By David Scalzetti, CFA - Senior Regulatory Products Director, ICE Data Services

On March 14, 2018, the SEC re-opened the Liquidity Risk Management rule after extensive SEC outreach to address certain concerns. Among other updates, the SEC is removing the aggregated liquidity classifications from the public domain and allowing three exceptions to classify an instrument into multiple buckets. The 3 exceptions include various sleeves with different sub-advisers, classifications based on the entire fund position instead of the RATS (i.e. reasonably anticipated trading size), and if different portions of a holding have various liquidity profiles (e.g. partial hedge).

I was partially expecting to see the SEC address one more complicated and confusing part of the rule in this reopening...

I was partially expecting to see the SEC address one more complicated and confusing part of the rule in this reopening... the handling of classifications for Futures, Forwards and Mortgage TBAs. By means of background, the rule requires certain funds to classify all of their holdings into one of 4 categories based on the number of days it takes to liquidate the holding or how long it takes to convert to cash (inclusive of settlement date): Highly Liquid, Moderately Liquid, Less Liquid or Illiquid.

Based on some of my conversations, many funds are struggling with what this means for holdings such as Mortgage TBAs or long-dated issues. With the opening stated goal of "reducing the risk that funds will be unable to meet their redemption obligations and mitigating dilution of the interests of fund shareholders", these investments cannot be used to help meet shareholder redemptions since cash is generally not paid upfront — rather the fund incurs an account payable at the time of creation of the exposure. Therefore, upon selling or unwinding this position, nothing is converted to cash — only an offsetting account receivable that is netted against the payable upon the long-dated settlement date.

There are two ways to think about highly "liquid" futures and certain long-dated Mortgage TBAs:

  1. The resulting profit or loss associated with unwinding the position does not settle within seven days, thus it would be classified as Less Liquid under the rules; or
  2. Generally a small initial margin payment is required upon entering into the trade, and that margin payment gets released upon the netting or unwinding of the position which would make these instruments classified as Highly Liquid

Given that a portfolio manager or trader can typically, with a single phone call or click of a button on an electronic trading platform, execute hundreds of millions of dollars' worth of these instruments on the wire, many in the industry find it difficult not to call these instruments highly liquid. My belief is that either these instruments should be exempt from the classification requirements, or additional flexibility or guidance should be provided by the SEC on the appropriate way to handle something that cannot, by definition, be "converted to cash".

Find out how ICE Data Services can help you navigate the SEC's Liquidity Risk Management Rule.

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