By Rob Daly

OPINION: Liquidity Risk Rule Leads to Systemic Risk

What the U.S. Securities and Exchange Commission plans for the mutual fund industry with its proposed liquidity risk rule truly cannot be a called an October Surprise, since the regulator first raised its trial balloon in September 2015.

The proposal, known as the Rule on Open-End Fund Liquidity risk, would require fund administrators to divide the assets of all their portfolios into multiple tiers based on liquidity risk and then keep a certain percentage of those assets in instruments that they could unwind within three days without affecting to respective markets.

Other portions of the proposed rule also would require additional reporting by the fund administrators as well as permit fund administrators to use swing-through pricing, which would allow them to pass transaction costs to the clients who are redeeming shares.

It’s not certain the regulator will seek to adopt this proposal in October, but certainly by the end of this year, not counting on divine or political intervention.Its timing is too close to the US presidential election and senators and representatives will have other things on their mind.

The upshot will be those fund administrators should be prepared to invest approximately $1.4 billion in the rule’s first year and then $240 million annually.

The surprising thing about the rule is that the SEC believes that most administrators will be able to meet their three-day reserve requirement without having to enter or exit any new positions.

Since the rule goes into effect 18 months after it is entered into the Federal Register if the great unwinding of illiquid credit positions has not happened by April 2018 then that is when it will happen.

Fund managers theoretically build up their positions of liquid assets to offset their illiquid assets, but that would require an influx of capital and would increase the amount of risk that they are going to carry on their balance sheets.

When the SEC approves this rule, it will be lighting a very long fuse on the credit market.

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