SEC Rule 22e-4 Creates Number of Compliance Problems for Buy Side

Anna Lyudvig
Chantal Mantovani

Lack of liquidity, coupled with the highly interconnected nature of modern derivatives, can lead to massive fund redemptions, increasing the pressure to sell into thin markets, according to Chantal Mantovani, Product Manager for RegTech and Fixed Income Analytics, Confluence.

Securities regulators worldwide have developed rules that require fund managers to both measure and report on the actual liquidity of the instruments in their portfolios and the length of time it might take to sell them, she wrote in a blog.

In the U.S., this has taken the form of SEC Rule 22e-4, which requires that a minimum percentage of the investments comprising a fund’s portfolio be highly liquid.

“Rule 22e-4 is specifically aimed at quantifying liquidity risk in most mutual fund and ETF portfolios,” she said. 

The regulation requires funds to classify their positions as being in one of four buckets: highly liquid investments, moderately liquid investments, less liquid investments and illiquid investments1.

Mantovani said that just like the Liquidity Stress Testing framework authored by the EU’s ESMA, Rule 22e-4 has created a number of potential compliance problems for fund managers. 

“To thrive amid these requirements, investment managers must have a quick and simple way to assess the true liquidity of their portfolios,” she said.

She argued this is made more complicated by the fact that not all assets or markets are created equal. 

Compared to bond trading, which is often sporadic, for example, most public equities trade at a fairly high frequency, she said.

“In many cases, performing the extensive analysis required for fund managers to maintain Rule 22e-4 compliance in bond markets necessitates working with third parties that have the expertise to navigate these new regulatory waters,” she said.

Portfolio managers should address these challenges with a robust liquidity management platform. 

She provided an example of Confluence’s platform, which leverages quantitative and qualitative approaches to create an accurate representation of how the bond market handles liquidity.

In terms of ensuring that liquidity remains accessible under any market conditions, both Rule 22e-4 in the U.S. and the Liquidity Stress Testing framework in the EU represent steps in the right direction, Mantovani said.

“While there are some differences, in all cases fund managers are asked to subjectively account for relevant market, trading and investment-specific conditions when classifying and reporting on their assets and the buckets in which they reside,” she said.

Confluence expects the rules issued across different regulatory frameworks to take some time to get aligned. 

“The same goes for market depth requirements that call for managers to assess the degree to which selling a given proportion of the position would impact the liquidity characteristics of the remaining holding, as well as the potential impact to investors,” Mantovani said.

According to Mantovani, the goal of these regulations is to measure the likelihood “a fund will get caught”.

She said the ability to liquidate any asset depends on three things – how much of it is to be sold, how quickly it can be sold and the price that firms are willing (or required) to take – and then systemically tracking such exposure. 

“Rule 22e-4 continues to represent a major step forward in this area, and by leveraging compliance expertise and robust technology, funds can meet the moment with precision, efficiency and peace of mind,” she said.