Senator Sherrod Brown (D-OH) urged the SEC to finalize its recently proposed rules concerning liquidity risk for open-end funds and derivatives use by investment companies, and offered several recommendations for improving market transparency and stability.
Senator Brown recommended that the SEC:
- consider providing more explicit instructions on how to (i) classify assets and (ii) determine whether a fund's asset classification is reasonable;
- implement procedures for enhancing the analysis of fund data and disclosures;
- complement the fund liquidity rule by finalizing a "strong rule" regarding the use of derivatives by investment companies;
- consider issuing "additional guidance for fund managers as part of the proposed rule on derivatives," particularly with respect to assessing and determining the risk-based coverage amount of segregated assets; and
- require the use of clear and risk-based coverage amounts predicated on a prescribed methodology, and, wherever possible, provide uniform guidance on how to determine stressed conditions.
Senator Brown urged the SEC to "remain focused on preventing potential threats to financial stability arising from illiquid market conditions or excessive leverage."
Commentary
Because mutual funds are the primary means by which retail investors access the securities market directly, the cost impact of these rules largely will fall on such investors, since it will reduce the returns they receive on their holdings of mutual funds. Accordingly, the regulators should consider the following questions: (i) are the costs appropriate, (ii) are the quantitative tests that are imposed by the regulations good measures of risk, or are they so crudely constructed that they end up increasing risk by discouraging the use of derivatives to hedge, and (iii) will the costs end up driving investors into the private fund market? In short, regulators must always remember that regulation is a two-edged – and perhaps even a three-edged – sword.
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