Episode 47: Understanding the Liquidity Rule

On episode 47 we are joined by Core Compliance’s President Tito Pombra. He joins us today to give us some insight on the SEC Rule 22e-4, otherwise known as the “Liquidity Rule.”



CCO Buzz: Hello and Welcome Back! On episode 47 of the CCO Buzz we are joined by Core Compliance’s President Tito Pombra. He joins us today to give us some insight on the SEC Rule 22e-4, otherwise known as the “Liquidity Rule.” After reading up a bit on the rule, it’s a bit difficult to navigate- so I’m glad we have Tito here to guide us and the Core Team on this new regulation. So, let’s begin…

In December of last year, The SEC released a new regulation, SEC Rule 22e-4, Tito can you tell us more about the new regulation?

Tito Pombra: Sure, the SEC’s “liquidity rule”, that’s what it’s called - was designed to assist the industry mitigate liquidity risk. It goes into effect for large firms in a few weeks on June 1st, and for smaller firms on December 1st, 2019. Its implementation aims to benefit fund investors and reinforce the public’s faith in the industry by requiring asset managers who offer mutual funds and exchange-traded funds (or” ETFs”) to establish a formal and comprehensive program to manage and report liquidity limit breaches to the fund board and the SEC, as well as provides an industrywide standard to liquidity. This new regulation was a collaboration to push for regulatory reform and transparency market wide.

CCO Buzz: What are the requirements of the new rule?

Tito Pombra: So, I have been doing compliance for 22 years – more than 22 years, and I think this is one of the most challenging rules ever to implement. I think a lot of CCOs and compliance professionals have been struggling with this rule. So, what does it mean? Overall the rule encompasses a required classification of fund holdings into 4 categories; which are based on a details of fund redemptions and how they may or may not affect their market values. The classifications provide a standard framework for ease of management, measuring, and reporting.

The four categories are Highly Liquid, Moderately Liquid, Less Liquid [and] Illiquid. They are defined as…

  • Highly Liquid - Can be converted to cash within 3 business days or less- without major effect to market value.
  • Moderately Liquid – Can be converted to cash in between 3-7 calendar days - without significantly changing the market value.
  • Less Liquid – Can be sold in 7 calendar days or less with out significantly changing market value, with the expectation to settle in more than 7 calendar days.
  • Illiquid – Which is a security that cannot be sold in 7 calendar days or less, without significantly changing market value.

So, the Illiquid part is the one that already existed in the 40 Act where there was a current limit of 15% - where the funds cannot invest more than 15% of total assets in illiquid securities. So, that is probably consistent, where the other three buckets are a new part of the rule.

Alongside of the classifications, this new regulation also requires…

  • Liquidity [risk] assessment, management, and periodic review;
  • Classification of portfolio investments (known as liquidity bucketing);
  • Determination of a highly liquid investment minimum (HLIM), if applicable;
  • Limitation of illiquid investments to 15% of net assets, as I mentioned earlier;
  • Adoption of policies and procedures for funds engaging in redemptions in-kind; and
  • Fund board oversight and board designation of Liquidity Risk Management Program Administrator

Most companies have taken the approach of having an individual running the program and delegated by the board to have a committee structure. So, a lot of firms are using the liquidity risk management oversight committee that reports up to the firm board on the liquidity rule.

CCO Buzz: That’s quite a bit to consider, but in the end what does this mean for Investors?

Tito Pombra: Well, like I said, it’s extremely challenging rule to implement and a lot of companies are struggling with it.  But then they are near the implementation [deadline] of the rule and they are all set to go on June 1st, hopefully to do that.  

Overall, this is great for investors as it enhances their own protections. As I mention before, the implementation of the rule is expected to strengthen liquidity risk management and provide transparency.

We have to understand that, under this rule, we are entering an area for the first time where investment advisers that offer these funds will also manage liquidity risk and under and industry-wide consistent approach. The rule not only formalizes the process, but also integrates fund investment and risk management into a firm’s operation guidelines.

Upon application of the rule, firms (regardless of firm size) are required to enhance their own programs and policies and procedures. Firms should reflect and analyze their own compliance structures within their governance, measurement, monitoring and reporting processes. Which will, in turn, enable their organization to better navigate under various market conditions. With the liquidity rule, firms are empowered to gauge the market and clients based on the universal classifications, strengthen their own compliance programs, and provide additional protection to their clients’ interests.

If you’d like to discuss the liquidity rule further or have any other questions regard your own compliance program and your compliance policies and procedures, please reach out to us at core compliance or call us at (619) 278-0020. Thank you.

CCO Buzz: Well that’s it for this week’s episode. If you’d like additional information, please check out our website at www.corecls.com. You can also follow us on Facebook, LinkedIn or Twitter @CoreCLS. Thank you and we hope you tune into next week’s episode of the CCO Buzz.