SEC Liquidity Risk

SEC Liquidity Risk rule 22e-4

A fundamental feature of open-end funds is that they allow investors to redeem their investment daily. Funds need to maintain sufficiently liquid assets in order to meet their redemptions, whilst minimizing the impact on the fund’s remaining investors.

Liquidity Risk Management Program

Rule 22e-4 requires funds, including ETFs, to establish a Liquidity Risk Management Program (LRMP) which is required to include multiple elements, including:

  • Assessment, management, and periodic review of a fund’s liquidity risk
  • Classification of the liquidity of fund portfolio investments
  • Determination of a highly liquid investment minimum
  • Limitation on illiquid investments
  • Board oversight

Managing Fund Liquidity Risk

Funds are required to assess, manage, and periodically review their Liquidity Risk, based on specified factors. Liquidity Risk is defined as the risk that a fund could not meet redemptions without significant dilution of remaining investors’ interests in the fund.

Part of the LRMP will be to establish what dilution is acceptable for the fund.

Liquidity Buckets

Each fund is required to classify each of its holdings monthly at least. The classification is based on the number of days in which the fund reasonably expects to convert a holding to cash (or sold or disposed of) in current market conditions without significantly changing the market value of the holding. Funds are required to classify each holding into one of four liquidity categories:

  • Highly Liquid – can convert to cash, by disposal and settlement, within 3 business days
  • Moderately Liquid – can convert to cash in 4 to 7 calendar days
  • Less Liquid – can dispose of holding within 1 week, but settlement will take longer
  • Illiquid – cannot dispose of holding within 1 week

The percentage of the fund’s net assets in each Liquidity Bucket is to be calculated and reported to the SEC monthly using form N-PORT.

Highly Liquid Investment Minimum

A fund is required to determine a minimum percentage of its net assets that must be held in Highly Liquid investments. The fund is also required to implement policies and procedures for responding to a shortfall, which must include board reporting.
Funds that primarily hold assets that are highly liquid investments and funds that meet the definition of in-kind ETF under the rule are not subject to this requirement.

15% Illiquid Investment Maximum

A fund is not permitted to purchase additional illiquid investments if more than 15 percent of its net assets are Illiquid. If a fund breaches the 15 percent limit, the occurrence must be reported to the board, along with an explanation of how the fund plans to bring its illiquid investments back within the limit within a reasonable period of time. A fund must notify breaches to the SEC using form N-LIQUID.

Board Oversight

A fund’s board, including a majority of the fund’s independent directors, is required to approve the fund’s Liquidity Risk Management Program and the designation of the fund’s adviser or officer(s) to administer the program. The fund’s board also is required to review, at least annually, a written report on the adequacy of the program and the effectiveness of its implementation.