Liquidity and the Law of Unintended Consequences

The SEC issued two important regulatory proposals during the past several months, the first of which was released in September 2015 and is designed to "enhance effective liquidity risk management" for mutual funds and exchange-traded funds. Among other things, the proposed regulations would shine a light on the liquidity characteristics of fund holdings, while also mandating that a portion of each portfolio be easily liquidated within three days without triggering big price losses.

The second proposal was released a couple of months later and is meant to "enhance the regulation of the use of derivatives" by registered investment companies, a term that includes mutual funds, ETFs, and closed-end funds. This proposal would require funds to comply with one of two rules designed to limit the amount of leverage they can develop with derivatives. The first rule would cap a fund's exposure to certain kinds of transactions (including derivatives) at 150% of net assets. The second would allow for exposure up to 300% but would require the use of a so-called value-at-risk test that would ensure a fund was taking on less market risk than if the fund did not use derivatives.

The overall proposals have plenty of merit. There is too much opacity in mutual funds in terms of both liquidity and derivatives exposure. The liquidity proposal is particularly well-timed given sharply changing regulatory and market conditions since the 2008 financial crisis. Meanwhile, regulation of derivatives exposure has been a topic of concern ever since derivatives first began to proliferate in fund portfolios. Morningstar's Public Policy Council has formulated and filed official responses to both proposals, and this column doesn't purport to represent Morningstar's official views on either. (The SEC has made all public comments available for the liquidity and derivatives proposals.)

A Surprising Feature of Derivatives While the first proposal is designed to ensure that portfolios maintain plenty of liquidity, the second has the potential to discourage fund managers from using tools that can typically help in that effort. That's because for all of the negative connotations associated with derivatives, they can often be much more liquid than bonds themselves. Take credit default swaps, for example. There are several ways to measure liquidity, but one of the simplest is to look at trading volume. In recent trading for both individual issuers and larger slices of the U.S. corporate-bond market, the volume of credit default swaps written regularly exceeded those for all U.S. corporate cash bonds. In part, that's because derivatives are more popular with many investors who don't have to find actual bonds to buy or sell; scarcity in a particular name could make that task difficult and time consuming. Moreover, entering into a derivative contract generally doesn't require an investor to come up with anywhere near the same amount of cash that would be necessary to purchase a bond outright. That's particularly important as broker/dealer and bank balance sheets have become increasingly constrained.

Ironically, it was the financial crisis itself that highlighted the better liquidity characteristics of many derivatives, including credit default swaps. As the crisis threatened the banks at the foundation of the capital markets, bond trading became extremely difficult and in some cases froze entirely. Outside of the super high-quality and liquid U.S. Treasury market, most bond prices plummeted. Derivatives tracking those bonds or their markets sold off, too, but because they could be much more easily traded, many of them maintained higher valuations than the bonds to which they were linked.

Definitely Worthy of SEC Attention As mentioned earlier, there are excellent reasons for the SEC to take on these issues. The cause is a matter of some debate, but most observers in the industry agree that banking regulations implemented since the 2008 financial crisis have inadvertently hurt liquidity in the bond market. And though high-profile liquidity troubles among mutual funds, such as those of Third Avenue Focused Credit, are extremely rare, it makes perfect sense for the SEC to get ahead of the issue and provide a framework and guidance for fund companies to both manage portfolio liquidity and provide information that investors can use to evaluate risks in their portfolios.

And while derivatives have arguably taken an inordinate share of the overall blame for the financial crisis, they too deserve a lot more scrutiny when it comes to their use, and disclosure thereof, in mutual funds. As the SEC's derivatives proposal notes, it's very easy for funds to develop leverage using derivatives, and until now, there have been very few limits on that activity or effective rules for how to disclose those exposures in a way that investors can analyze and understand. Indeed, Morningstar has called on the SEC to improve the standardization and frequency of portfolio disclosure so that investors can better understand the characteristics of their fund holdings, including derivatives.

Of course, both proposals are essentially first drafts, and if they're implemented, the final versions could look quite different. Even in their current form, it's not entirely clear what the implications could be for the construction of bond portfolios. But if the end result is that new rules make it significantly more difficult for funds to use derivatives in order to maintain or improve their liquidity, it would be an unfortunate consequence of a proposal that would otherwise provide important protections for investors.