs associated with net redemptions
by charging redeemers for both the dilution cost of redemptions as
well as the cost of allowing subscribers to fund shares at a
discount when the fund experiences net redemptions. Similarly, a
fund would still recoup the full dilution costs associated with net
subscriptions by charging subscribers for both the dilution cost of
subscriptions as well as the cost of allowing redeemers to sell
shares at a premium when the fund experiences net subscriptions in
excess of 2%.
\519\ See e.g., Eaton Vance Comment Letter at https://www.sec.gov/comments/s7-16-15/s71615-151.pdf for a description of
mechanics and an assertion that fees are economically superior.
\520\ We recognize that while swing pricing may change the
returns that investors see on a daily basis, it would not change
monthly returns and returns reported on a fund's statement relative
to a fee.
---------------------------------------------------------------------------
However, liquidity fees may be more operationally challenging to
implement relative to the proposed swing pricing requirement. With
swing pricing, a fund can pass liquidity costs on to redeeming or
purchasing investors via downward or upward adjustments in the NAV to
determine the transaction price for fund shares, with intermediaries
receiving this price at the end of the trading day. With a liquidity
fee, however, a fund would have to rely on intermediaries to pass the
liquidity costs on to transacting investors, which may involve greater
operational complexity for intermediaries compared to swing pricing.
While we recognize that some funds and their intermediaries are
currently able to apply redemption fees under rule 22c-2, applying
dynamic liquidity fees that may change in size from day-to-day may
involve greater operational complexity and costs. For instance,
liquidity fees may require more coordination with a fund's
intermediaries because these fees need to be imposed on a transaction-
by-transaction basis by each intermediary involved--which may be
difficult with respect to omnibus accounts that intermediaries may
create to aggregate all customer activity and holdings in a fund. We
could instead require intermediaries to submit purchase and redemption
orders separately to transact in a fund's shares, as some
intermediaries already do. This could allow funds or their transfer
agents to apply fees directly, but this type of requirement would also
require some intermediaries to make operational changes because they
would no longer be able to net otherwise offsetting customer purchases
and redemptions.
As noted above, this type of dynamic fee would depend on fund flow
information. A dynamic fee could be applied at the time of an investor
transaction, in which case a hard close would still be required so that
a fund has complete flow information by the time the NAV is struck,
allowing the fund to determine the corresponding dynamic fee.
Alternatively, the fee could be processed separately and applied to an
investor's account on a delayed basis, obviating the need for a hard
close because funds would no longer need complete flow information at
the time of the initial investor transaction.\521\ Delayed application
of the fee, however, may raise complications related to collecting fee
amounts from investors, particularly when an investor has otherwise
redeemed the full amount of its holdings. Follow-on fees also
significantly increase the number of transactions to process, and may
complicate reporting for custodians and advisers in situations where a
transaction may occur in one reporting period but the fee related to
the transaction is not applied until the next reporting period. In
addition, an intermediary may face difficulties projecting upcoming
cash balances in its client accounts if there are upcoming fees to be
charged, but the amounts of those fees are unknown. The fund itself may
also have challenges with projecting its own cash balance if it cannot
predict when accrued fees will be received from each intermediary.
---------------------------------------------------------------------------
\521\ See also section II.D.1.a for additional discussion of
delayed fee application.
---------------------------------------------------------------------------
(b) Set Fee
Another alternative could be a simple fee framework that would
require funds to charge a set fee of a specified percentage of the
transaction (e.g., 1%). This fee could be designed to either apply for
all investor transactions, apply if redemptions or subscriptions exceed
certain thresholds, or apply only on the redemption side or only on the
purchase side. Such an alternative could reduce the operational burdens
imposed on funds with respect to estimating trading costs and market
impact and, in the case of a fee that is always charged, also would not
require that a fund receive full order flow data before its NAV is
struck. However, this alternative could also lead funds to over- or
under-charge transacting investors because the trading costs a fund
experiences for a given level of net redemptions or subscriptions may
vary nonlinearly with the size of net redemptions or net subscriptions.
For example, a fund trading to accommodate relatively small redemptions
or subscriptions would most likely not result in market impact costs,
while accommodating substantial redemption or subscription activity
might result in market impact costs. As a result, a fund might
undercharge transacting investors relative to the trading costs their
activity imposes on a fund in cases when the set fee is lower than the
trading costs implied by the fund's aggregate investor activity.
Therefore, in such instances this alternative may be less effective
than swing pricing at mitigating dilution. Similarly, a fund might
overcharge transacting investors relative to the trading costs their
activity imposes on a fund in cases when the set fee is higher than the
trading costs implied by the fund's aggregate investor activity, non-
transacting investors are enriched at the expense of transacting
investors. If such a set fee could be calibrated correctly, the effects
of under- or over-charging transacting investors might offset each
other. However, perfectly calibrating a fee would require that a fund
correctly forecast the likelihood and magnitude of net redemptions and
net subscriptions, as well as the corresponding trading costs
associated with such flows, which may not be feasible.
(c) Fee Adjusted for Bid-Ask Spreads or Other Transaction Costs
Relatedly, another simpler liquidity fee alternative could still
use fees that are dynamic in the sense that they respond to market
conditions such as bid-ask spreads or other known transaction costs
associated with trading underlying investments, but are not tailored to
the order flow a fund receives on a given day. For example, a fund
could charge a liquidity fee on both subscriptions and redemptions on a
given day that reflects the estimated costs of buying and selling the
fund's underlying assets, respectively, excluding factors that depend
on order flow, such as market impact. Such an alternative would still
require funds to estimate trading costs, but would not require that a
fund receive full order flow data before its NAV is struck.
Economically, this alternative is equivalent to dual pricing, discussed
[[Page 77270]]
below, which instead charges these costs by establishing separate
transaction prices for subscriptions and redemptions.
(d) Liquidity Fee When Trading Costs Significantly Increase \522\
---------------------------------------------------------------------------
\522\ See also section II.D.3.b for additional discussion of
this alternative.
---------------------------------------------------------------------------
As another alternative, we could have proposed a liquidity fee that
would only apply under certain conditions, such as when trading costs
are significantly above those typically experienced. Under this
approach, either the Commission could define the circumstances that
would trigger the fee or funds could define the conditions under which
the fee would apply. In the latter case, a fund would establish written
policies and procedures designed to mitigate dilution and recoup the
costs the fund reasonably expects to incur as a result of shareholder
redemptions.
In both scenarios, this alternative may be less costly for funds
relative to the above alternatives, to the extent that applying the fee
less frequently is less operationally burdensome. Under this
alternative, funds would be able to recoup trading costs when these
costs significantly increase (e.g., during periods of market stress),
without increasing the costs of operation during other times. The
benefits of this approach to investors would depend on the relative
magnitude of dilution realized during normal periods when trading costs
are not significantly increasing versus the cost of applying an anti-
dilution tool on a daily basis. To the extent that dilution during
normal times is negligible while the operational burden of applying the
fee is not, a fee that applies only when trading costs increase
significantly may benefit fund investors. However, to the extent that
dilution during normal times can accumulate to a significant amount
over time, fund investors would not be protected against it. The
benefit of this alternative would also depend on whether the specified
conditions that trigger the fee could be anticipated by investors prior
to the fund imposing the fee. To the extent that investors would be
able to forecast that a fund is moving closer to the fee trigger, they
may decide to preemptively redeem their shares before the fee is
initiated, potentially exacerbating the first-mover advantage and
contributing to further fund stress.
The economic tradeoffs of this alternative would also depend on
whether a fund defines the circumstances under which the fee would
apply or the Commission would define such circumstances. Under the
first scenario, funds would be able to tailor the triggers to their
specific circumstances, such as the fund size, the portfolio
characteristics, and investor base composition, as well as the
historically observed dilution. As a result, funds may be better
equipped to protect their investors during times of increased trading
costs. However, under this scenario, fund discretion over the fee
triggers may result in some funds defining triggers in a suboptimal way
in order to compete with similar funds for investors. Under the second
scenario, funds would not have such discretion, which could better
protect investors from dilution. However, because mutual funds vary
significantly in their portfolios and sizes, it would be challenging to
establish a trigger that is not dependent on timely flow information
and would equally protect investors of all funds from dilution.
(e) Liquidity Fee for Funds That Are Not Primarily Highly Liquid When
Trading Costs Increase Significantly
As another alternative, we could have proposed a liquidity fee only
for certain types of funds. For example, we could have proposed a fee
that funds that are not primarily highly liquid (e.g., funds that hold
less than an identified percentage of their portfolio in highly liquid
assets, such as less than 50%, 66%, or 75%) would be required to impose
during periods of increased trading costs. Under this alternative,
affected funds and their investors would experience similar benefits
and costs as in the alternative above. However, the aggregate magnitude
of these effects would be smaller because it would not affect all
mutual funds. To the extent that funds that invest primarily in highly
liquid investments do not experience trading cost increases that are as
substantial as all other funds during periods of market stress, this
alternative may benefit investors in primarily highly liquid funds by
not imposing additional costs related to establishing policies and
procedures related to the liquidity fee. However, all funds would have
to establish procedures for monitoring whether they hold primarily
highly liquid investments or not.
The cost savings of this alternative relative to the alternative
that would require a fee for all funds during periods of increased
trading costs would depend on how often highly liquid investments may
become temporarily less liquid. To the extent that funds expect certain
investments that are highly liquid during normal times to become less
liquid during stress periods, these funds may have to preemptively
establish compliance around the liquidity fee implementation. This
effect would be more pronounced for funds that are near the 50%
threshold.
This alternative may also affect competition in the mutual fund
sector, to the extent it could make investment in mutual funds that are
not primarily highly liquid less attractive to investors. In addition,
some funds may exit some of their moderately liquid and illiquid
investments in order to fall under the definition of primarily highly
liquid. This, in turn, may make markets for moderately liquid and
illiquid investments more illiquid and negatively affect capital
formation for these investments.
ii. Dual Pricing \523\
---------------------------------------------------------------------------
\523\ See also section II.D.1.b for additional discussion of
this alternative.
---------------------------------------------------------------------------
As an alternative to the proposed swing pricing requirement, we
could have required that funds implement dual pricing, which is used in
some other jurisdictions. Dual pricing would effectively set two
transaction prices for a fund: one price for purchases and another for
redemptions. The price adjustments for the funds' shares could either
be constant or calculated to reflect the estimated costs of buying and
selling the fund's underlying investments, excluding factors that
depend on order flow, such as market impact. The first approach would
be similar to one of the set fee alternative discussed above, as it
would be less reliant on fund flow information than the proposed swing
pricing requirement, but the charge imposed on transacting investors
would also less accurately reflect the specific liquidity features of
the fund's current investments in light of the size of the redemptions
the fund is experiencing. As an example of the second approach, a fund
would set its purchase price to be the fund's NAV on that day plus an
amount that reflects the potential trading costs such as bid-ask
spreads that subscriptions impose on a fund given current market
conditions, and exclude factors such as market impact that may require
knowledge of the fund's order flow on that day. Similarly, the
redemption price of a fund share would be the fund's NAV minus an
amount that reflects the potential trading costs redemptions would
impose on a fund given current market conditions. Operationally, dual
pricing would not require that funds receive complete order flow data
prior to determining their dual transaction prices, removing the need
for a hard
[[Page 77271]]
close. However, dual pricing would require intermediaries and other
market participants to update their processes to handle two potential
transaction prices rather than a single NAV, which would impose costs
on such intermediaries. In addition, intermediaries that currently
submit a single net order (e.g., using omnibus accounting) would need
to separately submit aggregate purchases and aggregate redemptions to a
fund, which would impose costs on such intermediaries.
iii. Spread Cost Adjustment on Days With Estimated Net Outflows \524\
---------------------------------------------------------------------------
\524\ See also section II.D.3.a for additional discussion of
this alternative.
---------------------------------------------------------------------------
Another alternative to the proposed swing pricing requirement would
be to require that funds use estimated flows to determine whether they
expect to have net redemptions on a given day and, if so, to require
that the fund adjust its current NAV to reflect good faith estimates of
spread costs.\525\ This alternative would not require funds to assess
market impact, nor would it require that funds use swing pricing on
days when a fund estimates that there will be net subscriptions. By
setting the price for fund shares to reflect good faith estimates of
spread costs on days when a fund estimates it will have net outflows,
the fund would protect non-transacting investors from dilution due to
the spread costs, to the extent that the fund correctly estimates the
direction of the net flows. This approach could ameliorate first-mover
advantage because redeeming shareholders would be required to pay at
least the spread component of transaction costs imposed on the fund by
their redemptions on days where the fund accurately predicts that it
will experience net redemptions. As a result, this alternative may help
to mitigate run risk and potential fire sales of funds' portfolio
holdings. However, basing the decision to apply a spread cost
adjustment on estimated flows may reduce the effectiveness of this
alternative by possibly causing the fund to adjust its share price down
on days where transacting investors ultimately do not dilute remaining
fund shareholders. While applying a spread cost adjustment on days when
a fund incorrectly predicts net redemptions could result in more
shareholder dilution than if an adjustment had not been applied, this
possibility would not impede the effectiveness of the alternative to
mitigate first-mover advantage.
---------------------------------------------------------------------------
\525\ U.S. GAAP states that if an asset measured at fair value
has a bid price and an ask price (for example, an input from a
dealer market), the price within the bid-ask spread that is most
representative of fair value in the circumstances shall be used to
measure fair value, and that the use of bid prices for asset
positions is permitted but not required for these purposes. See FASB
ASC 820-10-35-36C. Therefore, we recognize that requiring a fund's
share price to be determined using bid-side values for the
underlying investments would introduce inconsistency in instances
where the fund does not use bid prices to value securities for
purposes of U.S. GAAP. As a result, funds needing to apply different
pricing for these different purposes could experience incremental
effort and cost.
---------------------------------------------------------------------------
The alternative would impose lower costs on funds and
intermediaries relative to the proposed swing pricing requirement
because there would be no requirement for a hard close and no
requirement to estimate market impact factors or other transaction
costs. By limiting the adjustment of the share price to a step function
(i.e., share price is either adjusted to reflect spread costs or not at
all), the alternative avoids any imprecision that may be introduced by
having the size of the fund's share price adjustment also depend on the
size of predicted net outflows. To the extent that funds currently do
not implement swing pricing because of existing operational challenges
or any stigma that may be associated with the use of that tool, this
alternative would likely overcome these challenges by prescribing an
approach that is mandatory and that could be implemented more easily
under existing operational structures compared to the proposed swing
pricing requirement that would rely on a hard close while still
providing some anti-dilution benefits to mutual fund investors.
iv. A Choice of an Anti-Dilution Tool
As another alternative to the proposed swing pricing requirement,
we could have proposed to require all funds to implement an anti-
dilution tool, while allowing them to choose among several tools, such
as swing pricing, liquidity fees, or other alternative approaches
discussed above. This alternative may benefit funds and their
investors, to the extent that certain anti-dilution tools are better
suited for certain types of funds in reducing investor dilution. For
example, funds that have infrequent subscriptions or redemptions may
find a liquidity fee less operationally costly to implement compared to
other tools. Similarly, funds that have more volatile flows on a day-
to-day basis may find that swing pricing would be a more effective
approach to combat dilution because the trading costs would be recouped
instantaneously with investors' trading activity, compared to liquidity
fees that would not be recouped by a fund until a later date. Further,
funds that have de minimis transaction costs for prolonged periods of
time may find a liquidity fee that would only apply during stressed
conditions more appropriate from the operational prospective. This
alternative may benefit mutual fund investors by increasing investor
choice relative to the proposal. To the extent that different investors
have varying preferences for anti-dilution tools, they would be able to
invest in the mutual fund sector according to their preferences. As
such, this alternative may increase competition in the mutual fund
sector. However, this alternative could be more costly relative to the
proposal and other alternatives discussed above because fund
intermediaries and service providers would need to establish systems
that accommodate all the anti-dilution options that would exist across
mutual funds.
3. Hard Close Requirement
The proposal would require a hard close, meaning that an order may
be executed at the current day's price only if the fund or its
designated parties receive the order before 4 p.m. ET. As discussed in
section III.B.3, funds and intermediaries are likely to incur
significant costs in order to comply with the hard close requirement.
Therefore, we have considered alternative approaches to the hard close
requirement.
a. Indicative Flows \526\
---------------------------------------------------------------------------
\526\ See also section II.D.2.a for additional discussion of
this alternative.
---------------------------------------------------------------------------
One alternative to the proposed hard close requirement would be to
require that funds receive indicative flow information from
intermediaries by an established time. This approach would be less
likely to affect investors who place orders near the 4 p.m. ET pricing
time, as intermediaries may not necessarily need to establish earlier
cut-off times. While intermediaries would incur one-time costs to
update their systems and processes to calculate indicative flow
information, as well as ongoing costs related to the transmission of
the indicative flow information to funds or their designated parties,
these costs would be lower than the costs intermediaries would incur
under the proposed hard close requirement. The proposed hard close
requirement, however, would likely not result in the same ongoing costs
for intermediaries that this alternative would require. For example,
intermediaries may need to develop a process for estimating indicative
flows and sending them to funds, separate from the process of
submitting orders to fund transfer agents and Fund/SERV.
[[Page 77272]]
Likewise, funds would need to develop processes for receiving the
indicative flow information and monitoring whether each intermediary
has provided indicative flow information in a timely manner. Moreover,
indicative flow information likely would be less accurate and complete
than the flow information funds would receive under the proposed hard
close requirement. As a result, funds' swing pricing determinations may
be less accurate than under the proposal (e.g., a fund may not adjust
its NAV when it should have, or vice versa, due to incomplete flow
information), which would limit a fund's ability to mitigate dilution
through swing pricing.
b. Estimated Flows \527\
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\527\ See also section II.D.2.b for additional discussion of
this alternative.
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Another alternative approach to a hard close would be to continue
allowing funds to use reasonable estimates of their flows in
determining transaction costs from investors' trading activity and to
provide them with a safe harbor in cases where the produced estimates
of the funds' net flows are different from realized net flows. This
approach would have limited effect on intermediaries, as funds would
base their estimates on models incorporating available information.
However, because funds would base anti-dilution decisions on less
precise flow data, this alternative could reduce the effectiveness of a
fund's swing pricing by possibly causing it to adjust its NAV on days
where transacting investors ultimately do not dilute remaining fund
shareholders. On days where a fund estimates the direction of flows
incorrectly, e.g., if a fund forecasts that it will experience net
subscriptions but actually experiences net redemptions, applying a
swing factor could result in more shareholder dilution than if a swing
factor had not been applied. This may make mutual funds less attractive
to investors. However, the success of this approach would depend on how
well funds can predict the additional flows that they receive after
their NAV has been determined.
c. Later Cut-Off Times for Intermediaries \528\
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\528\ See also section II.D.2.c for additional discussion of
this alternative.
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Another alternative is to establish later cut-off times for
intermediaries to submit order flow information, for example, two or
three hours after the fund's pricing time (e.g., 6 or 7 p.m. ET if the
fund's pricing time is 4 p.m. ET). Under this alternative,
intermediaries would have more time to submit their orders to funds and
may not need to impose a cut-off time for investor orders earlier than
the pricing time. To the extent that investors would not be subjected
to an earlier cut-off time under this alternative, investors that use
affected intermediaries would not experience disadvantage over
investors that trade with the fund directly in terms of different
degree of market risk described above. However, although this
alternative may be more beneficial to investors compared to the
proposed hard close requirement, it would require similar operational
changes and impose similar costs. For example, retirement plan
recordkeepers would still need to submit orders before receiving funds'
prices. This alternative, however, may be less disruptive than the
proposed hard close requirement for intermediaries that typically
provide orders by around 6 or 7 p.m. ET, which we understand is the
case for many broker-dealers. Under this approach, funds would likely
need to publish their prices later than current practice to provide
time to make swing pricing decisions. This could delay the distribution
of pricing information to the public and to intermediaries. However,
because intermediaries would no longer be revising orders contingent on
the fund's share price to the same extent, this may not be as
disruptive as a later NAV publication would be under the status quo.
4. Commission Reporting and Public Disclosure
As an alternative, we could have proposed public disclosure of
position-level liquidity classifications. This alternative may provide
more information about a fund's liquidity risk profile to investors,
thereby improving their portfolio allocation decisions. While funds may
have gained some insight into how other funds manage liquidity risk via
their narrative disclosures, to the extent those disclosures tended to
be boilerplate, observing other funds' liquidity profiles might provide
some information that is useful in a fund's own liquidity
classification process. Although the process for funds' liquidity
classifications will be more uniform across funds under the proposal,
we recognize that the same investment may still be classified
differently by different funds due to classifications being position-
dependent (i.e., the more of a security is held by a fund, the less
liquid its classification would be). Therefore, even if position-level
liquidity classifications are disclosed, the comparison of
classifications across funds may still not be as meaningful for
investors in all cases. Position-level disclosure also could
potentially reveal additional information about a fund's trading
strategy if, for example, a security was classified as illiquid solely
because the fund had material non-public information about the
security. In addition, investors also may find the proposed aggregate
liquidity information more useful, to the extent that they are focused
on a fund's overall liquidity profile rather than the liquidity of any
particular investment.
We also could have proposed filings would become public when they
are filed as opposed to keeping the filings confidential until 30 days
after they are filed (60 days after the end of the reporting period).
This could take several forms. For example, we could maintain the
proposed filing deadline, which would mean that a fund's filing would
be due and become public 30 days after the end of the reporting period.
Alternatively, we could pair a publication-upon-filing framework with
lengthening the delay between the end of the reporting period (for
example, to 45 days after the end of the period). Making filings public
immediately upon filing could improve investor understanding of fund
portfolios because they would be able to review the information closer
to real time (though still with a substantial delay), assuming that the
filing deadline was 30 days after each month end as proposed. This
would enhance the ability of investors to choose the right fund that
suits their portfolio construction goals. Many funds already make
portfolio information public with a 30-day delay on a voluntary basis,
but this alternative would result in a consistent framework across the
entire open-end fund industry. This approach would also reduce the
amount of information the Commission would be required to keep
confidential.\529\ On the other hand, to the extent funds are at risk
of predatory trading or copy-catting when their portfolios become
public sooner, this approach could serve to increase those risks.\530\
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\529\ Certain data would remain confidential, such as the
composition of the fund's ``miscellaneous securities.'' See supra
section II.E.1.d.
\530\ See supra note 287 (comment letter from major industry
participant citing research showing that risk of predatory trading
or copycatting as a result of increased publication frequency is
overstated).
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We could have taken the inverse approach as well. Instead of
providing for publication at the same time information is filed, we
could have provided for a longer period between the time information is
filed and when
[[Page 77273]]
it is made public, and also could have extended the deadline for
filing. The benefits and costs of this alternative would likewise be
the reverse of the publication-upon-filing alternative. Namely, this
alternative could reduce the risks of predatory trading or copy-catting
because by the time the information became public, it would be more
likely to be stale. On the other hand, it would also be less useful to
investors seeking to understand their funds and, if we paired a delay
in publication with a delay in the deadline for filing with the
Commission, it would be less useful to the Commission as well.
F. Request for Comment
We request comment on all aspects of the economic analysis of the
proposed amendments. To the extent possible, we request that commenters
provide supporting data and analysis with respect to the benefits,
costs, and effects on competition, efficiency, and capital formation of
adopting the proposed amendments or any reasonable alternatives. In
particular, we ask commenters to consider the following questions:
234. What additional qualitative or quantitative information should
be considered as part of the baseline for the economic analysis of
these amendments?
235. Are the benefits and costs of proposed amendments accurately
characterized? If not, why not? Should any of the costs or benefits be
modified? What, if any, other costs or benefits should be taken into
account? If possible, please offer ways of estimating these benefits
and costs. What additional considerations can be used to estimate the
benefits and costs of the proposed amendments?
236. Are the benefits and costs of the proposed swing pricing
amendments accurately characterized? If not, why not? What, if any,
other costs or benefits should be taken into account? If possible,
please offer ways of estimating these benefits and costs.
237. Are the effects on competition, efficiency, and capital
formation arising from the proposed amendments accurately
characterized? If not, why not?
238. Are the economic effects of the above alternatives accurately
characterized? If not, why not? Should any of the costs or benefits be
modified? What, if any, other costs or benefits should be taken into
account?
239. Are the economic effects of the alternative approaches to
implementing swing pricing adequately characterized? If not, why not?
Should any of the costs or benefits be modified? What, if any, other
costs or benefits should be taken into account?
240. Are there other reasonable alternatives to the proposed
amendments that should be considered? What are the costs, benefits, and
effects on competition, efficiency, and capital formation of any other
alternatives?
241. What effects would the proposed changes have on (1) investment
options available to investors if certain asset classes are not
available or are less available in open-end vehicles (including UITs);
and (2) the markets for those underlying assets, including, but not
limited to, the market for bank loan interests.
242. How likely is it that open-end fund managers will choose to
offer their products via different structures, such as ETFs, closed-end
funds, or CITs, rather than comply with the proposed requirements?
Relatedly, how likely is it that investors will move assets from open-
end funds to other types of funds in response to the proposed
requirements?
243. Are there data sources or data sets that can help refine the
estimates of the benefits and costs associated with the proposed
amendments? If so, please identify them.
244. Are there data sources that can help us estimate the aggregate
number and value of transactions in mutual fund shares with more
accuracy? If so, please identify them.
245. Which third-party service providers would be affected the most
by the proposed amendments? Please explain why. If possible, please
provide data on the number and size of such entities.
246. Would these amendments cause a fund or any third-party service
providers assessing liquidity to have new or unforeseen burdens? Would
this increase the cost of third-party services?
247. Would certain types of funds have to substantially rebalance
their portfolios as a result of the proposed changes to the liquidity
risk management program? Provide a list of specific investments that
funds would have to hold in limited amounts under the proposed
amendments. Are there close alternatives to these investments that
funds would be able to hold? For example, can bank loan interests be
substituted with CLOs? If no, please explain why.
248. Can the vertical slice assumption for the purposes of
calculation of stressed trade size be implemented for all types of fund
investments? For example, are there indivisible minimum trade units for
any investments for which 10% of such an investment would not be
possible to sell due to such indivisibility? How do funds currently
operationalize the calculation of the reasonably anticipated trade
size: via a vertical slice assumption or in any other way for
indivisible investments?
249. What price impact models do funds currently use for liquidity
classifications of their investments? Are there advantages of using one
model over another? Are there price impact models available to use only
through certain third-party service providers assessing liquidity? Do
service providers assessing liquidity vary in costs for their services?
250. What would be the costs of obtaining daily pricing and
liquidity information for the purposes of daily liquidity
classifications? What are the current costs related to obtaining such
information?
251. Do funds currently monitor their liquidity classifications on
a daily basis? Are there specific types of funds that do not currently
evaluate their classifications more frequently than monthly?
252. To what extent would funds implement swing pricing if it were
optional, rather than mandatory, as long as funds received complete
order flow data prior to determining their NAVs on a given day?
253. How dilutive are fund purchases relative to fund sales? How do
the benefits of swing pricing in response to purchases compare to the
benefits of swing pricing in response to sales?
254. Which components of trading costs contribute the most to fund
dilution? How significant are market impact costs? If we adopted an
alternative that excluded market impact from swing factor calculations,
would the rule's effectiveness at mitigating dilution be significantly
reduced?
255. Of the alternatives to swing pricing discussed above, which
strikes the most appropriate balance of investor benefits and
implementation costs? Is it more operationally complex and costly to
charge fund investors a liquidity fee, or to use dual pricing?
256. What are the benefits of processing trade information via
omnibus accounts? How costly would transmitting individual investor
order information to funds be for intermediaries? Are per-trade costs
the same for all intermediaries? Would there be other ancillary
benefits associated with a move away from omnibus account and order
netting?
257. What other costs or impediments beyond system switching costs
would the proposed hard close requirement impose? Will these costs be
different for different types of intermediaries? If so,
[[Page 77274]]
what is the differential? How do these costs compare to the potential
future benefits of the hard close, such as more efficient order
processing?
258. Will certain intermediaries be unable to bear the costs of the
proposed hard close requirement? If yes, please explain why. Would the
costs differ, depending on whether an intermediary or a service
provider is affiliated with a fund family or not?
259. What effect will a hard close requirement have on the
availability of certain transaction types offered to investors? Please
list the types of transactions that would become unavailable under the
proposed hard close requirement?
260. Would investors and other data users benefit significantly
from the proposed monthly N-PORT disclosures? Would the quality and
availability of mutual funds' portfolio data available to investors and
other users improve significantly under the proposed amendments?
261. Would the proposed aggregate liquidity disclosure benefit
investors? What are the benefits and costs of such disclosure relative
to investment-by-investment liquidity classification disclosure? Are
there any substantial burdens that funds would experience with the
detailed liquidity classification disclosure beyond the costs
associated with the disclosure process itself?
IV. Paperwork Reduction Act
A. Introduction
Certain provisions of the proposed amendments contain ``collection
of information'' requirements within the meaning of the Paperwork
Reduction Act of 1995 (``PRA'').\531\ We are submitting the proposed
collections of information to the Office of Management and Budget
(``OMB'') for review in accordance with the PRA.\532\ The proposed
amendments would have an effect on the current collection of
information burdens of rules 22e-4 and 22c-1 under the Investment
Company Act, as well as Forms N-PORT and N-CEN under the Investment
Company Act and Form N-1A under the Investment Company Act and the
Securities Act.
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\531\ 44 U.S.C. 3501 through 3521.
\532\ 44 U.S.C. 3507(d); 5 CFR 1320.11.
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The titles for the existing collections of information we are
amending are: (1) ``Rule 22e-4 (17 CFR 270.22e-4) under the Investment
Company Act of 1940, Investment Company Liquidity Risk Management
Programs'' (OMB control number 3235-0737); (2) ``Rule 22c-1 Under the
Investment Company Act of 1940, Pricing of redeemable securities for
distribution, redemption and repurchase'' (OMB control number 3235-
0734); (3) ``Rule 30b1-9 and Form N-PORT'' (OMB control number 3235-
0730); (4) ``Form N-1A under the Securities Act of 1933 and under the
Investment Company Act of 1940, Registration Statement of Open-End
Management Investment Companies'' (OMB control number 3235-0307); and
(5) ``Form N-CEN'' (OMB control number 3235-0729).
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a
currently valid OMB control number. Each requirement to disclose
information, offer to provide information, or adopt policies and
procedures constitutes a collection of information requirement under
the PRA. These collections of information would help funds manage
liquidity, mitigate dilution of shareholders' interests, and provide
information to the Commission and investors. The Commission staff would
also use the collection of information in its examination and oversight
program in identifying patterns and trends across registrants. We
discuss below the collection of information burdens associated with the
proposed rule and form amendments.
B. Rule 22e-4
Rule 22e-4 requires funds to establish a written liquidity risk
management program that is reasonably designed to assess and manage
liquidity risk. Several of the proposed amendments to rule 22e-4 would
modify existing collection of information requirements. These
amendments include:
Changing the framework for classifying the liquidity of a
fund's portfolio investments, including requiring use of a stressed
trade size, defining the value impact standard, and requiring daily
reviews of the fund's liquidity classifications. We believe funds would
update their policies and procedures that incorporate liquidity risk
management program elements to reflect these proposed amendments.
Expanding the scope of funds that must determine and
maintain a highly liquid investment minimum. As a result of this
proposed change, additional funds would be required to comply with the
current rule's collection of information requirements related to highly
liquid investment minimums. These collection of information
requirements include:
[cir] The fund's investment adviser or officers designated to
administer the liquidity risk management program must provide a written
report to the fund's board at least annually that describes a review of
the adequacy and effectiveness of the fund's liquidity risk management
program, including the operation of the highly liquid investment
minimum.
[cir] The fund must adopt and implement policies and procedures for
responding to a shortfall of the fund's assets that are highly liquid
investments below its highly liquid investment minimum, which must
include reporting to the fund's board of directors with a brief
explanation of the causes of the shortfall, the extent of the
shortfall, and any actions taken in response, and, if the shortfall
lasts more than 7 consecutive calendar days, an explanation of how the
fund plans to come back into compliance with its minimum within a
reasonable period of time.
[cir] A fund must maintain a written record of how its highly
liquid investment minimum and any adjustments to the minimum were
determined, as well as any reports to the board regarding a shortfall
in the fund's highly liquid investment minimum, for five years, the
first two years in an easily accessible place.
The respondents to rule 22e-4 are open-end management investment
companies, including, under certain circumstances, in-kind ETFs and the
principal underwriters or depositors of unit investment trusts, but
excluding money market funds. None of the proposed amendments would
affect the rule's collection of information requirements for unit
investment trusts or in-kind ETFs. Compliance with rule 22e-4 is
mandatory for funds. Information provided to the Commission in
connection with staff examinations or investigations is kept
confidential subject to the provisions of applicable law. If
information collected pursuant to rule 22e-4 is reviewed by the
Commission's examination staff, it is accorded the same level of
confidentiality accorded to other responses provided to the Commission
in the context of its examination and oversight program.
In our most recent Paperwork Reduction Act submission for rule 22e-
4, we estimated a total aggregate annual hour burden of 28,150 hours,
and a total aggregate annual external cost burden of $0.\533\ Based on
filing data as of
[[Page 77275]]
December 2021, we estimate that 11,488 funds would be subject to these
proposed amendments.\534\ The proposed collections of information are
designed to help increase the likelihood that funds are better prepared
to manage liquidity during stressed conditions, and help protect
investors from dilution. These collections would also help facilitate
the Commission's inspection and enforcement capabilities.
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\533\ The most recent rule 22e-4 PRA submission was approved in
2020 (OMB Control No. 3235-0737). That PRA estimated that 846 fund
complexes were subject to rule 22e-4. We continue to believe that
funds within the same fund complex would experience certain
efficiencies in responding to the collection of information
requirements and, depending on the size of the fund complex, per
fund costs may be higher or lower than our estimated averages;
however, we are changing from a fund complex to a per fund estimate
based on staff experience with per fund burdens and to improve the
quality of this estimate.
\534\ As of Dec. 2021, we estimate 11,488 open-end funds,
excluding money market funds.
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The table below summarizes our PRA initial and ongoing annual
burden estimates associated with the proposed amendments to rule 22e-4.
The following estimates of average burden hours and costs are made for
purposes of the Paperwork Reduction Act.
[[Page 77276]]
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[[Page 77277]]
C. Rule 22c-1
Rule 22c-1 enables funds to use swing pricing as a tool to mitigate
shareholder dilution. Swing pricing is currently optional for certain
open-end funds. The proposed amendments would amend rule 22c-1 to make
swing pricing for open-end funds (other than ETFs or money market
funds) mandatory instead of optional. Funds that would be required to
implement swing pricing under our amendments must establish and
implement swing pricing policies and procedures.\535\ The policies and
procedures must: (1) provide that the fund will adjust its net asset
value if the fund has net redemptions or if it has net purchases
exceeding the inflow swing threshold; and (2) specify the process for
determining the swing factor. The rule also would require a fund to
retain a written copy of the periodic report provided to the board
prepared by the swing pricing administrator that describes, among other
things, the swing pricing administrator's review of the adequacy of the
fund's swing pricing policies and procedures and the effectiveness of
their implementation. The retention of these records is necessary to
allow the staff during examinations of funds to determine whether a
fund is in compliance with its swing pricing policies and procedures
and with rule 22c-1.
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\535\ See proposed rule 22c-1(b).
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Compliance with rule 22c-1(b) would be mandatory for funds subject
to the proposed swing pricing requirements. Based on filing data as of
December 2021, we estimate that 9,043 funds would be subject to these
proposed amendments.\536\ Information provided to the Commission in
connection with staff examinations or investigations is kept
confidential subject to the provisions of applicable law. If
information collected pursuant to rule 22c-1 is reviewed by the
Commission's examination staff, it is accorded the same level of
confidentiality accorded to other responses provided to the Commission
in the context of its examination and oversight program.
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\536\ As of Dec. 2021, we estimate 9,043 open-end funds,
excluding money market funds and ETFs.
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The most recent PRA submission estimated that 5 fund complexes had
funds that might adopt swing pricing policies and procedures under the
optional rule.\537\ The current estimated hour burdens and time costs
associated with rule 22c-1, including the burden associated with the
requirements that funds adopt policies and procedures and obtain board
approval of them, provide periodic written reports by the swing pricing
administrator to the board, and retain certain records and written
reports related to swing pricing, are an average aggregate annual
burden of 113 hours and average aggregate time costs of $73,803.\538\
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\537\ The most recent rule 22c-1 PRA submission was approved in
2020 (OMB Control No. 3235-0734). We continue to believe that funds
within the same fund complex would experience certain efficiencies
in responding to the collection of information requirements and,
depending on the size of the fund complex, per fund costs may be
higher or lower than our estimated averages; however, we are
changing from a fund complex to a per fund estimate based on staff
experience with per fund burdens and to improve the quality of this
estimate.
\538\ The estimated burden hours include 280 total hours (or 56
hours per fund complex) to initially prepare and approve swing
pricing policies and procedures, amortized over 3 years, and 20
total hours (or 4 hours per fund complex) to retain swing pricing
records under rule 22c-1 each year.
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The table below summarizes our PRA initial and ongoing annual
burden estimates associated with the proposed amendments to rule 22c-1.
The following estimates of average burden hours and costs are made
solely for purposes of the Paperwork Reduction Act.
BILLING CODE 8011-01-P
[[Page 77278]]
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BILLING CODE 8011-01-C
[[Page 77279]]
D. Form N-PORT
Form N-PORT requires registered management investment companies
(except for money market funds and small business investment companies)
and ETFs that are organized as unit investment trusts to report
portfolio holdings information in a structured, XML format. The form is
filed electronically using the Commission's electronic filing system,
EDGAR. We propose the following amendments to Form N-PORT:
The proposed amendments to Form N-PORT would require
filing Form N-PORT on a monthly basis, within 30 days after the end of
each month. Currently, a fund must maintain in its records the
information that is required to be included on Form N-PORT not later
than 30 days after the end of each month, but is only required to file
that information within 60 days after the end of every third month. We
are not proposing to adjust the estimated collection of information
burden in connection with this change, in part because we believe the
reduced recordkeeping burden is commensurate with the increased burden
associated with filing the information that previously would have been
preserved as a record. The Commission similarly did not adjust the PRA
burden estimate when it amended Form N-PORT to move from a requirement
to file reports monthly to a requirement to prepare the information
monthly but file it quarterly.\539\
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\539\ See 2018 Liquidity Disclosure Adopting Release, supra note
22, at section IV.B.
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We are proposing to require each open-end fund (other than
money market funds and in-kind ETFs) to report the aggregate percentage
of its portfolio represented in each of the three proposed liquidity
categories, which would be publicly available. These funds would be
required to adjust the reported amounts to account for the amounts of
margin or collateral posted in connection with certain derivatives
transactions as well as outstanding liabilities, and to report
information about the value of these adjustments. Currently, these
funds are required to report position-level liquidity information on a
non-public section of Form N-PORT, meaning the amendments would require
aggregating that information, making the required adjustments, and
reporting the adjusted aggregate information as well as information
about the adjustments that were made.
For open-end funds that would be subject to the swing
pricing requirement under the proposal, we are proposing to provide
enhanced transparency into the frequency and amount of each fund's
swing pricing adjustments. Specifically, the proposal would require
these funds to report information about the number of days a fund
applied a swing factor during the month and the amount of each swing
factor applied.
We also propose conforming amendments to certain existing
items to account for other aspects of the proposal, including
amendments to the filing frequency of unstructured portfolio
information on Part F of Form N-PORT and miscellaneous holdings
disclosure to account for the proposal to make monthly Form N-PORT
information available to the public, amendments to reflect the proposed
amendments to rule 22e-4, and amendments to certain entity identifiers.
The respondents to these collections of information will be
management investment companies (other than money market funds and
small business investment companies) and ETFs that are organized as
unit investment trusts. We estimate that there are 12,153 such funds
required to file on Form N-PORT, although certain of the proposed new
collections of information would apply to subsets of these funds, as
reflected in the below table.\540\ The proposed collections of
information are mandatory for the identified types of funds. Certain
information reported on the form is kept confidential, and we propose
that this would continue to be the case.\541\ We propose that all other
responses to Form N-PORT reporting requirements would not be kept
confidential, and instead would be made public 60 days after the end of
the month to which they relate (30 days after they are filed);
currently, only the report for every third month is made public. The
proposed amendments are designed to assist the Commission in its
regulatory, disclosure review, inspection, and policymaking roles, and
to help investors and other market participants better assess different
fund products.
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\540\ The most recent Form N-PORT PRA submission was approved in
2022 (OMB Control No. 3235-0730). That PRA submission estimated that
11,980 funds were required to file on Form N-PORT. Our current
estimate has increased due to changes in the numbers of funds.
\541\ See General Instruction F of Form N-PORT; General
Instruction F of proposed Form N-PORT.
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In our most recent PRA submission for Form N-PORT, we estimated the
annual aggregate compliance burden to comply with the current
collection of information requirements in Form N-PORT is 1,839,903
burden hours with an internal cost burden of $654,658,288 and an
external cost burden estimate of $113,858,133. We estimate that funds
prepare and file their reports on Form N-PORT either by (1) licensing a
software solution and preparing and filing the reports in house, or (2)
retaining a service provider to provide data aggregation, validation,
and/or filing services as part of the preparation and filing of reports
on behalf of the fund. We estimate that 35% of funds subject to the N-
PORT filing requirements will license a software solution and file
reports on Form N-PORT in house, and the remaining 65% will retain a
service provider to file reports on behalf of the fund.
Table 10 below summarizes our initial and ongoing annual burden
estimates associated with the proposed amendments to Form N-PORT. The
following estimates of average burden hours and costs are made solely
for purposes of the Paperwork Reduction Act.
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[[Page 77280]]
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[[Page 77281]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.011
BILLING CODE 8011-01-C
E. Form N-1A
Form N-1A is used by registered open-end management investment
companies (except insurance company separate accounts and small
business investment companies licensed under the United States Small
Business Administration), to register under the Investment Company Act
and to offer their shares under the Securities Act. Unlike many other
Federal information collections, which are primarily for the use and
benefit of the collecting agency, this information collection is
primarily for the use and benefit of investors. The information filed
with the Commission also permits the verification of compliance with
securities law requirements and assures the public availability and
dissemination of the information. In our most recent Paperwork
Reduction Act submission for Form N-1A, we estimated for Form N-1A a
total annual aggregate ongoing hour burden of 1,672,077 hours, and the
total annual aggregate external cost burden is $132,940,008.\542\
Compliance with the disclosure requirements of Form N-1A is mandatory,
and the responses to the disclosure requirements will not be kept
confidential.
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\542\ The most recent Form N-1A PRA submission was approved in
2021 (OMB Control No. 3235-0307).
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We propose to amend Item 11(a) of Form N-1A to require, if
applicable, that funds disclose that if an investor places an order
with a financial intermediary, the financial intermediary may require
the investor to submit its order earlier to receive the next calculated
NAV. In addition, as a result of the proposed amendments to rule 22c-1
to require that certain funds use swing pricing, we estimate that
additional funds would be required to disclose information about swing
pricing in response to certain existing items in the form.\543\ The
Commission previously estimated that 474 funds would choose to use
swing pricing under the optional framework.\544\ We now estimate that
9,043 funds would be required to use swing pricing and to disclose
relevant information on Form N-1A.\545\ We also propose to remove the
requirement to provide an upper limit on the swing factor from Item
6(d).
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\543\ See Items 6(d), 4(b)(2)(ii), 4(b)(2)(iv)(E), and 13(a) of
Form N-1A.
\544\ See Swing Pricing Adopting Release, supra note 11, at
n.544 and accompanying text.
\545\ This estimate, which is as of Dec. 2021, is based on Form
N-CEN filings received through May 2022.
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Table 11 below summarizes our initial and ongoing annual burden
estimates associated with the proposed amendments to Form N-1A. The
following estimates of average burden hours and costs are made solely
for purposes of the Paperwork Reduction Act.
[[Page 77282]]
[GRAPHIC] [TIFF OMITTED] TP16DE22.012
F. Form N-CEN
Form N-CEN requires registered investment companies, other than
face-amount certificate companies to report annual, census-type
information. Filers must submit this report electronically using the
Commission's EDGAR system in XML format. We propose the following
amendments to Form N-CEN:
Adding a requirement that an open-end fund that uses a
liquidity service provider report: (a) the name each liquidity service
provider; (b) identifying information, including the legal entity
identifier and location, for each liquidity service provider; (c) if
the liquidity service provider is affiliated with the fund or its
investment adviser; (d) the asset classes for which that liquidity
service provider provided classifications; and (e) whether the service
provider was hired or terminated during the reporting period;
Removing requirements that a filer report certain
information regarding its use of swing pricing; and
Revising the approach to certain entity identifiers.\546\
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\546\ We do not believe that the proposed amendments to separate
the concepts of LEI and RSSD ID more clearly in the form would
change the burdens of the current form, as the form already requires
a fund to report the RSSD ID, if any, if a financial institution
does not have an assigned LEI.
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The respondents to these collections of information will be
registered investment companies with the exception of face amount
certificate companies. We estimate that there are 2,754 such
registrants required to file on Form N-CEN.\547\ The proposed
collections of information are mandatory. Responses are not kept
confidential. The purpose of Form N-CEN is to satisfy the filing and
disclosure requirements of section 30 of the Investment Company Act,
and of rule 30a-1 thereunder. The proposed amendments are designed to
facilitate the Commission's oversight of registered funds and its
ability to assess trends and risks.
---------------------------------------------------------------------------
\547\ This estimate, which is as of Dec. 2021, is based on Form
N-CEN filings received through May 2022.
---------------------------------------------------------------------------
In our most recent PRA submission for Form N-CEN, we estimated the
annual aggregate compliance burden to comply with the current
collection of information requirements in Form N-CEN is 54,890 burden
hours with an internal cost burden of $19,267,461 and an external cost
burden estimate of $1,344,981.\548\
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\548\ The most recent Form N-CEN PRA submission was approved in
2021 (OMB Control No. 3235-0729). The previous PRA submission
estimated that 2,835 registrants were required to file on Form N-
CEN. Our current estimate has decreased due to changes in the
numbers of registrants.
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[[Page 77283]]
Table 12 below summarizes our initial and ongoing annual burden
estimates associated with the proposed amendments to Form N-CEN. The
following estimates of average burden hours and costs are made solely
for purposes of the Paperwork Reduction Act.
[GRAPHIC] [TIFF OMITTED] TP16DE22.013
G. Request for Comment
We request comment on whether these estimates are reasonable.
Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits comments
in order to: (1) evaluate whether the proposed collection of
information is necessary for the proper performance of the functions of
the Commission, including whether the information will have practical
utility; (2) evaluate the accuracy of the Commission's estimate of the
burden of the proposed collection of information; (3) determine whether
there are ways to enhance the quality, utility, and clarity of the
information to be collected; and (4) determine whether there are ways
to minimize the burden of the collection of information on those who
are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons wishing to submit comments on the collection of information
requirements of the proposed amendments should direct them to the OMB
Desk Officer for the Securities and Exchange Commission,
[email protected], and should send a copy to
Vanessa A. Countryman, Secretary, Securities and Exchange Commission,
100 F Street NE, Washington, DC 20549-1090, with reference to File No.
S7-26-22. OMB is required to make a decision concerning the collections
of information between 30 and 60 days after publication of this
release; therefore a comment to OMB is best assured of having its full
effect if OMB receives it within 30 days after publication of this
release. Requests for materials submitted to OMB by the
[[Page 77284]]
Commission with regard to these collections of information should be in
writing, refer to File No. S7-26-22, and be submitted to the Securities
and Exchange Commission, Office of FOIA Services, 100 F Street NE,
Washington, DC 20549-2736.
V. Initial Regulatory Flexibility Analysis
The Commission has prepared the following Initial Regulatory
Flexibility Analysis (``IRFA'') in accordance with section 3(a) of the
Regulatory Flexibility Act (``RFA'').\549\ It relates to: (1) the
proposed amendments concerning funds' liquidity risk management
programs under rule 22e-4; (2) the proposed swing pricing amendments
under rule 22c-1(b); (3) the proposed hard close requirement under rule
22c-1(a); and (4) the proposed disclosure amendments to Form N-1A, Form
N-PORT, and Form N-CEN.
---------------------------------------------------------------------------
\549\ 5 U.S.C. 603(a).
---------------------------------------------------------------------------
A. Reasons for and Objectives of the Proposed Actions
The Commission is proposing amendments to its current rules for
open-end funds regarding liquidity risk management programs and swing
pricing. The proposed amendments would provide additional standards for
making liquidity determinations, amend certain aspects of the liquidity
categories, and require more frequent liquidity classifications. The
objectives of the proposed liquidity amendments are to improve
liquidity risk management programs to better prepare these funds for
stressed conditions and improve transparency in liquidity
classifications. The proposed amendments also require any open-end
fund, other than a money market fund or exchange-traded fund, to use
swing pricing. The objectives of swing pricing are to more fairly
allocate costs, reduce the potential for dilution of investors who are
not currently transacting in the fund's shares, and reduce any
potential first-mover advantages. In addition, the Commission is
proposing a ``hard close'' requirement for these funds. The proposed
hard close amendments would serve multiple objectives, including
facilitating funds' ability to operationalize swing pricing by ensuring
that funds receive timely flow information and to modernize order
processing generally. Finally, the Commission is proposing amendments
to reporting requirements that apply to certain registered investment
companies, including registered open-end funds (other than money market
funds), registered closed-end funds, and unit investment trusts. These
proposed amendments seek to improve fund disclosure by requiring more
timely reporting of monthly portfolio holdings and related information
to the Commission and the public, amend certain reported identifiers,
and make other amendments to require additional information about open-
end funds' liquidity risk management and use of swing pricing. Each of
these objectives is discussed in detail in section II above.
B. Legal Basis
The Commission is proposing the rule and form amendments contained
in this document under the authority set forth in the Investment
Company Act, particularly sections 6, 8, 22, 24, 30, 31, 34, 38, and 45
thereof [15 U.S.C. 80a-1 et seq.], the Investment Advisers Act,
particularly section 206 thereof [15 U.S.C. 80b-1 et seq.], the
Exchange Act, particularly sections 10, 13, 15, 23, and 35A thereof [15
U.S.C. 78a et seq.], the Securities Act, particularly sections 7, 10,
17, and 19 thereof [15 U.S.C. 77a et seq.], and the Trust Indenture
Act, particularly section 319 thereof [15 U.S.C. 77aaa et seq.].
C. Small Entities Subject to the Amendments
An investment company is a small entity if, together with other
investment companies in the same group of related investment companies,
it has net assets of $50 million or less as of the end of its most
recent fiscal year.\550\ Commission staff estimates that, as of June
2022, there were 46 open-end management investment companies that would
be considered small entities; this number includes 2 money market funds
and 11 open-end ETFs. Commission staff also estimates that, as of June
2022, there were 31 closed-end investment management companies and 5
unit investment trusts that would be considered small entities.
---------------------------------------------------------------------------
\550\ See 17 CFR 270.0-10(a).
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D. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
1. Liquidity Risk Management Programs
The proposed amendments to rule 22e-4 would provide additional
standards for making liquidity determinations, amend certain aspects of
the liquidity categories, and require more frequent liquidity
classifications. Specifically, the proposal would provide objective
minimum standards that funds would use to classify investments,
including by: (1) requiring funds to assume the sale of a stressed
trade size, rather than the rule's current approach of assuming the
sale of a reasonably anticipated trade size in current market
conditions; (2) defining the value impact standard with more
specificity on when a sale or disposition would significantly change
the market value of an investment; and (3) removing classification by
asset class. The proposed amendments would also remove the less liquid
investment category, which would reduce the number of liquidity
categories from four to three, and expand the scope of the illiquid
investment category. In addition, the proposed amendments would extend
the requirement to maintain a highly liquid investment minimum to a
broader scope of funds and would change how the highly liquid
investment minimum calculation and the calculation of the 15% limit on
illiquid investments take into account the amount of assets that are
posted as margin or collateral for certain derivatives transactions.
Finally, the proposal would require daily classifications.
We estimate that approximately 44 funds are small entities that
would be required to comply with the proposed amendments to the
liquidity risk management program requirement.\551\ The proposed
amendments would impose burdens on all open-end funds subjected to the
rule, including those that are small entities. We discuss the specifics
of these burdens in the Economic Analysis and Paperwork Reduction Act
sections above. These sections also discuss the professional skills
that we believe compliance with this aspect of the proposal would
require. While we would expect larger funds or funds that are part of a
large fund complex to incur higher costs related to the proposed
liquidity rule amendments in absolute terms relative to a smaller fund
or a fund that is part of a smaller fund complex, we would expect a
smaller fund to find it more costly, per dollar managed, to comply with
the proposed requirements because it would not be able to benefit from
a larger fund complex's economies of scale. For example, larger fund
complexes would have economies of scale in amending existing liquidity
risk management policies and procedures
[[Page 77285]]
and in revising their frameworks for classifying the liquidity of
investments.
---------------------------------------------------------------------------
\551\ See text following supra note 550. Money market funds are
excluded from the proposed liquidity risk management program
requirement. In addition, in-kind ETFs are not subject to the
current rule's classification requirements or highly liquid
investment minimum requirements and, therefore, would not be subject
to the proposed amendments to these provisions. Because in-kind ETFs
are subject to certain of the proposed amendments, such as
amendments to the calculation of the 15% limit on illiquid
investments, we include all 11 of the small funds that are open-end
ETFs in the estimated number of small entities affected.
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2. Swing Pricing
Under the proposal, every open-end fund other than an excluded fund
would be required to establish and implement swing pricing policies and
procedures that adjust the fund's current NAV per share by a swing
factor either if the fund has net redemptions or if it has net
purchases of more than 2% of the fund's net assets. The swing pricing
administrator would be required to review investor flow information to
determine: (1) if the fund experiences net purchases or net
redemptions; and (2) the amount of net purchases or net redemptions. In
determining the swing factor, the proposed rule would require a fund's
swing pricing administrator to make good faith estimates, supported by
data, of the costs the fund would incur if it purchased or sold a pro
rata amount of each investment in its portfolio to satisfy the amount
of net purchases or net redemptions (i.e., a vertical slice).
Additionally, under the proposed rule, the fund's board of directors
would be required to: (1) approve the fund's swing pricing policies and
procedures; (2) designate the fund's swing pricing administrator; and
(3) review, no less frequently than annually, a written report prepared
by the swing pricing administrator. Finally, under the proposed rule
the fund would be required to maintain the swing pricing policies and
procedures and a copy of the written report in an easily accessible
place.
We estimate that approximately 33 funds are small entities that
would be required to comply with the proposed swing pricing
requirement.\552\ The proposed requirement would impose burdens on all
open-end funds (other than money market funds and ETFs), including
those that are small entities. We discuss the specifics of these
burdens in the Economic Analysis and Paperwork Reduction Act sections
above. These sections also discuss the professional skills that we
believe compliance with this aspect of the proposal would require.
While we would expect larger funds or funds that are part of a large
fund complex to incur higher costs related to the proposed swing
pricing requirement in absolute terms relative to a smaller fund or a
fund that is part of a smaller fund complex, we would expect a smaller
fund to find it more costly, per dollar managed, to comply with the
proposed requirement because it would not be able to benefit from a
larger fund complex's economies of scale. For example, a larger fund
complex would have economies of scale in developing and adopting swing
pricing policies and procedures. This is particularly true for larger
fund complexes that currently employ swing pricing in their operations
in a foreign jurisdiction, such as in Europe.
---------------------------------------------------------------------------
\552\ See text following supra note 550. ETFs and money market
funds are excluded from the proposed swing pricing requirement.
---------------------------------------------------------------------------
3. Hard Close
We are proposing amendments to rule 22c-1 to require a hard close
for funds that are subject to the proposed swing pricing requirement.
The hard close would provide that a request to redeem or purchase a
fund's shares may be executed at the current day's price only if the
fund, its designated transfer agent, or a registered securities
clearing agency receives the eligible order before the pricing time as
of which the fund calculates its NAV. Orders received after the fund's
established pricing time would receive the next day's price.
We estimate that approximately 33 funds are small entities that
would be required to comply with the proposed hard close
requirement.\553\ The proposed amendments would impose burdens on all
open-end funds (except for money market funds and ETFs), including
those that are small entities. We discuss the specifics of these
burdens in the Economic Analysis section above. The proposed hard close
may involve costs to change business practices, operations, and
computer systems, including integration of new technologies, for funds,
including small entities, which may require specialized operational and
technology skills. We would expect that the burdens of these changes
would be greater for smaller entities relative to the size of their
business than for larger entities, which would benefit from economies
of scale.
---------------------------------------------------------------------------
\553\ See text following supra note 550. ETFs and money market
funds are excluded from the proposed hard close requirement.
---------------------------------------------------------------------------
We estimate that the proposed hard close would also affect 8 small
transfer agents.\554\ Intermediaries that are small entities would also
be affected; however, we lack data for accurately estimating the number
of these other intermediaries that are small entities that service
open-end fund shareholders and would be affected by the proposed hard
close amendments. Those other intermediaries may include a subset of:
471 small advisers,\555\ 731 small broker-dealers,\556\ 1,280 small
recordkeepers,\557\ 3,529 small bank entities,\558\ and small insurance
companies.\559\ Furthermore, how much these proposed amendments would
affect these intermediaries would be determined largely by the
importance these intermediaries and their clients place on receiving
the NAV calculated on the day a client places an order.
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\554\ A ``small transfer agent'' is a transfer agent that: (1)
received less than 500 items for transfer and less than 500 items
for processing during the preceding six months (or in the time that
it has been in business, if shorter); (2) transferred items only of
issuers that would be deemed small businesses or small
organizations; and (3) maintained master shareholder files that in
the aggregate contained less than 1,000 shareholder accounts or was
the named transfer agent for less than 1,000 shareholder accounts at
all times during the preceding fiscal year (or in the time that it
has been in business, if shorter); and (4) is not affiliated with
any person (other than a natural person) that is not a small
business or small organization. See rule 0-10(h) under the Exchange
Act. We estimate 8 affected small transfer agents, based on the
number of small transfer agents reporting mutual fund activity in
their filings on Form TA-2 as of Mar. 31, 2022.
\555\ A ``small adviser'' is a SEC-registered investment adviser
that: (1) has assets under management having a total value of less
than $25 million; (2) did not have total assets of $5 million or
more on the last day of the most recent fiscal year; and (3) does
not control, is not controlled by, and is not under common control
with another investment adviser that has assets under management of
$25 million or more, or any person (other than a natural person)
that had total assets of $5 million or more on the last day of its
most recent fiscal year. We estimate 471 small advisers, based on
filings on Form ADV as of Dec. 2021.
\556\ A ``small broker-dealer'' is a broker or dealer that: (1)
had total capital (net worth plus subordinated liabilities) of less
than $500,000 on the date in the prior fiscal year as of which its
audited financial statements were prepared pursuant to rule 17a-5(d)
under the Exchange Act or, if not required to file such statements,
a broker or dealer that had total capital (net worth plus
subordinated liabilities) of less than $500,000 on the last business
day of the preceding fiscal year (or in the time that it has been in
business, if shorter); and (2) is not affiliated with any person
(other than a natural person) that is not a small business or small
organization. See rule 0-10(c) under the Exchange Act. We estimate
731 small broker-dealers, based on filings of FOCUS Reports as of
Dec. 2021.
\557\ See Pension Benefit Statements--Lifetime Income
Illustrations [85 FR 59132 (Sept. 18, 2020)], at n.71 and
accompanying text. We estimate 1,280 small recordkeepers, based on
filings of Form 5500 as reported by the Department of Labor, in the
2017 plan year. According to that data, there were 1,725
recordkeepers servicing defined contribution plans. The 445 largest
recordkeepers serviced plans holding approximately 99% of total plan
assets, while the remaining 1,280 (small recordkeepers) serviced
plans holding a mere 1%. The Department of Labor considered other
thresholds for recordkeepers and selected the 99 percent threshold
for recordkeepers to include more recordkeepers in cost estimates,
and thus avoid underestimating costs.
\558\ See Rules Regarding Availability of Information [85 FR
57616 (Sept. 15, 2020)], at n.7 and accompanying text (stating that
as of Mar. 2020, there were approximately 2,925 small bank holding
companies, 132 small savings and loan holding companies, and 472
small State member banks). We estimate a total of 3,529 small banks
supervised by the Federal Reserve as of Mar. 2020.
\559\ We lack data for estimating the number of small insurance
companies.
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[[Page 77286]]
4. Reporting Requirements
a. Form N-1A
Form N-1A is the form used by certain open-end management
investment companies to register under the Investment Company Act and
to register their securities under the Securities Act. We propose to
amend Item 11(a) of Form N-1A to require, if applicable, that funds
disclose that if an investor places an order with a financial
intermediary, the financial intermediary may require the investor to
submit its order earlier to receive the next calculated NAV. We also
propose to remove the requirement to provide an upper limit on the
swing factor from Item 6(d).
We estimate that approximately 33 funds are small entities that
would be required to comply with our proposed amendments for Form N-
1A.\560\ The proposed amendments would impose burdens on all open-end
funds (other than money market funds and ETFs), including those that
are small entities. We discuss the specifics of these burdens in the
Economic Analysis and Paperwork Reduction Act sections above. These
sections also discuss the professional skills that we believe
compliance with this aspect of the proposal would require. We recognize
that, due to economies of scale, the costs associated with the proposed
amendments to Form N-1A may be more easily borne by larger fund
complexes than smaller ones, and that costs borne by funds would be
passed along to investors in the form of higher fees and expenses.
---------------------------------------------------------------------------
\560\ See text following supra note 550. ETFs and money market
funds file reports on Form N-1A but would not be impacted by our
proposed amendments.
---------------------------------------------------------------------------
b. Form N-PORT
Form N-PORT requires open-end and closed-end funds, as well as ETFs
organized as UITs, to report monthly portfolio holdings information on
a quarterly basis in a structured, XML format. We propose the following
amendments to Form N-PORT: (1) require funds to file Form N-PORT on a
monthly basis, within 30 days after the end of each month; (2) require
open-end funds to report the aggregate percentage of a fund's portfolio
represented in each of the three proposed liquidity categories, which
would be publicly available; (3) provide enhanced transparency into the
frequency and amount of a fund's swing pricing adjustments; and (4)
changes to entity identifiers.
We estimate that approximately 75 open-end and closed-end funds are
small entities that would be required to comply with our proposed
amendments for Form N-PORT.\561\ The proposed amendments would impose
burdens on all Form N-PORT filers, including those that are small
entities. We discuss the specifics of these burdens in the Economic
Analysis and Paperwork Reduction Act sections above. These sections
also discuss the professional skills that we believe compliance with
this aspect of the proposal would require. We recognize that, due to
economies of scale, the costs associated with the proposed amendments
to Form N-PORT may be more easily borne by larger fund complexes than
smaller ones, and that costs borne by funds would be passed along to
investors in the form of higher fees and expenses.
---------------------------------------------------------------------------
\561\ See text following supra note 550. Money market funds do
not file Form N-PORT. While exchange-traded funds organized as unit
investment trusts file Form N-PORT, there are no such funds that
would be considered small entities.
---------------------------------------------------------------------------
c. Form N-CEN
Form N-CEN is used to collect annual, census-type information for
all registered investment companies, other than face-amount certificate
companies. Filers must submit this report electronically using the
Commission's EDGAR system in XML format. We propose amendments to Form
N-CEN that would identify liquidity service providers and certain
related information, as well as remove the requirements that a filer
report information regarding its use of swing pricing, which is being
moved to Form N-PORT. We also propose amendments related to entity
identifiers.
We estimate that approximately 82 funds are small entities that
would be required to comply with our proposed amendments for Form N-
CEN.\562\ The proposed amendments would impose burdens on all Form N-
CEN filers, including those that are small entities. We discuss the
specifics of these burdens in the Economic Analysis and Paperwork
Reduction Act sections above. These sections also discuss the
professional skills that we believe compliance with this aspect of the
proposal would require. We recognize that, due to economies of scale,
the costs associated with the proposed amendments to Form N-CEN may be
more easily borne by larger fund complexes than smaller ones, and that
costs borne by funds would be passed along to investors in the form of
higher fees and expenses.
---------------------------------------------------------------------------
\562\ See text following supra note 550. In-kind ETFs would not
be affected by the proposed amendments to report information about
liquidity classification vendors but, to avoid under-estimating the
number of small entities, we assume that the 11 small entity ETFs
are not in-kind ETFs and would be affected by the change. We
similarly assume that all 44 funds that are small entities would use
a liquidity classification vendor, although this may not be the
case. If a fund does not use a liquidity classification vendor, it
would not be required to report information about a vendor on Form
N-CEN.
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E. Duplicative, Overlapping, or Conflicting Federal Rules
We do not believe that the proposed amendments would duplicate,
overlap, or conflict with other existing Federal rules.
F. Significant Alternatives
The RFA directs the Commission to consider significant alternatives
that would accomplish our stated objectives, while minimizing any
significant economic impact on small entities. We considered the
following alternatives for small entities in relation to the proposed
amendments to rules 22e-4 and 22c-1, as well as the proposed disclosure
and reporting requirements: (1) establishing different requirements
that take into account the resources available to small entities; (2)
exempting small entities from all or part of the requirements; (3)
clarifying, consolidating, or simplifying requirements under the rules
for small entities; and (4) using performance rather than design
standards.
We do not believe that establishing different requirements for, or
exempting, any subset of funds, including funds that are small
entities, from the proposed amendments to rule 22e-4 would permit us to
achieve our stated objectives. As discussed above, we believe that the
proposed liquidity amendments would improve liquidity risk management
programs to better prepare funds for stressed conditions and improve
transparency in liquidity classifications. Small funds do not entail
less liquidity risk than larger funds, and investors in small funds
would benefit from improvements in the liquidity risk management
programs and more transparent liquidity classifications just as
investors in larger funds would. We therefore do not believe it would
be appropriate to establish different requirements for, or exempt,
funds that are small entities from the proposed liquidity risk
management amendments to rule 22e-4. Similarly, our objectives would
not be served by clarifying, consolidating, or simplifying the
liquidity requirements for small entities. With respect to using
performance rather than design standards, the proposed amendments
primarily use design rather than performance standards to better
prepare funds for stressed market conditions, prevent funds from over-
estimating the
[[Page 77287]]
liquidity of their investments, and improve transparency of fund
liquidity.
Regarding the proposed changes to the liquidity classification
framework, we acknowledge that to the extent that small funds would
experience a more substantial operational burden compared to larger
fund complexes that exhibit economies of scale, smaller funds may
become less competitive than larger funds. However, we believe there
are no significant alternatives for smaller funds other than exemption,
and providing an exemption from the proposed liquidity classification
changes could subject investors in small funds to greater liquidity
risk and would create diverging liquidity frameworks among funds, as
small funds are already subject to the current rule's liquidity
classification requirements.
Additionally, we are not establishing different requirements for,
or exempting, funds that are small entities from the swing pricing
requirement, because we believe that all funds should be required to
use swing pricing as a tool to mitigate potential shareholder dilution.
We do not believe that the potential dilution that proposed rule 22c-
1(b) is meant to prevent would affect large funds and their
shareholders more significantly than small funds and their
shareholders. We acknowledge that a fund that is a small entity would
need to incur the costs of compliance with the proposed amendments to
the rule, which may constitute a greater percentage of the small fund's
net assets than with a larger fund. We also acknowledge that certain
larger fund groups with both U.S. and European operations may already
have experience with swing pricing that smaller funds would not, which
could result in greater costs, relative to a fund's net assets, for
smaller funds than larger ones. However, despite these considerations,
we do not believe that investors in small funds should be afforded less
protection against the risk of dilution than investors in large funds.
We therefore do not believe it would be appropriate to establish
different requirements for, or to exempt, funds that are small entities
from the proposed swing pricing requirement. For example, we are not
allowing funds that are small entities to use a different inflow swing
threshold or market impact threshold than those the proposed rule
identifies. As discussed above, we do not believe the potential
dilution that the proposed swing pricing requirement is meant to
prevent would affect large funds and their shareholders more
significantly than small funds and their shareholders. Permitting funds
that are small entities to use higher thresholds could subject small
funds to greater dilution than larger funds, and we believe all
investors should be afforded the same protection against the risk of
dilution.\563\ Similarly, our objectives would not be served by
clarifying, consolidating, or simplifying the swing pricing
requirements for small entities. With respect to using performance
rather than design standards, the proposed amendments primarily use
design rather than performance standards to promote more consistent and
uniform standards for all funds. We are also not establishing different
requirements for, or exempting, funds that are small entities from the
proposed hard close requirement because we believe the requirement is
important to every fund's ability to operationalize swing pricing. Our
hard close proposal is designed to support the proposed swing pricing
amendments by facilitating the more timely receipt of fund order flow
information. We believe that requiring a hard close would reduce a
fund's reliance on estimates, providing more accurate swing factor
determinations. We do not believe investors in smaller funds would
benefit from a greater use of estimates than investors in larger funds.
We therefore do not believe it would be appropriate to establish
different requirements for, or exempt, funds that are small entities
from the proposed hard close requirement in rule 22c-1. Similarly, our
objectives would not be served by clarifying, consolidating, or
simplifying the hard close requirement for small entities. With respect
to using performance rather than design standards, the proposed
amendments primarily use design rather than performance standards to
promote more consistent and uniform standards for all funds.
---------------------------------------------------------------------------
\563\ While we recognize that smaller funds may be less likely
than larger funds to have market impact costs at the 1% threshold
for net redemptions or the 2% threshold for net purchases, as
discussed above, we believe uniform thresholds for all funds would
provide a consistent and objective threshold for all funds to
consider market impacts.
---------------------------------------------------------------------------
Finally, we do not believe that the interest of investors would be
served by establishing different requirements for, or exempting, funds
that are small entities from the proposed disclosure and reporting
amendments, or subjecting these funds to different disclosure and
reporting requirements than larger funds. We believe that all fund
investors, including investors in funds that are small entities, would
benefit from disclosure and reporting requirements that would permit
them to make investment choices that better match their risk
tolerances. Furthermore, we note that the current disclosure
requirements on Form N-1A, Form N-PORT, and Form N-CEN do not
distinguish between small entities and other funds. Similarly, our
objectives would not be served by clarifying, consolidating or
simplifying the proposed disclosure and reporting requirements for
small entities. With respect to using performance rather than design
standards, the proposed amendments primarily use design rather than
performance standards to promote more consistent and uniform standards
for all funds.
We recognize that, due to economies of scale, the costs associated
with the proposed amendments to these forms may be more easily borne by
larger fund complexes than smaller ones, and that costs borne by funds
would be passed along to investors in the form of higher fees and
expenses. However, we believe there are no significant alternatives for
smaller funds other than exemption, and providing exemptions for
smaller funds from the proposed reporting and disclosure requirements
would disadvantage investors in smaller funds by creating a lack of
information about these funds' use of swing pricing or aggregate
liquidity classifications.
G. General Request for Comment
The Commission requests comments regarding this IRFA. We request
comments on the number of small entities that may be affected by our
proposed amendments, including for the affected small intermediaries
that we lack data to quantify with accuracy, and whether the proposed
amendments would have any effects not considered in this analysis. We
request that commenters describe the nature of any effects on small
entities subject to the rules and forms, and provide empirical data to
support the nature and extent of such effects. We also request comment
on the proposed compliance burdens and the effect these burdens would
have on smaller entities.
VI. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \564\ we must advise OMB whether a proposed
regulation constitutes a ``major'' rule. Under SBREFA, a rule is
considered ``major'' where, if adopted, it results in or is likely to
result in (1) an annual effect on the economy of $100 million or more;
(2) a major increase in costs or prices for
[[Page 77288]]
consumers or individual industries; or (3) significant adverse effects
on competition, investment or innovation.
---------------------------------------------------------------------------
\564\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
---------------------------------------------------------------------------
We request comment on whether the proposal would be a ``major
rule'' for purposes of SBREFA. We request comment on the potential
impact of the proposed rule on the economy on an annual basis; any
potential increase in costs or prices for consumers or individual
industries; and any potential effect on competition, investment, or
innovation. Commenters are requested to provide empirical data and
other factual support for their views to the extent possible.
Statutory Authority
The Commission is proposing the rule and form amendments contained
in this document under the authority set forth in the Investment
Company Act, particularly sections 6, 8, 22, 24, 30, 31, 34, 38, and 45
thereof [15 U.S.C. 80a-1 et seq.], the Investment Advisers Act,
particularly section 206 thereof [15 U.S.C. 80b-1 et seq.], the
Exchange Act, particularly sections 10, 13, 15, 23, and 35A thereof [15
U.S.C. 78a et seq.], the Securities Act, particularly sections 7, 10,
17, and 19 thereof [15 U.S.C. 77a et seq.], the Trust Indenture Act,
particularly section 319 thereof [15 U.S.C. 77aaa et seq.], and 44
U.S.C. 3506-3507.
List of Subjects in 17 CFR Parts 270 and 274
Investment companies, Reporting and recordkeeping requirements,
Securities.
Text of Proposed Rules and Rule and Form Amendments
For the reasons set forth in the preamble, the Commission is
proposing to amend title 17, chapter II of the Code of Federal
Regulations as follows:
PART 270--RULES AND REGULATIONS, INVESTMENT COMPANY ACT OF 1940
0
1. The authority citation for part 270 continues to read, in part, as
follows:
Authority: 15 U.S.C. 80a-1 et seq., 80a-34(d), 80a-37, 80a-39,
and Pub. L. 111-203, sec. 939A, 124 Stat. 1376 (2010), unless
otherwise noted.
* * * * *
Section 270.22c-1 also issued under secs. 6(c), 22(c), and 38(a)
(15 U.S.C. 80a-6(c), 80a-22(c), and 80a-37(a));
* * * * *
Section 270.31a-2 is also issued under 15 U.S.C. 80a-30.
0
2. Amend Sec. 270.22c-1 by revising it to read as follows:
Sec. 270.22c-1 Pricing of redeemable securities for distribution,
redemption and repurchase.
(a) Forward pricing required. No registered investment company
issuing any redeemable security, no person designated in such issuer's
prospectus as authorized to consummate transactions in any such
security, no principal underwriter of, or dealer in, any such security
shall sell, redeem, or repurchase any such security except at a price
based on the current net asset value of such security established for
the next pricing time after receipt of a direction to purchase or
redeem such security.
(1) The investment company's board of directors must initially set
the pricing time(s), and must make and approve any changes to the
pricing time(s).
(2) The investment company must calculate the current net asset
value of any redeemable security at least once daily, Monday through
Friday, at the pricing time(s) its board of directors set, except on:
(i) Days during which the investment company receives no direction
to purchase or redeem its redeemable securities; or
(ii) Customary national business holidays described or listed in
the prospectus and local and regional business holidays listed in the
prospectus.
(3) For an investment company that is required to implement swing
pricing under paragraph (b) of this section:
(i) A direction to purchase or redeem the investment company's
redeemable securities is eligible to receive the price established for
a pricing time solely if the investment company, its designated
transfer agent, or a registered clearing agency receives an eligible
order before that pricing time; and
(ii) The price an eligible order receives is based on the current
net asset value as of the pricing time and includes any adjustment to
the current net asset value required by paragraph (b) of this section.
(b) Swing pricing requirement. A registered open-end management
investment company (but not a registered open-end management investment
company that is regulated as a money market fund under Sec. 270.2a-7
or an exchange-traded fund as defined in paragraph (d) of this section)
(a ``fund'') must establish and implement swing pricing policies and
procedures as described in paragraphs (b)(1) through (5) of this
section in order to adjust its current net asset value per share to
mitigate dilution of the value of its outstanding redeemable securities
as a result of shareholder purchase or redemption activity.
(1) The fund's swing pricing policies and procedures must:
(i) Provide that the fund must adjust its net asset value per share
by a swing factor if the fund has net redemptions or if the fund has
net purchases exceeding its inflow swing threshold. The swing pricing
administrator must review investor flow information to determine if the
fund has net purchases or net redemptions and the amount of net
purchases or net redemptions. The swing pricing administrator is
permitted to make such determination based on reasonable, high
confidence estimates; and
(ii) Specify the process for determining the swing factor, in
accordance with paragraph (b)(2) of this section.
(2) In determining the swing factor, the swing pricing
administrator must make good faith estimates, supported by data, of the
costs the fund would incur if it purchased or sold a pro rata amount of
each investment in its portfolio equal to the amount of net purchases
or net redemptions.
(i) If the fund has net redemptions, the good faith estimates must
include, for selling the pro rata amount of each investment in the
fund's portfolio:
(A) Spread costs;
(B) Brokerage commissions, custody fees, and any other charges,
fees, and taxes associated with portfolio investment sales; and
(C) If the amount of the fund's net redemptions exceeds the market
impact threshold, the market impact, as described in paragraph
(b)(2)(iii) of this section.
(ii) If the amount of the fund's net purchases exceeds the inflow
swing threshold, the good faith estimates must include, for purchasing
the pro rata amount of each investment in the fund's portfolio:
(A) Spread costs;
(B) Brokerage commissions, custody fees, and any other charges,
fees, and taxes associated with portfolio investment purchases; and
(C) The market impact, as described in paragraph (b)(2)(iii) of
this section.
(iii) A fund must determine market impact by:
(A) Establishing a market impact factor for each investment, which
is an estimate of the percentage change in the value of the investment
if it were purchased or sold, per dollar of the amount of the
investment that would be purchased or sold; and
(B) Multiplying the market impact factor for each investment by the
dollar amount of the investment that would be
[[Page 77289]]
purchased or sold if the fund purchased or sold a pro rata amount of
each investment in its portfolio to invest the net purchases or meet
the net redemptions.
(iv) The swing pricing administrator may estimate costs and market
impact factors for each type of investment with the same or
substantially similar characteristics and apply those estimates to all
investments of that type rather than analyze each investment
separately.
(3) The fund's board of directors, including a majority of
directors who are not interested persons of the fund, must:
(i) Approve the fund's swing pricing policies and procedures;
(ii) Designate the fund's swing pricing administrator. The
administration of swing pricing must be reasonably segregated from
portfolio management of the fund and may not include portfolio
managers; and
(iii) Review, no less frequently than annually, a written report
prepared by the swing pricing administrator that describes:
(A) The swing pricing administrator's review of the adequacy of the
fund's swing pricing policies and procedures and the effectiveness of
their implementation, including their effectiveness at mitigating
dilution;
(B) Any material changes to the fund's swing pricing policies and
procedures since the date of the last report; and
(C) The swing pricing administrator's review and assessment of the
fund's swing factors, considering the requirements of paragraph (b)(2)
of this section, including the information and data supporting the
determination of the swing factors and, if the swing pricing
administrator implements either an inflow swing threshold lower than 2
percent of the fund's net assets or a market impact threshold lower
than 1 percent of the fund's net assets, the information and data
supporting the determination of such threshold.
(4) The fund must maintain the policies and procedures adopted by
the fund under this paragraph (b) that are in effect, or at any time
within the past six years were in effect, in an easily accessible
place, and must maintain a written copy of the report provided to the
board under paragraph (b)(3)(iii) of this section for six years, the
first two in an easily accessible place.
(5) Any fund (a ``feeder fund'') that invests, pursuant to section
12(d)(1)(E) of the Act (15 U.S.C. 80a-12(d)(1)(E)), in another fund (a
``master fund'') may not use swing pricing to adjust the feeder fund's
net asset value per share; however, a master fund must use swing
pricing to adjust the master fund's net asset value per share, pursuant
to the requirements set forth in this paragraph (b).
(6) Notwithstanding section 18(f)(1) of the Act (15 U.S.C. 80a-
18(f)(1)), a fund with a share class that is an exchange-traded fund is
subject to the swing pricing requirement only with respect to any share
classes that are not exchange-traded funds.
(c) Exceptions permitted. Notwithstanding paragraph (a) of this
section:
(1) Secondary market transactions. A sponsor of a unit investment
trust (``trust'') engaged exclusively in the business of investing in
eligible trust securities (as defined in Sec. 270.14a-3(b)) may sell
or repurchase trust units in a secondary market at a price based on the
offering side evaluation of the eligible trust securities in the
trust's portfolio, determined at any time on the last business day of
each week, effective for all sales made during the following week, if
on the days that such sales or repurchases are made the sponsor
receives a letter from a qualified evaluator stating, in its opinion,
that:
(i) In the case of repurchases, the current bid price is not higher
than the offering side evaluation, computed on the last business day of
the previous week; and
(ii) In the case of resales, the offering side evaluation, computed
as of the last business day of the previous week, is not more than one-
half of one percent ($5.00 on a unit representing $1,000 principal
amount of eligible trust securities) greater than the current offering
price.
(2) Notwithstanding the provisions above, any registered separate
account offering variable annuity contracts, any person designated in
such account's prospectus as authorized to consummate transactions in
such contracts, and any principal underwriter of or dealer in such
contracts must be permitted to apply the initial purchase payment for
any such contract at a price based on the current net asset value of
such contract which is next computed:
(i) Not later than two business days after receipt of the direction
to purchase by the insurance company sponsoring the separate account
(``insurer''), if the contract application and other information
necessary for processing the direction to purchase (collectively,
``application'') are complete upon receipt; or
(ii) Not later than two business days after an application which is
incomplete upon receipt by the insurer is made complete, provided that,
if an incomplete application is not made complete within five business
days after receipt,
(A) The prospective purchaser is informed of the reasons for the
delay; and
(B) The initial purchase payment is returned immediately and in
full, unless the prospective purchaser specifically consents to the
insurer retaining the purchase payment until the application is made
complete.
(3) This paragraph does not prevent any registered investment
company from adjusting the price of its redeemable securities sold
pursuant to a merger, consolidation or purchase of substantially all of
the assets of a company that meets the conditions specified in Sec.
270.17a-8.
(d) Definitions. For the purposes of this section:
Designated transfer agent means a registered transfer agent (as
defined in section 3(a)(25) of the Securities Exchange Act of 1934 (15
U.S.C. 78c(a)(25))) that is designated in the fund's registration
statement filed with the Commission.
Eligible order means a direction, which is irrevocable as of the
next pricing time after receipt, to:
(i) Purchase or redeem a specific number of fund shares or an
indeterminate number of fund shares of a specific value; or
(ii) Purchase the fund's shares using the proceeds of a
contemporaneous order to redeem a specific number of shares of another
registered investment company (an exchange).
Exchange-traded fund means an open-end management investment
company (or series or class thereof), the shares of which are listed
and traded on a national securities exchange, and that has formed and
operates under an exemptive order under the Act granted by the
Commission or in reliance on Sec. 270.6c-11.
Inflow swing threshold means an amount of net purchases equal to 2
percent of a fund's net assets, or such smaller amount of net purchases
as the swing pricing administrator determines is appropriate to
mitigate dilution.
Initial purchase payment means the first purchase payment submitted
to the insurer by, or on behalf of, a prospective purchaser.
Investor flow information means information about the fund
investors' daily purchase and redemption activity, which may consist of
individual, aggregated, or netted eligible orders, and which excludes
any purchases or redemptions that are made in kind and not in cash.
Market impact threshold means an amount of net redemptions equal to
1
[[Page 77290]]
percent of a fund's net assets, or such smaller amount of net
redemptions as the swing pricing administrator determines is
appropriate to mitigate dilution.
Pricing time means the time or times of day as of which the
investment company calculates the current net asset value of its
redeemable securities pursuant to paragraph (a) of this section.
Prospective purchaser means either an individual contract owner or
an individual participant in a group contract.
Qualified evaluator means any evaluator that represents it is in a
position to determine, on the basis of an informal evaluation of the
eligible trust securities held in a unit investment trust's portfolio,
whether:
(i) The current bid price is higher than the offering side
evaluation, computed on the last business day of the previous week; and
(ii) The offering side evaluation, computed as of the last business
day of the previous week, is more than one-half of one percent ($5.00
on a unit representing $1,000 principal amount of eligible trust
securities) greater than the current offering price.
Swing factor means the amount, expressed as a percentage of the
fund's net asset value and determined pursuant to the fund's swing
pricing policies and procedures, by which a fund adjusts its net asset
value per share.
Swing pricing means the process of adjusting a fund's current net
asset value per share to mitigate dilution of the value of its
outstanding redeemable securities as a result of shareholder purchase
and redemption activity, pursuant to the requirements set forth in
paragraph (b) of this section.
Swing pricing administrator means the fund's investment adviser,
officer, or officers responsible for administering the swing pricing
policies and procedures. The swing pricing administrator may consist of
a group of persons.
0
3. Amend Sec. 270.22e-4 by:
0
a. Removing paragraphs (a)(3) and (10);
0
b. Removing the designations for paragraphs (a)(1) and (2) and (a)(4)
through (14) and placing in alphabetical order;
0
c. Adding, in alphabetical order, a definition for ``Convertible to
U.S. dollars'';
0
d. Revising the definitions for ``Exchange-traded fund'', ``Highly
liquid investment'', ``Illiquid investment'', ``In-Kind Exchange Traded
Fund or In-Kind ETF'', ``Liquidity risk'', ``Moderately liquid
investment'', and ``Person(s) designated to administer the program'';
0
e. Adding, in alphabetical order, a definition for ``Significantly
changing the market value of an investment''; and
0
f. Revising paragraphs (b)(1)(i)(C), (b)(1)(ii) and (iii), (b)(1)(iv)
introductory text, and (b)(3)(iii).
The revisions read as follows:
Sec. 270.22e-4 Liquidity risk management programs.
(a) * * *
Convertible to U.S. dollars means the ability to be sold or
disposed of, with the sale or disposition settled in U.S. dollars.
Exchange-traded fund or ETF means an open-end management investment
company (or series or class thereof), the shares of which are listed
and traded on a national securities exchange, and that has formed and
operates under an exemptive order under the Act granted by the
Commission or in reliance on Sec. 270.6c-11.
* * * * *
Highly liquid investment means any U.S. dollars held by a fund and
any investment that the fund reasonably expects to be convertible to
U.S. dollars in current market conditions in three business days or
less without significantly changing the market value of the investment,
as determined pursuant to the provisions of paragraph (b)(1)(ii) of
this section.
* * * * *
Illiquid investment means any investment that the fund reasonably
expects not to be convertible to U.S. dollars in current market
conditions in seven calendar days or less without significantly
changing the market value of the investment, as determined pursuant to
the provisions of paragraph (b)(1)(ii) of this section. Any investment
whose fair value is measured using an unobservable input that is
significant to the overall measurement is an illiquid investment.
In-Kind Exchange Traded Fund or In-Kind ETF means an ETF that meets
redemptions through in-kind transfers of securities, positions, and
assets other than a de minimis amount of U.S. dollars and that
publishes its portfolio holdings daily.
Liquidity risk means the risk that the fund could not meet requests
to redeem shares issued by the fund without significant dilution of
remaining investors' interests in the fund.
Moderately liquid investment means any investment that is neither a
highly liquid investment nor an illiquid investment.
Person(s) designated to administer the program means the fund or
In-Kind ETF's investment adviser, officer, or officers (which may not
be solely portfolio managers of the fund or In-Kind ETF) responsible
for administering the program and its policies and procedures pursuant
to paragraph (b)(2)(ii) of this section.
Significantly changing the market value of an investment means:
(i) For shares listed on a national securities exchange or a
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.
(ii) For any other investment, any sale or disposition that the
fund reasonably expects would result in a decrease in sale price of
more than 1%.
* * * * *
(b) * * *
(1) * * *
(i) * * *
(C) Holdings of U.S. dollars and cash equivalents, as well as
borrowing arrangements and other funding sources; and
* * * * *
(ii) Classification. Each fund must, using information obtained
after reasonable inquiry and taking into account relevant market,
trading, and investment-specific considerations, classify daily each of
the fund's portfolio investments (including each of the fund's
derivatives transactions) as a highly liquid investment, moderately
liquid investment, or illiquid investment. To determine the liquidity
classification of each investment, the fund must:
(A) Measure the number of days in which the investment is
reasonably expected to be convertible to U.S. dollars without
significantly changing the market value of the investment, and include
the day on which the liquidity classification is made in that
measurement; and
(B) Assume the sale of 10% of the fund's net assets by reducing
each investment by 10%.
(iii) Highly liquid investment minimum. A fund must determine and
maintain a highly liquid investment minimum that is equal to or higher
than 10% of the fund's net assets.
(A) When determining a highly liquid investment minimum, a fund
must consider the factors specified in paragraphs (b)(1)(i)(A) through
(D) of this section, as applicable (but considering those factors
specified in paragraphs (b)(1)(i)(A) and (B) only as they apply during
normal conditions, and during stressed conditions only to the extent
they are reasonably foreseeable during the period until the next review
of the highly liquid investment minimum).
[[Page 77291]]
(B) For purposes of determining compliance with its highly liquid
investment minimum, the fund must reduce the value of its highly liquid
investments that are assets otherwise eligible to meet the fund's
highly liquid investment minimum by an amount equal to:
(1) The value of any highly liquid investments that are assets
posted as margin or collateral in connection with any derivatives
transaction that the fund has classified as a moderately liquid
investment or illiquid investment; and
Note 1 to paragraph (b)(1)(iii)(B)(1):
A fund that has posted highly liquid investments and non-highly
liquid investments as margin or collateral in connection with
derivatives transactions classified as moderately liquid or illiquid
investments first should apply posted assets that are highly liquid
investments in connection with these transactions, unless it has
specifically identified non-highly liquid investments as margin or
collateral in connection with such derivatives transactions.
(2) Any fund liabilities.
(C) The highly liquid investment minimum determined pursuant to
paragraph (b)(1)(iii) of this section may not be changed during any
period of time that a fund's assets that are highly liquid investments
are below the determined minimum without approval from the fund's board
of directors, including a majority of directors who are not interested
persons of the fund;
(D) A fund must periodically review, no less frequently than
annually, the highly liquid investment minimum; and
(E) A fund must adopt and implement policies and procedures for
responding to a shortfall of the fund's highly liquid investments below
its highly liquid investment minimum, which must include requiring the
person(s) designated to administer the program to report to the fund's
board of directors no later than its next regularly scheduled meeting
with a brief explanation of the causes of the shortfall, the extent of
the shortfall, and any actions taken in response, and if the shortfall
lasts more than 7 consecutive calendar days, must include requiring the
person(s) designated to administer the program to report to the board
within one business day thereafter with an explanation of how the fund
plans to restore its minimum within a reasonable period of time.
(iv) Illiquid investments. No fund or In-Kind ETF may acquire any
illiquid investment if, immediately after the acquisition, the fund or
In-Kind ETF would have invested more than 15% of its net assets in
illiquid investments that are assets. In determining its compliance
with this paragraph, in addition to the value of a fund's illiquid
investments that are assets, where a fund has posted margin or
collateral in connection with a derivatives transaction that is
classified as an illiquid investment, the fund also must include as
illiquid investments that are assets the value of margin or collateral
posted in connection with the derivatives transaction that the fund
would receive if it exited the transaction. If a fund or In-Kind ETF
holds more than 15% of its net assets in illiquid investments that are
assets:
* * * * *
(3) * * *
(iii) If applicable, a written record of the policies and
procedures related to how the highly liquid investment minimum, and any
adjustments thereto, were determined, including assessment of the
factors incorporated in paragraph (b)(1)(iii)(A) of this section and
any materials provided to the board pursuant to paragraph
(b)(1)(iii)(E) of this section, for a period of not less than five
years (the first two years in an easily accessible place) following the
determination of, and each change to, the highly liquid investment
minimum.
* * * * *
0
4. Amend Sec. 270.30b1-9 by revising it to read as follows:
Sec. 270.30b1-9 Monthly report.
Each registered management investment company or exchange-traded
fund organized as a unit investment trust, or series thereof, other
than a registered open-end management investment company that is
regulated as a money market fund under Sec. 270.2a-7 or a small
business investment company registered on Form N-5 (Sec. Sec. 239.24
and 274.5 of this chapter), must file a monthly report of portfolio
holdings on Form N-PORT (Sec. 274.150 of this chapter), current as of
the last business day, or last calendar day, of the month. A registered
investment company that has filed a registration statement with the
Commission registering an offering of its securities for the first time
under the Securities Act of 1933 is relieved of this reporting
obligation with respect to any reporting period or portion thereof
prior to the date on which that registration statement becomes
effective or is withdrawn. Reports on Form N-PORT must be filed with
the Commission no later than 30 days after the end of each month.
0
5. Amend Sec. 270.31a-2 by revising paragraph (a)(2) to read as
follows:
Sec. 270.31a-2 Records to be preserved by registered investment
companies, certain majority-owned subsidiaries thereof, and other
persons having transactions with registered investment companies.
(a) * * *
(2) Preserve for a period not less than six years from the end of
the fiscal year in which any transactions occurred, the first two years
in an easily accessible place, all books and records required to be
made pursuant to paragraphs (b)(5) through (12) of Sec. 270.31a-1 and
all vouchers, memoranda, correspondence, checkbooks, bank statements,
cancelled checks, cash reconciliations, cancelled stock certificates,
and all schedules evidencing and supporting each computation of net
asset value of the investment company shares, including schedules
evidencing and supporting each computation of an adjustment to net
asset value of the investment company shares based on swing pricing
policies and procedures established and implemented pursuant to Sec.
270.22c-1(b), and other documents required to be maintained by Sec.
270.31a-1(a) and not enumerated in Sec. 270.31a-1(b).
* * * * *
PART 274--FORMS PRESCRIBED UNDER THE INVESTMENT COMPANY ACT OF 1940
0
6. The general authority citation for part 274 continues to read as
follows:
Authority: 15 U.S.C. 77f, 77g, 77h, 77j, 77s, 78c(b), 78l, 78m,
78n, 78o(d), 80a-8, 80a-24, 80a-26, 80a-29, and 80a-37, unless
otherwise noted.
* * * * *
0
7. Amend Form N-1A (referenced in Sec. Sec. 239.15A and 274.11A) by
revising Item 6(d) and Item 11(a)(2). The revisions read as follows:
Note: The text of Form N-1A does not, and these amendments will
not, appear in the Code of Federal Regulations.
Form N-1A
* * * * *
Item 6. Purchase and Sale of Fund Shares
* * * * *
(d) If the Fund uses swing pricing, explain the Fund's use of swing
pricing; including what swing pricing is, the circumstances under which
the Fund will use it, and the effects of swing pricing on the Fund and
investors. With respect to any portion of a Fund's assets that is
invested in one or more open-end management investment companies that
are registered under the Investment Company Act, the Fund shall include
a statement that the Fund's net asset value is calculated based upon
the net asset
[[Page 77292]]
values of the registered open-end management companies in which the
Fund invests, and, if applicable, state that the prospectuses for those
companies explain the circumstances under which they will use swing
pricing and the effects of using swing pricing.
* * * * *
Item 11. Shareholder Information
(a) * * *
(2) A statement as to when calculations of net asset value are made
and that the price at which a purchase or redemption is effected is
based on the next calculation of net asset value after the order is
placed. If applicable, explain that if an investor places an order with
a financial intermediary, the financial intermediary may require the
investor to submit its order earlier to receive the next calculated net
asset value.
* * * * *
0
8. Amend Sec. 274.150(a) by revising it to read as follows:
Sec. 274.150 Form N-PORT, Monthly portfolios holdings report.
(a) Except as provided in paragraph (b) of this section, this form
shall be used by registered management investment companies or
exchange-traded funds organized as unit investment trusts, or series
thereof, to file reports pursuant to Sec. 270.30b1-9 of this chapter
not later than 30 days after the end of each month.
* * * * *
0
9. Amend Form N-PORT (referenced in Sec. 274.150) by:
0
a. Revising General Instructions A, E, and F and Items B.4, B.5, B.6,
B.7, B.8, C.1, C.7, C.10, C.11, Part D, and Part F; and
0
b. Adding Items B.11 and B.12.
The revisions and addition read as follows:
Note: The text of Form N-PORT does not, and these amendments
will not, appear in the Code of Federal Regulations.
Form N-PORT
* * * * *
General Instructions
A. Rule as to Use of Form N-PORT
Form N-PORT is the reporting form that is to be used for monthly
reports of Funds other than money market funds and SBICs under section
30(b) of the Act, as required by rule 30b1-9 under the Act (17 CFR
270.30b1-9). Funds must report information about their portfolios and
each of their portfolio holdings as of the last business day, or last
calendar day, of each month. A registered investment company that has
filed a registration statement with the Commission registering its
securities for the first time under the Securities Act of 1933 is
relieved of this reporting obligation with respect to any reporting
period or portion thereof prior to the date on which that registration
statement becomes effective or is withdrawn.
Reports on Form N-PORT must disclose portfolio information as
calculated by the fund for the reporting period's ending net asset
value (commonly, and as permitted by rule 2a-4, the first business day
following the trade date). Reports on Form N-PORT for each month must
be filed with the Commission no later than 30 days after the end of
such month. If the due date falls on a weekend or holiday, the filing
deadline will be the next business day.
A Fund may file an amendment to a previously filed report at any
time, including an amendment to correct a mistake or error in a
previously filed report. A Fund that files an amendment to a previously
filed report must provide information in response to all items of Form
N-PORT, regardless of why the amendment is filed.
* * * * *
E. Definitions
References to sections and rules in this Form N-PORT are to the
Act, unless otherwise indicated. Terms used in this Form N-PORT have
the same meanings as in the Act or related rules (including rule 18f-4
solely for Items B.9 and 10 of the Form), unless otherwise indicated.
As used in this Form N-PORT, the terms set out below have the
following meanings:
``Absolute VaR Test'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
``Class'' means a class of shares issued by a Fund that has more
than one class that represents interests in the same portfolio of
securities under rule 18f-3 [17 CFR 270.18f-3] or under an order
exempting the Fund from provisions of section 18 of the Act [15 U.S.C.
80a-18].
``Controlled Foreign Corporation'' has the meaning provided in
section 957 of the Internal Revenue Code [26 U.S.C. 957].
``Derivatives Exposure'' has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
``Designated Index'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
``Designated Reference Portfolio'' has the meaning defined in rule
18f-4(a) [17 CFR 270.18f-4(a)]
``Exchange-Traded Fund'' means an open-end management investment
company (or Series or Class thereof) or unit investment trust (or
series thereof), the shares of which are listed and traded on a
national securities exchange at market prices, and that has formed and
operates under an exemptive order under the Act granted by the
Commission or in reliance on rule 6c-11 [17 CFR 270.6c-11].
``Fund'' means the Registrant or a separate Series of the
Registrant. When an item of Form N-PORT specifically applies to a
Registrant or a Series, those terms will be used.
``Highly Liquid Investment Minimum'' has the meaning defined in
rule 22e-4 [17 CFR 270.22e-4].
``Illiquid Investment'' has the meaning defined in rule 22e-4 [17
CFR 270.22e-4].
``ISIN'' means, with respect to any security, the ``international
securities identification number'' assigned by a national numbering
agency, partner, or substitute agency that is coordinated by the
Association of National Numbering Agencies.
``LEI'' means, with respect to any company, the ``legal entity
identifier'' as assigned by a utility endorsed by the Global LEI
Regulatory Oversight Committee or accredited by the Global LEI
Foundation.
``Multiple Class Fund'' means a Fund that has more than one Class.
``Registrant'' means a management investment company, or an
Exchange-Traded Fund organized as a unit investment trust, registered
under the Act.
``Relative VaR Test'' has the meaning defined in rule 18f-4(a) [17
CFR 270.18f-4(a)].
``Restricted Security'' has the meaning defined in rule 144(a)(3)
under the Securities Act of 1933 [17 CFR 230.144(a)(3)].
``RSSD ID'' means the identifier assigned by the National
Information Center of the Board of Governors of the Federal Reserve
System.
``Securities Portfolio'' has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
``Series'' means shares offered by a Registrant that represent
undivided interests in a portfolio of investments and that are
preferred over all other series of shares for assets specifically
allocated to that series in accordance with rule 18f-2(a) [17 CFR
270.18f-2(a)].
``Swap'' means either a ``security-based swap'' or a ``swap'' as
defined in sections 3(a)(68) and (69) of the Securities Exchange Act of
1934 [15 U.S.C. 78c(a)(68) and (69)] and any
[[Page 77293]]
rules, regulations, or interpretations of the Commission with respect
to such instruments.
``Swing Factor'' has the meaning defined in rule 22c-1 [17 CFR
270.22c-1].
``Value-at-Risk'' or VaR has the meaning defined in rule 18f-4(a)
[17 CFR 270.18f-4(a)].
``VaR Ratio'' means the value of the Fund's portfolio VaR divided
by the VaR of the Designated Reference Portfolio.
F. Public Availability
Information reported on Form N-PORT will be made publicly available
60 days after the end of the reporting period.
The SEC does not intend to make public the information reported on
Form N-PORT with respect to a Fund's Highly Liquid Investment Minimum
(Item B.7), derivatives transactions (Item B.8), Derivatives Exposure
for limited derivatives users (Item B.9), median daily VaR (Item
B.10.a), median VaR Ratio (Item B.10.b.iii), VaR backtesting results
(Item B.10.c), country of risk and economic exposure (Item C.5.b),
delta (Items C.9.f.v, C.11.c.vii, or C.11.g.iv), liquidity
classification for individual portfolio investments (Item C.7), or
miscellaneous securities (Part D), or explanatory notes related to any
of those topics (Part E) that is identifiable to any particular fund or
adviser. However, the SEC may use information reported on this Form in
its regulatory programs, including examinations, investigations, and
enforcement actions.
* * * * *
Item B.4. Securities Lending.
a. * * *
iii. If the borrower does not have an LEI, provide the borrower's
RSSD ID, if any.
iv. Aggregate value of all securities on loan to the borrower.
* * * * *
Item B.5. Return Information.
a. Total return of the Fund during the reporting period. If the Fund is
a Multiple Class Fund, report the return for each Class. Such return(s)
shall be calculated in accordance with the methodologies outlined in
Item 26(b)(1) of Form N-1A, Instruction 13 to sub-Item 1 of Item 4 of
Form N-2, or Item 26(b)(i) of Form N-3, as applicable.
* * * * *
c. Net realized gain (loss) and net change in unrealized
appreciation (or depreciation) attributable to derivatives for each of
the following asset categories during the reporting period: commodity
contracts, credit contracts, equity contracts, foreign exchange
contracts, interest rate contracts, and other contracts. Within each
such asset category, further report the same information for each of
the following types of derivatives instrument: forward, future, option,
swaption, swap, warrant, and other. Report in U.S. dollars. Losses and
depreciation shall be reported as negative numbers.
d. Net realized gain (loss) and net change in unrealized
appreciation (or depreciation) attributable to investments other than
derivatives during the reporting period. Report in U.S. dollars. Losses
and depreciation shall be reported as negative numbers.
Item B.6. Flow information. Provide the aggregate dollar amounts
for sales and redemptions/repurchases of Fund shares during the
reporting period. If shares of the Fund are held in omnibus accounts,
for purposes of calculating the Fund's sales, redemptions, and
repurchases, use net sales or redemptions/repurchases from such omnibus
accounts. The amounts to be reported under this Item should be after
any front-end sales load has been deducted and before any deferred or
contingent deferred sales load or charge has been deducted. Shares sold
shall include shares sold by the Fund to a registered unit investment
trust. For mergers and other acquisitions, include in the value of
shares sold any transaction in which the Fund acquired the assets of
another investment company or of a personal holding company in exchange
for its own shares. For liquidations, include in the value of shares
redeemed any transaction in which the Fund liquidated all or part of
its assets. Exchanges are defined as the redemption or repurchase of
shares of one Fund or series and the investment of all or part of the
proceeds in shares of another Fund or series in the same family of
investment companies.
* * * * *
Item B.7. Highly Liquid Investment Minimum information.
* * * * *
b. If applicable, provide the number of days that the eligible
value of the Fund's holdings in highly liquid investments fell below
the Fund's Highly Liquid Investment Minimum during the reporting
period.
* * * * *
Item B.8. Derivatives Transactions. For portfolio investments of
open-end management investment companies, provide:
a. The value of the Fund's highly liquid investments that are
assets that it has posted as margin or collateral in connection with
derivatives transactions that are classified as moderately liquid
investments or illiquid investments under rule 22e-4 [17 CFR 270.22e-
4].
b. The value of any margin or collateral posted in connection with
any derivatives transaction that is classified as an illiquid
investment under rule 22e-4 [17 CFR 270.22e-4] where the fund would
receive the value of the margin or collateral if it exited the
derivatives transaction.
* * * * *
Item B.11. Swing Factor.
a. Provide the number of times the Fund applied a Swing Factor
during the reporting period.
b. For each business day during the reporting period, provide the
amount of any Swing Factor applied by the Fund. Indicate whether each
Swing Factor applied is positive (reflecting net purchases) or negative
(reflecting net redemptions) with the appropriate sign (+ or -). Report
N/A for any business day on which the fund did not apply a Swing
Factor.
Item B.12. Liquidity aggregate classification information. For
portfolio investments of open-end management investment companies:
a. Provide the aggregate percentage of investments that are assets
(excluding any investments that are reflected as liabilities on the
Fund's balance sheet) compared to total investments that are assets of
the Fund for each of the following categories as specified in rule 22e-
4:
1. Highly Liquid Investments.
2. Moderately Liquid Investments.
3. Illiquid Investments.
b. To calculate the aggregate percentages under Item B.12.a, reduce
the amount of the Fund's assets that are classified as highly liquid
investments by the amount reported under Item B.8.a and by the amount
of the fund's liabilities. Increase the amount of the Fund's assets
that are classified as illiquid investments by the amount reported
under Item B.8.b. To the extent these adjustments result in the sum of
the Fund's investments in each category not equaling 100% of the Fund's
total investments that are assets, the Fund may adjust the percentage
of investments attributed to the moderately liquid investment category
so that the sum of the Fund's investments in each category equals 100%
of the Fund's total investments that are assets.
Item C.1. Identification of investment.
* * * * *
c. If the issuer does not have an LEI, provide the issuer's RSSD
ID, if any.
d. Title of the issue or description of the investment.
e. CUSIP (if any).
[[Page 77294]]
f. At least one of the following other identifiers:
i. ISIN.
ii. Ticker (if ISIN is not available).
iii. Other unique identifier (if ticker and ISIN are not
available). Indicate the type of identifier used.
* * * * *
Item C.7. Liquidity classification information.
a. For portfolio investments of open-end management investment
companies, provide the liquidity classification(s) for each portfolio
investment among the following categories as specified in rule 22e-4
[17 CFR 270.22e-4]. For portfolio investments with multiple liquidity
classifications, indicate the percentage amount attributable to each
classification.
i. Highly Liquid Investments
ii. Moderately Liquid Investments
iii. Illiquid Investments
* * * * *
Instructions to Item C.7. Funds may choose to indicate the
percentage amount of a holding attributable to multiple classification
categories only in the following circumstances: (1) if portions of the
position have differing liquidity features that justify treating the
portions separately; (2) if a fund has multiple sub-advisers with
differing liquidity views; or (3) if the fund chooses to classify the
position through evaluation of how long it would take to liquidate the
entire position. In (1) and (2), a fund would classify by treating each
portion of the position as a separate investment to arrive at an
assumed sale size that is equal to 10% of the fund's net assets by
reducing each investment by 10%.
* * * * *
Item C.10. For repurchase and reverse repurchase agreements, also
provide:
* * * * *
b. * * *
iii. If the counterparty does not have an LEI, provide the
counterparty's RSSD ID, if any.
* * * * *
Item C.11. For derivatives, also provide:
* * * * *
b. * * *
ii. If the counterparty does not have an LEI, provide the
counterparty's RSSD ID, if any.
* * * * *
Part D: Miscellaneous Securities
Report miscellaneous securities, if any, using the same Item
numbers and reporting the same information that would be reported for
each investment in Part C if it were not a miscellaneous security.
Information reported in this Item will be nonpublic.
* * * * *
Part F: Exhibits
Attach no later than 60 days after the end of the reporting period
the Fund's complete portfolio holdings as of the close of the period
covered by the report, except for reports covering the last month of
the Fund's second and fourth fiscal quarters. These portfolio holdings
must be presented in accordance with the schedules set forth in
Sec. Sec. 210.12-12--210.12-14 of Regulation S-X [17 CFR 210.12-12--
210.12-14].
* * * * *
0
10. Amend Form N-CEN (referenced in Sec. 274.101) by revising General
Instruction E and Items B.16, B.17, C.5, C.6, C.9, C.10, C.11, C.12,
C.13, C.14, C.15, C.16, C.17, C.21, D.12, D.13, D.14, E.2, F.1, F.2,
F.4, and Instructions to Item G.1 to read as follows:
Note: The text of Form N-CEN does not, and these amendments
will not, appear in the Code of Federal Regulations.
Form N-CEN
* * * * *
General Instructions
* * * * *
E. Definitions
Except as defined below or where the context clearly indicates the
contrary, terms used in Form N-CEN have meanings as defined in the Act
and the rules and regulations thereunder. Unless otherwise indicated,
all references in the form or its instructions to statutory sections or
to rules are sections of the Act and the rules and regulations
thereunder.
In addition, the following definitions apply:
``Class'' means a class of shares issued by a Fund that has more
than one class that represents interest in the same portfolio of
securities under rule 18f-3 under the Act (17 CFR 270.18f-3) or under
an order exempting the Fund from provisions of section 18 of the Act
(15 U.S.C. 80a-18).
``CRD number'' means a central licensing and registration system
number issued by the Financial Industry Regulatory Authority.
``Exchange-Traded Fund'' means an open-end management investment
company (or Series or Class thereof) or unit investment trust (or
series thereof), the shares of which are listed and traded on a
national securities exchange at market prices, and that has formed and
operates under an exemptive order under the Act granted by the
Commission or in reliance on rule 6c-11 under the Act (17 CFR 270.6c-
11).
``Exchange-Traded Managed Fund'' means an open-end management
investment company (or Series or Class thereof) or unit investment
trust (or series thereof), the shares of which are listed and traded on
a national securities exchange at net asset value-based prices, and
that has formed and operates under an exemptive order under the Act
granted by the Commission or in reliance on an exemptive rule under the
Act adopted by the Commission.
``Fund'' means the Registrant or a separate Series of the
Registrant. When an item of Form N-CEN specifically applies to a
Registrant or Series, those terms will be used.
``LEI'' means, with respect to any company, the ``legal entity
identifier'' as assigned by a utility endorsed by the Global LEI
Regulatory Oversight Committee or accredited by the Global LEI
Foundation.
``Money Market Fund'' means an open-end management investment
company registered under the Act, or Series thereof, that is regulated
as a money market fund pursuant to rule 2a-7 under the Act (17 CFR
270.2a-7).
``PCAOB number'' means the registration number issued to an
independent public accountant registered with the Public Company
Accounting Oversight Board.
``Registrant'' means the investment company filing this report or
on whose behalf the report is filed.
``RSSD ID'' means the identifier assigned by the National
Information Center of the Board of Governors of the Federal Reserve
System.
``SEC File number'' means the number assigned to an entity by the
Commission when that entity registered with the Commission in the
capacity in which it is named in Form N-CEN.
``Series'' means shares offered by a Registrant that represent
undivided interests in a portfolio of investments and that are
preferred over all other Series of shares for assets specifically
allocated to that Series in accordance with rule 18f-2(a) (17 CFR
270.18f-2(a)).
* * * * *
Item B.16. Principal underwriters.
a. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Is the principal underwriter an affiliated person of the
Registrant, or its
[[Page 77295]]
investment adviser(s) or depositor? [Y/N]
* * * * *
Item B.17. Independent public accountant. Provide the following
information about each independent public accountant:
* * * * *
d. If no LEI is provided, RSSD ID, if any:__
e. State, if applicable:__
f. Foreign country, if applicable:__
g. Has the independent public accountant changed since the last
filing? [Y/N]
* * * * *
Item C.5. Investments in certain foreign corporations.
* * * * *
b. * * *
iii. If no LEI is provided, RSSD ID, if any:__
* * * * *
Item C.6. Securities lending.
* * * * *
c. * * *
iii. If no LEI is provided, RSSD ID, if any:__
iv. Is the securities lending agent an affiliated person, or an
affiliated person of an affiliated person, of the Fund? [Y/N]
v. Does the securities lending agent or any other entity indemnify
the fund against borrower default on loans administered by this agent?
[Y/N]
vi. If the entity providing the indemnification is not the
securities lending agent, provide the following information:
1. Name of person providing indemnification:__
2. LEI, if any, of person providing indemnification:__
3. If no LEI is provided, RSSD ID, if any:__
vii. Did the Fund exercise its indemnification rights during the
reporting period? [Y/N]
d. * * *
iii. If no LEI is provided, RSSD ID, if any: __
iv. Is the cash collateral manager an affiliated person, or an
affiliated person of an affiliated person, of a securities lending
agent retained by the Fund? [Y/N]
v. Is the cash collateral manager an affiliated person, or an
affiliated person of an affiliated person, of the Fund? [Y/N]
* * * * *
Item C.9. Investment advisers.
a. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Was the investment adviser hired during the reporting period?
[Y/N]
1. If the investment adviser was hired during the reporting period,
indicate the investment adviser's start date: __
b. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Termination date:__
c. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Is the sub-adviser an affiliated person of the Fund's
investment adviser(s)? [Y/N]
ix. Was the sub-adviser hired during the reporting period? [Y/N]
1. If the sub-adviser was hired during the reporting period,
indicate the sub-adviser's start date:__
d. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Termination date:
Item C.10. Transfer agents.
a. * * *
iv. If no LEI is provided, RSSD ID, if any:__
v. State, if applicable:__
vi. Foreign country, if applicable:__
vii. Is the transfer agent an affiliated person of the Fund or its
investment adviser(s)? [Y/N]
viii. Is the transfer agent a sub-transfer agent? [Y/N]
* * * * *
Item C.11. Pricing services.
a. * * *
ii. LEI, if any, or RSSD ID, if any, or provide and describe other
identifying number:__
* * * * *
Item C.12. Custodians.
a. * * *
iii. If no LEI is provided, RSSD ID, if any:__
iv. State, if applicable:__
v. Foreign country, if applicable:__
vi. Is the custodian an affiliated person of the Fund or its
investment adviser(s)? [Y/N]
vii. Is the custodian a sub-custodian? [Y/N]
viii. With respect to the custodian, check below to indicate the
type of custody:
1. Bank--section 17(f)(1) (15 U.S.C. 80a-17(f)(1)):__
2. Member national securities exchange--rule 17f-1 (17 CFR 270.17f-
1):__
3. Self--rule 17f-2 (17 CFR 270.17f-2):__
4. Securities depository--rule 17f-4 (17 CFR 270.17f-4):__
5. Foreign custodian--rule 17f-5 (17 CFR 270.17f-5):__
6. Futures commission merchants and commodity clearing
organizations--rule 17f-6 (17 CFR 270.17f-6):__
7. Foreign securities depository--rule 17f-7 (17 CFR 270.17f-7):__
8. Insurance company sponsor--rule 26a-2 (17 CFR 270.26a-2):__
9. Other:__ . If other, describe:__.
* * * * *
Item C.13. Shareholder servicing agents.
a. * * *
ii. LEI, if any, or RSSD ID, if any, or provide and describe other
identifying number:__
* * * * *
Item C.14. Administrators.
a. * * *
ii. LEI, if any, or RSSD ID, if any, or provide and describe other
identifying number:__
* * * * *
Item C.15. Affiliated broker-dealers. Provide the following
information about each affiliated broker-dealer:
* * * * *
e. If no LEI is provided, RSSD ID, if any:__
f. State, if applicable:__
g. Foreign country, if applicable:__
h. Total commissions paid to the affiliated broker-dealer for the
reporting period:__
Item C.16. Brokers.
a. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Gross commissions paid by the Fund for the reporting
period:__
* * * * *
Item C.17. Principal transactions.
a. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Total value of purchases and sales (excluding maturing
securities) with Fund:__
* * * * *
Item C.21. Liquidity classification services. For open-end
management investment companies subject to rule 22e-4 (17 CFR 270.22e-
4), respond to the following:
a. Provide the following information about each person that
provided liquidity classification services to the Fund during the
reporting period:
[[Page 77296]]
i. Full name:__
ii. LEI, if any, or RSSD ID, if any, or provide and describe other
identifying number:__
iii. State, if applicable:__
iv. Foreign country, if applicable:__
v. Is the liquidity classification service an affiliated person of
the Fund or its investment adviser(s)? [Y/N]
vi. Asset class(es) for which liquidity classification services
were provided to the Fund:__
b. Was a liquidity classification service hired or terminated
during the reporting period? [Y/N]
* * * * *
Item D.12. Investment advisers (small business investment companies
only).
a. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Was the investment adviser hired during the reporting period?
[Y/N]
1. If the investment adviser was hired during the reporting period,
indicate the investment adviser's start date:__
b. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Termination date:__
c. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Is the sub-adviser an affiliated person of the Fund's
investment adviser(s)? [Y/N]
ix. Was the sub-adviser hired during the reporting period? [Y/N]
1. If the sub-adviser was hired during the reporting period,
indicate the sub-adviser's start date:__
d. * * *
v. If no LEI is provided, RSSD ID, if any:__
vi. State, if applicable:__
vii. Foreign country, if applicable:__
viii. Termination date:__
Item D.13. Transfer agents (small business investment companies
only).
a. * * *
iv. If no LEI is provided, RSSD ID, if any:__
v. State, if applicable:__
vi. Foreign country, if applicable:__
vii. Is the transfer agent an affiliated person of the Fund or its
investment adviser(s)? [Y/N]
viii. Is the transfer agent a sub-transfer agent? [Y/N]
* * * * *
Item D.14. Custodians (small business investment companies only).
a. * * *
iii. If no LEI is provided, RSSD ID, if any:__
iv. State, if applicable:__
v. Foreign country, if applicable:__
vi. Is the custodian an affiliated person of the Fund or its
investment adviser(s)? [Y/N]
vii. Is the custodian a sub-custodian? [Y/N]
viii. With respect to the custodian, check below to indicate the
type of custody:
1. Bank--section 17(f)(1) (15 U.S.C. 80a-17(f)(1)):__
2. Member national securities exchange--rule 17f-1 (17 CFR 270.17f-
1):__
3. Self--rule 17f-2 (17 CFR 270.17f-2):__
4. Securities depository--rule 17f-4 (17 CFR 270.17f-4):__
5. Foreign custodian--rule 17f-5 (17 CFR 270.17f-5):__
6. Futures commission merchants and commodity clearing
organizations--rule 17f-6 (17 CFR 270.17f-6):__
7. Foreign securities depository--rule 17f-7 (17 CFR 270.17f-7):__
8. Insurance company sponsor--rule 26a-2 (17 CFR 270.26a-2): __
9. Other:__. If other, describe:__.
* * * * *
Item E.2. Authorized participants. For each authorized participant
of the Fund, provide the following information:
* * * * *
b. SEC file number:__
c. CRD number:__
d. LEI, if any:__
e. If no LEI is provided, RSSD ID, if any:__
f. The dollar value of the Fund shares the authorized participant
purchased from the Fund during the reporting period:__
g. The dollar value of the Fund shares the authorized participant
redeemed during the reporting period:__
h. Did the Fund require that an authorized participant post
collateral to the Fund or any of its designated service providers in
connection with the purchase or redemption of Fund shares during the
reporting period? [Y/N]
Instruction. The term ``authorized participant'' means a member or
participant of a clearing agency registered with the Commission, which
has a written agreement with the Exchange-Traded Fund or Exchange-
Traded Managed Fund or one of its service providers that allows the
authorized participant to place orders for the purchase and redemption
of creation units.
* * * * *
Item F.1. Depositor. Provide the following information about each
depositor:
* * * * *
d. If no LEI is provided, RSSD ID, if any:__
e. State, if applicable:__
f. Foreign country, if applicable:__
g. Full name of ultimate parent of depositor:__
Item F.2. Administrators.
a. * * *
ii. LEI, if any, or RSSD ID, if any, or provide and describe other
identifying number:__
* * * * *
Item F.4. Sponsor. Provide the following information about each
sponsor:
* * * * *
d. If no LEI is provided, RSSD ID, if any:__
e. State, if applicable:__
f. Foreign country, if applicable:__
* * * * *
Item G.1. Attachments.
* * * * *
Instructions.
* * * * *
2. * * *
(f) Security supported (if applicable). Disclose the full name of
the issuer, the title of the issue (including coupon or yield, if
applicable) and at least two identifiers, if available (e.g., CIK,
CUSIP, ISIN, LEI, RSSD ID).
* * * * *
By the Commission.
Dated: November 2, 2022.
Vanessa A. Countryman,
Secretary.
[FR Doc. 2022-24376 Filed 12-15-22; 8:45 am]
BILLING CODE 8011-01-P