October 31, 2017 - On October 26th the US Department of the Treasury (“Treasury”) released the third in a series of reports on financial regulation, this one focusing on the asset management and insurance industries. Of particular interest to all loan market participants but especially managers of loan mutual funds was Treasury’s discussion of, and recommendations on, the Liquidity Risk Management Rules (“Liquidity Rules”) promulgated last October by the SEC. In a nutshell, Treasury supported the need for liquidity risk management rules, strongly endorsed the Liquidity Rule’s requirement that open-end mutual funds be limited to no more than 15% of illiquid assets, but rejected any “highly prescriptive” regulatory approach to liquidity risk management such as the “bucketing” requirement described below. Instead Treasury called for the adoption by the SEC of a “principles-based” approach to liquidity risk management rulemaking and recommended that the SEC postpone implementation of the bucketing requirement under the Liquidity Rule.
Some background: As we noted last year, the final rule requires open-end funds to divide, or “bucket”, their assets into four liquidity categories or buckets: i) highly liquid investments (cash and investments convertible to cash in three days), ii) moderately liquid investments (investments convertible to cash in four to seven days), iii) less liquid investments (investments that can be sold within seven days, but whose settlement takes longer), and iv) illiquid investments (those that cannot be sold within seven days). The Liquidity Rule represented a reprieve of sorts for the loan market because they were identified by the SEC as the sort of assets that would generally go into category three, “less liquid investments” rather than the fourth, “illiquid investments”. This was critical because the rule also states that funds cannot hold more than 15% of their assets in illiquid investments. Loans risked being put into category four because of their extended settlement times but ultimately the SEC focused on “ability to sell” rather than “ability to sell and settle” when determining what constituted an illiquid investment. (Nevertheless, language in the Liquidity Rule suggests that loans that trade on distressed documents (which have even more extended settlement times) might be appropriate candidates for the illiquid investments bucket).
The Liquidity Rule also requires managers to determine a “highly liquid minimum”, in other words, assets like cash or highly liquid investments, based on their investment strategies and portfolio liquidity during normal and foreseeable stressed conditions, their short-term and long-term cash flow projections and their holdings of cash and cash equivalents, borrowing arrangements and other funding sources.
It is unclear whether the SEC will follow Treasury’s recommendations and postpone bucketing past the current December 2018 implementation date but we will closely monitor developments on this important rule.