Sec Speeches Cryptocurrency Closing Act: Statement on Proposed Open-End Fund Liquidity Risk Management Programs and Swing Pricing; Form N-PORT Reporting

Thank you, Mr. Chair. I cannot support even releasing this proposal for comment. At a time when so much of our rulebook is up for discussion, nobody has the bandwidth to consider properly a proposal that would fundamentally alter the way open-end funds operate, how investors interact with them, and the infrastructure surrounding them. Yet the Commission is poised to kick off such consideration today and to wrap it up early in the New Year when the sixty-day comment period ends.

Open-end funds are among the most important financial market innovations. They have been central to the financial portfolios of generations of Americans. As the proposing release notes, more than 102 million Americans owned these funds at the end of last year, and the funds were valued at $26 trillion.[1] Open-end funds make capital available to companies across the country and across the world.

In 2016, the Commission adopted a liquidity risk management rule. The Commission amended that rule in 2018, and now we are back at the drawing board with an eraser and bold marker at the ready. Our explanation for the changes being proposed is March 2020, a time of great stress across the financial markets and the broader economy. Many funds suffered outflows. The Proposing Release asserts that shareholders who remained in the funds suffered as the funds’ liquid assets were depleted and other assets had to be sold to meet redemptions. This one month taught us, the Release suggests, that open-end funds are a threat to long-term investors and–channeling our friends at the Financial Stability Oversight Council–financial stability. The proposed remedy is an overhaul of our liquidity regime, the institution of mandatory swing-pricing, and a hard close to support swing pricing.

Among the proposed changes are shifting the liquidity buckets, requiring funds to assume a stressed trade size of 10% of each of the fund’s portfolio investments when determining liquidity, establishing fixed standards for determining significant market value impact, and requiring funds to classify their portfolio investments each business day, instead of monthly.

And then there is mandatory swing pricing. . . . This part of the proposal is stunning in light of the stone-cold reception the proposal to require swing pricing for money-market funds received. They, along with exchange-traded funds (“ETFs”) get a pass in this proposal. The stated aim of swing pricing is to reduce dilution of non-transacting fund shares and lower potential first-mover advantages, especially when the market is volatile.

The 2016 liquidity reforms gave US registered open-end funds the authority to use swing pricing,[2] but they have not used it. The Commission has decided that swing pricing is just too valuable a tool to leave unused at the bottom of the junk drawer, and looks to Europe for encouragement. The Commission finds confidence in Europe’s experience with swing pricing. Swing pricing, however, is voluntary there and we have different “intermediary structures between funds and their investors,”[3] different “regulatory frameworks and investor base,”[4] and “the European mutual fund sector does not depend as much as the U.S. mutual fund sector on pension plans.”[5]

Since industry has failed to make the changes to allow for swing pricing’s implementation in the US, the Commission will simply have to do the job for them by instituting a hard close. At present, a fund shareholder’s order to purchase or redeem shares will be executed at the current day’s price if the intermediary receives the order before the fund’s established time for calculating its net asset value, usually 4 o’clock eastern time. The fund might not receive the order flow information until as late as the next morning.[6] Swing pricing, however, is dependent upon the fund or one of its service providers, such as a transfer agent or a registered clearing agency, receiving order flow information prior to the establishment of that day’s share price to allow the fund to determine whether to implement the swing factor, and if so, how large it should be. The Proposing Release offers a solution: “[i]ntermediaries would need to reengineer their systems to ensure disseminated order information reaches the transfer agent or Fund/SERV before 4 p.m.”[7] Such a hard close would have cascading consequences; some intermediaries likely would set their own internal cut-off times — including adopting a blanket policy of processing orders at the next day’s price.[8] Retirement plan recordkeepers, the Release admits, could have a particularly rough transition.[9] It would not just be fund administrators and intermediaries who would have to alter their current practices and expectations, investors interested in securing same-day pricing would have to adjust too, but the Commission thinks it’s worth it.[10]

Dilution may occur and is more likely in volatile times, but the solution we are proposing today may cost fund investors more than the dilution does. We have other options. First, investors concerned about dilution can invest in ETFs. Second, we could empower each fund to analyze, based on its own portfolio holdings and investor base, the need for anti-dilution tools and to craft the tool that would work best for it. Funds could compete for investors concerned about dilution based on the efficacy of their anti-dilution tools. The release offers several alternatives, including a simplified liquidity fee.[11] If a fund chose to implement it, a simplified liquidity fee could apply to all redemption orders and be processed as part of a transaction, without the need for the Commission to upend the current order flow regime.[12] A heterogeneous, market-driven approach would contribute to a more resilient system; funds would not all be doing exactly the same thing during volatile periods. I hope that commenters will help us think about different options for addressing dilution concerns, along with weighing in on the proposed changes.

Today’s proposed amendments to the Commission’s liquidity management and swing pricing rules resemble less a series of regulatory initiatives than an essay on Greek tragedy. In Poetics,[13] Aristotle painstakingly lays out and analyzes the elements of a quality Greek tragedy.[14] For example, Aristotle instructs that “A perfect tragedy should be arranged not on the simple but on the complex plan.”[15] We have taken that message to heart. The hallmark of Greek tragedy is the protagonist’s downfall, “brought about not by vice or depravity, but by some error or frailty.”[16] The Commission’s flaw is hubris—thinking we can redesign open-end funds to eliminate their purported flaws has only revealed our own. In a significant departure from Aristotle’s six elements, however, it will not be the hero who suffers – the Commission will be just fine, thank you – it will be fund investors, administrators, and intermediaries who will pay the price should this tragedy unfold. Although I expect my plea will come too late, Aristotle wrote that “without action there cannot be a tragedy,”[17] so there is still time to reconsider the wisdom of proposing these measures.

As my colleagues ponder that option, I offer my thanks to the staff of the Divisions of Investment Management, Economic and Risk Analysis, and Examinations, and the Offices of the Chief Accountant and General Counsel. Although I am unable to support today’s proposal, I appreciate all of the work and effort staff has expended on an extremely complex rulemaking. I am particularly grateful for the time you took to discuss my questions and concerns. As always, I look forward t