Vendors Accused of Over-Promising on Liquidity Rule

On October 13, 2016, the US Securities and Exchange Commission (SEC) released its final rule to “promote effective liquidity risk management throughout the open-end fund industry, thereby reducing the risk that funds will be unable to meet redemption obligations and mitigating dilution of the interests of fund shareholders.” It set a go-live date for December 1, 2018.

These liquidity rules, as they have come to be known, require that fund managers classify holdings in four buckets that are designed to segment the assets based on the length of time that it would take to convert them to cash—highly liquidity, moderately liquid, less liquid, and illiquid. When the SEC first proposed these new liquidity rules back in September 2015, the agency had suggested six buckets. Based on feedback from the industry, that number was chopped down to four. 

But one area where feedback from industry participants—and, specifically, vendors—may have ultimately hindered the final rule was when it came to liquidity reporting for fixed-income products, according to panelists at this year’s Risk USA conference, held in New York on October 25.

Charles Bragg, US chief risk officer for UBS Asset Management, said that while the final rule that came out was better than what was originally proposed, they are still struggling with how to go about bucketing fixed-income assets, and whether they should build that functionality internally or turn to the vendor community, whom, he contended, over-sold their ability to produce accurate and detailed information relating to fixed-income liquidity.

“Two years ago I sat on a panel with someone from the SEC who helped craft the rule and their interpretation at the time was that the vendors had perfect information for fixed income—maybe not perfect, but very solid data that could easily incorporate the rules,” said Bragg. “I can tell you that in the conversations that we’ve had with some of the external vendors, they’re not quite there. I think there’s been significant progress on that, but I think that’s going to be a challenge for the industry—how you build out that reporting, and right now we’re looking at both an internal solution and [a solution from a third-party vendor].”

Matthew Halperin, independent global risk officer at MFS Investments, concurred with Bragg’s view of the vendor community and said that that’s why the SEC has been taking a longer-than-expected time to deliver updates to the final rules. He added that he hoped that the SEC would give an extension. 

“I agree, [the SEC] thought the vendors were all turnkey and ready,” Halperin said. 

He added that MFS has been calculating liquidity for a number of years and, as such, they will have to retrofit their systems to meet the new rule. Additionally, these rules present an “IT plumbing problem” because they will have to work out how to move around data between the four buckets. 

“If you are a subadvisor for another firm, you have to work with that other firm. I may have my way of wanting to bucket something, but the chief risk officer [at the other firm] might want to do something else. So I then have to have a record of [for example] bucket two is MFS, bucket one is Genworth. That is a challenge that a lot of us are working through and it’s going to take some time,” he said. 

‘The Illusion of Precision’

Halperin said that classifying fixed income is a challenge that requires external help. Essentially, he said, you have to infer liquidity based on what you’ve pulled out of the trade and what’s out there in the market. To this, he said that generally, all the vendors have a similar solution. 

“I think that the SEC is really underestimating what’s happening here, and how much it’s just an expectation and a judgment and a statistical exercise to figure out liquidity in fixed income,” Halperin said. “Back in the early days or mortgages, we used to talk about ‘the illusion of precision’ in mortgage prepayment modeling. I think it’s the same thing here—we’re going to have the illusion of precision on liquidity. But we’ll be able to fill in the numbers and file the forms.”

To do this, his firm has turned to an undisclosed third-party provider, not necessarily because its functionality is exceptional, but more because this is a big data problem that it does not have the resources to deal with. 

“I’m choosing external because it’s a big-data management exercise and there’s no value in me doing it just for myself and coming up with a slightly better tweak on the statistical inference of liquidity,” he said. “I’d just as soon have one of the half-dozen vendors that are out there [do it]; they’re out there deploying the data, scrubbing the data, running statistics, and they have the team of analysts and statisticians that can do it on a regular basis. I can hire those folks, but that isn’t how I want to do liquidity, so there’s no value in it for me in doing that.”

Bragg, who has been at UBS for over 20 years and originally started on the investment bank side of the organization, said that asset managers across the board—and not just at UBS—generally have fewer resources to work with. As a result, most asset managers in the space are working with external providers—in UBS Asset Management’s case, they use MSCI for its fixed income market risk monitoring—because they have limited staff to deal with these rules. 

“To the point of data management, do I with a really—with a very limited staff—want to spend all my time managing data, or do I want my small teams actually analyzing and reporting on that? That to me is a key element,” he said. “I think there’s a genuine desire to outsource that, but there are a lot of people concerned that at this stage of the game—13, 14 months out to implementation—[the industry is wondering if] we are really there.”