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Notes on the SEC’s Proposal on Mutual Fund Liquidity

Mutual Fund Liquidity

I'm still working through the SEC's proposal on Mutual Fund Liquidity, which I mentioned at the end of this article:

Q: Are you going to write anything regarding the SEC's proposal on open end mutual funds and ETFs regarding liquidity?

A: …my main question to myself is whether I have enough time to do it justice. There's their white paper on liquidity and mutual funds. The proposed rule is a monster at 415 pages, and I may have better things to do. If I do anything with it, you'll see it here first.

These are just notes on the Mutual Fund Liquidity proposal so far. Here goes:

1) It's a solution in search of a problem.

After the financial crisis, regulators got one message strongly — focus on liquidity. Good point with respect to banks and other depositary financials, useless with respect to everything else. Insurers and asset managers pose no systemic risk, unless like American International Group Inc (NYSE:AIG) they have a derivatives counterparty. Even money market funds weren't that big of a problem — halt withdrawals for a short amount of time, and hand out losses to withdrawing unitholders.

The problem the SEC is trying to deal with seems to be that in a crisis, mutual fund holders who do not sell lose value from those who are selling because the Net Asset Value at the end of the day does not go low enough. In the short run, mutual fund managers tend to sell liquid assets when redemptions are spiking; the prices of illiquid assets don't move as much as they should, and so the NAV is artificially high post-redemptions, until the prices of illiquid assets adjust.

The proposal allows for “swing pricing.” From the SEC release:

The Commission will consider proposed amendments to Investment Company Act rule 22c-1 that would permit, but not require, open-end funds (except money market funds or ETFs) to use “swing pricing.”

Swing pricing is the process of reflecting in a fund's NAV the costs associated with shareholders' trading activity in...