Discussion summary

Liquidity Working Group

On February 23, 2017, ICE Data Services hosted a Liquidity Working Group. The briefing included an update on certain industry and regulatory developments, as well as discussion of ICE Data Services initiatives addressing the measurement and management of liquidity by funds. The venue provided an opportunity for clients to share liquidity-related observations, concerns and questions with peers, and for ICE Data Services to deepen our understanding of the concrete challenges our clients face when managing liquidity risk. This working group program reflects our ongoing commitment to collaborate with the funds industry as we set out to collectively develop best practices supporting critical industry objectives.

The Regulatory State of Affairs

The session began with a regulatory briefing provided by Hope Jarkowski, co-head of government affairs, Intercontinental Exchange, Inc., punctuated by questions from the audience. Jarkowski discussed the outlook for legislative, regulatory and executive branch initiatives in a number of areas of interest to fund companies, current and future SEC regulations and the composition of the SEC. Among the points she addressed:

SEC Liquidity Risk Management Program Update

The SEC requirement that funds implement liquidity risk management programs is likely to reinforce the industry’s growing use of formal, technology-enabled criteria and tools to assess liquidity of securities and portfolios, as a supplement to the traditional emphasis on the judgment of a fund’s traders and portfolio managers.

“While actively engaging in research and developing out our approach to measuring liquidity over the years, we have regularly sought industry feedback as a source of validation and potential insights,” explained Rob Haddad, Head of Product Strategy and Innovation, ICE Data Services. As a result of this dialogue, ICE Liquidity Indicators is designed to support a multitude of liquidity risk management needs in the financial markets, and is currently being leveraged to assist firms complying with the SEC’s new rule. Haddad highlighted how several of the current features now available in the product, and certain new features planned to be released in the coming months, are a direct response to insights gleaned during working group sessions like these.

Working group participants noted that measuring and managing portfolio liquidity is more than a static process. When market conditions depress a fund’s liquidity profile, internal risk management guidelines or external regulatory requirements may drive the portfolio manager to seek to regain liquidity by adjusting the fund’s holdings. Further, working group members described the use of liquidity risk measurement tools are not isolated to the regulatory compliance and risk management functions, but are expected to be integrated within portfolio management workflows in some fashion. At a minimum, the group has experienced the involvement from portfolio management as an important validation step as part of the due diligence process when analyzing a liquidity solution’s methodology, coverage, quality, and functionality at the security and portfolio level. Participants in the Liquidity Working Group discussion raised the following questions and viewpoints when discussing the SEC Liquidity Risk Management Rule:

  • How much time will the SEC allow for a fund to bring its holdings of “highly liquid” assets back above the fund’s stated minimum, after a breach?
  • On the opposite end of the liquidity spectrum, how long will a fund be allowed to get its illiquid asset holdings back under the 15% maximum after a break above that level?
  • Factors beyond a fund’s control, such as market activity or a spike in redemptions, can drive a portfolio’s highly liquid asset holdings beneath a threshold. In that case, a fund that was managing its liquidity effectively could be forced to buy or sell assets to restore a calculated liquidity level, solely due to market movement or shareholder redemptions.
  • When a spike in redemptions diminishes the liquidity of a fund’s remaining assets, it can be difficult to restore liquidity to a desired level by altering portfolio composition when the fund doesn’t know how long redemptions will continue to exceed typical levels.

Additionally, feedback surrounding the practical implementation steps and timelines supporting compliance with the SEC Liquidity Risk Management Rule included:

  • Generally, funds boards are leaning on management to formulate project plans and propose an implementation schedule to the board.
  • Several fund companies are already using a liquidity risk measurement solution, or actively testing, to support preparations ahead of the implementation date for the SEC Liquidity Risk Management Program.
  • From those firms actively testing, general consensus around implementing a liquidity risk measurement solution is likely to take place in the second half of 2017, following board approval.
  • It was noted that since the SEC Report Modernization Rule (Forms N-PORT and N-CEN) takes effect six months prior to the SEC Liquidity Risk Management Rule, and forms N-PORT and N-CEN require funds to disclose portfolio liquidity buckets, the timeline for complying with the Liquidity Risk Management Rule is effectively reduced by six months (i.e., with the stated date of December 2018 moving up to June 2018 for large fund companies with over $1B in AUM).
  • Further, it was noted that all reports filed on Form N-PORT to the SEC will be nonpublic for the first six months following June 1, 2018, while public disclosure of the third month of the quarter of these filings will not take effect until December 2018 -- which the Liquidity Working Group considered akin to a “dress rehearsal” for funds.

Update on ICE Liquidity Indicatorstm

While the Liquidity Working Group discussion evolved into more specific points of the SEC rule, Haddad demonstrated several new features of ICE Liquidity Indicators, beginning with the enhanced stress testing package enabling user-defined adjustments to key security assumptions (e.g., bid-ask spreads, volatility assumptions, etc.) - showing how perceived portfolio liquidity can dynamically change in light of scenario analysis. Haddad further illustrated new features designed to support key aspects when clients are determining where a security position fit within the four aggregate portfolio liquidity buckets (i.e., Highly Liquid, Moderately Liquid, Less Liquid, and Illiquid). Importantly, these features incorporate the security-level liquidity modeling process, while tailoring the fund’s viewpoint on acceptable market price impact, reasonable trade size (RTS) setting, percentage of projected trade volume capture, and other stress settings, in order to generate portfolio-level liquidity bucket categories.

Haddad also described how the service can be used to compare and rank peer funds in terms of portfolio-level liquidity. Haddad presented a chart displaying liquidity scores for 46 U.S. high yield corporate mutual funds during 2015. The chart clearly distinguished two funds as less liquid than all the rest in the beginning of 2015, and degraded even further by the end of 2015 during a market sell-off in commodities and energy, relative to their peer funds which appeared to exhibit fairly stable liquidity profiles. One of the two subsequently suffered a widely publicized failure in December 2015, suspending redemptions and transferring all its assets to a liquidating trust. “We would never claim our Liquidity Indicators can predict when a fund is about to fail,” Haddad said. “Rather, it’s a way to help clients identify a potential area of risk exposure.”

Looking Ahead

ICE Data Services and Donnelley Financial Solutions are working together to develop a service for U.S. mutual funds to submit portfolio data to the SEC for the new Form N-PORT under the SEC’s Investment Company Reporting Modernization rules adopted in October 2016. Form N-PORT requires extensive data on liquidity of a fund’s holdings, along with other data. The planned service will route ICE data on funds’ holdings to be submitted to the SEC via the Donnelley platform. Content will come from existing ICE Data Services products along with new content we will create specifically for Form N-PORT.

We look forward to continuing the dialogue with you on topics related to liquidity, as part of our regular interactions with clients and at industry events. A panel discussion on liquidity risk management for funds is on the agenda for our annual Funds Advisory Board (FAB) conference on May 16 in New York, which you are invited to attend.

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